Part I. Rulings — Internal Revenue Bulletin 2000-6

IRS and Treasury issued final regulations under sections 367(a) and (b) (the 1998 regulations). The 1998 regulations addressed transactions under section 367(b) only to the extent the transactions are also subject to the stock transfer rules of section 367(a). Thus, the 1977 regulations have remained in effect to the extent not superseded by the 1998 regulations. The preamble to the 1998 regulations stated that the IRS and Treasury would issue guidance at a later date to address the portions of the 1991 proposed regulations related to section 367(b) that were not addressed in the 1998 regulations.

After consideration of the 1977 regulations and their updates and amendments, the 1991 proposed regulations and their updates and amendments, the 1998 regulations, and all comments received with respect to such regulations, the IRS and Treasury adopt §§1.367(b)–1 through 1.367(b)–6 as final regulations under section 367(b).

Overview

A . General Policies of Section 367(b)

Section 367(b) governs corporate restructurings under sections 332, 351, 354, 355, 356, and 361 (except to the extent described in section 367(a)(1)) in which the status of a foreign corporation as a “corporation” is necessary for application of the relevant nonrecognition provisions. Section 367(b) provides that a foreign corporation that is a party to one of the enumerated nonrecognition transactions shall be respected as a corporation, and thereby the parties involved in the transaction shall obtain the benefits of the applicable nonrecognition exchange provisions and their related provisions (such as section 381) (together, the Subchapter C provisions), except to the extent provided in regulations.

The principal purpose of section 367(b) is to prevent the avoidance of U.S. tax that can arise when the Subchapter C provisions apply to transactions involving foreign corporations. The potential for tax avoidance arises because of differences between the manner in which the United States taxes foreign corporations and their shareholders and the manner in which the United States taxes domestic

Section 42.—Low-Income Housing Credit

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of February 2000. See Rev. Rul. 2000–9, page 497.

Section 280G.—Golden Parachute Payments

Federal short-term, mid-term, and long-term rates are set forth for the month of February 2000. See Rev. Rul, 2000–9, page 497.

Section 367.—Foreign Corporations

26 CFR 1.367(a)–3: Treatment of transfers of stock or securities to foreign corporations.

T.D. 8862

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 1, 7, and 602

Stock Transfer Rules

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

SUMMARY: This document contains final regulations addressing the application of nonrecognition exchange provisions in Subchapter C of the Internal Revenue Code to transactions that involve one or more foreign corporations. These regulations provide guidance for taxpayers engaging in those transactions in order to determine the extent to which income shall be included and appropriate corresponding adjustments shall be made.

DATES: Effective Date . These regulations are effective as of February 23, 2000. Applicability Dates . These regulations apply to section 367(b) exchanges that occur on or after February 23, 2000. However, taxpayers may choose to apply these regulations to section 367(b) exchanges that occur before February 23, 2000, as specified in §1.367(b)–6(a)(2).

FOR FURTHER INFORMATION CONTACT: Mark D. Harris, (202) 622-3860 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained in these final regulations have been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under control number 15451271. Responses to these collections of information are mandatory.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid control number.

The estimated average annual reporting burden in these final regulations is 4 hours.

Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be sent to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, OP:FS:FP, Washington, DC 20224, and to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503.

Books or records relating to these collections of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103.

Background

On December 27, 1977, the IRS and Treasury issued proposed and temporary regulations under section 367(b) of the Internal Revenue Code (Code). Subsequent guidance updated and amended the 1977 temporary regulations (the 1977 regulations) several times over the next 14 years. On August 26, 1991, the IRS and Treasury issued proposed regulations §§1.367(b)–1 through 1.367(b)–6 (the 1991 proposed regulations). Comments to the 1991 proposed regulations were received, and a public hearing was held on November 22, 1991. In June of 1998, the

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all earnings and profits amount results in the taxation of previously unrepatriated earnings accumulated during a U.S. shareholder’s (direct or indirect) holding period. This income inclusion prevents the conversion of a deferral of tax into a forgiveness of tax and generally ensures that the section 381 carryover basis reflects an after-tax amount. However, the all earnings and profits amount inclusion does not consider tax attributes that accrue during a non-U.S. person’s holding period.

Commentators criticized the scope of the 1991 proposed regulations, arguing that the all earnings and profits amount should be limited to the amount that a shareholder would include in income as a deemed dividend under section 1248. The scope of the all earnings and profits amount is broader than the section 1248 amount because, for example, the all earnings and profits amount is calculated without regard to whether the foreign corporation is a CFC and without regard to a shareholder’s gain in the stock. However, this view too narrowly construes the role of section 367(b) by focusing on potential shareholder-level consequences without adequately considering the section 367(b) policy of determining the appropriate carryover of corporate-level attributes in inbound nonrecognition transactions. Thus, the final regulations retain the 1991 proposed regulations’ definition of all earnings and profits amount. The final regulations also generally retain (subject to a new de minimis exception) the taxation of all exchanging U.S. shareholders in inbound nonrecognition transactions.

In finalizing these regulations, the IRS and Treasury considered whether future section 367(b) regulations should limit the extent to which tax attributes carry over from foreign to domestic corporations. Such a limitation would more directly implement the section 367(b) policy related to the carryover of attributes and, as a result, reduce the class of U.S. persons required to have an income inclusion in connection with an inbound nonrecognition transaction. Such a limitation would also enable the section 367(b) regulations to address the carryover of attributes attributable to a non-U.S. person’s holding period. The IRS and Treasury request comments as to the merits of an attribute carryover limitation, as well as

corporations and their U.S. shareholders.

The Subchapter C provisions generally have been drafted to apply to domestic corporations and U.S. shareholders, and thus do not fully take into account the cross-border aspects of U.S. taxation (such as deferral, foreign tax credits, and section 1248). Section 367(b) was enacted to help ensure that international tax considerations in the Code are adequately addressed when the Subchapter C provisions apply to an exchange involving a foreign corporation. Because determining the proper interaction of the Code’s international and Subchapter C provisions is “necessarily highly technical,” Congress granted the Secretary broad regulatory authority to provide the “necessary or appropriate” rules, rather than enacting a complex statutory regime. H.R. Rep. No. 658, 94 ^th Cong., 1 ^st Sess. 241 (1975). Accordingly, as the preamble to the 1991 proposed regulations stated, the section 367(b) regulations require adjustments or inclusions in order to prevent the material distortion of income that can occur when the Subchapter C provisions apply to an exchange involving a foreign corporation. The 1991 proposed regulations simplified the 1977 regulations and were generally favorably received by taxpayers. The final regulations adopt the 1991 proposed regulations with modifications. The modifications are based on further considerations of fairness, simplicity, and administrability.

The final regulations also incorporate the section 367(b) rules contained in the 1998 regulations. The 1998 regulations finalized portions of the 1991 proposed regulations to the extent necessary to address the overlap between section 367(b) and the section 367(a) stock transfer rules. Because the scope of the final regulations is broader than that overlap, the final regulations adopt the 1998 section 367(b) provisions in a manner appropriate to their incorporation into the final regulations.

The IRS and Treasury are also issuing other guidance under section 367(b). Temporary and proposed regulations (T.D. 8862, page 466 and REG–116048–99, page 584) address the elimination of an election available to certain taxpayers under the 1977 regulations and the 1991 proposed regulations. In addition, the IRS and Treasury intend to issue other proposed regula

tions that provide rules regarding the combination and separation of corporate-level tax attributes in applicable section 367(b) exchanges.

B. Specific Policies in Context of Inbound Nonrecognition Transactions

Section 1.367(b)–3 addresses transactions in which a foreign corporation transfers assets to a domestic corporation pursuant to a Subchapter C provision. These transactions include a section 332 liquidation of a foreign corporation into a domestic parent corporation and an asset reorganization, such as a C, D or F reorganization, of a foreign corporation into a domestic corporation (inbound nonrecognition transactions). Section 381 generally provides rules regarding the extent to which corporate attributes carry over in such transactions.

The principal policy consideration of section 367(b) with respect to inbound nonrecognition transactions is the appropriate carryover of attributes from foreign to domestic corporations. This consideration has interrelated shareholder-level and corporate-level components. At the shareholder level, the section 367(b) regulations are concerned with the proper taxation of previously deferred earnings and profits. At the corporate level, the section 367(b) regulations are concerned with both the extent and manner in which tax attributes carry over in light of the variations between the Code’s taxation of foreign and domestic corporations.

The section 367(b) regulations have historically focused on the carryover of earnings and profits and bases of assets, simultaneously addressing the shareholder and corporate level concerns by accounting for any necessary adjustments through an income inclusion by the U.S. shareholders of the foreign acquired corporation (and without limiting the extent to which the domestic acquiring corporation succeeds to the attributes). The 1991 proposed regulations required a U.S. shareholder of the foreign acquired corporation (or, in certain cases, a foreign subsidiary of the U.S. shareholder) to currently include in income the allocable portion of the foreign acquired corporation’s earnings and profits accumulated during the U.S. shareholder’s holding period (all earnings and profits amount). The requirement to include in income the

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ples of section 1248 for purposes of determining the all earnings and profits amount, the requirements of section 1248 unrelated to computing the amount of earnings and profits attributable to a shareholder’s block of stock should not apply. The final regulations explicitly state this principle. The 1991 proposed regulations applied this principle, for example, when they provided that the all earnings and profits amount is calculated without regard to whether the foreign corporation is a controlled foreign corporation (CFC). The final regulations further specify that the all earnings and profits amount includes earnings attributable to an exchanging shareholder’s stock, without regard to whether the exchanging shareholder owned 10 percent of the stock of the foreign acquired corporation. A new example in the final regulations illustrates these rules.

§1.367(b)–2(e): Treatment of Deemed Dividends

Section 1.367(b)–2(e) of the 1991 proposed regulations provided that a deemed dividend shall be treated as an actual dividend. Thus, a deemed dividend was considered as paid out of the earnings and profits of a foreign corporation and was considered as having been paid through intermediate owners (when appropriate). One commentator noted that an inclusion under the 1991 proposed regulations could yield a different result from an inclusion under section 1248 because section 1248 treats a corporation as having paid the section 1248 amount directly to an exchanging shareholder despite any intermediate owners.

A deemed dividend under section 367(b) is distinguishable from a section 1248 inclusion because a section 1248 inclusion is not treated as a dividend at the corporate level. Thus, a corporation does not reduce its earnings and profits with regard to an inclusion under section 1248. Instead, the shareholder-level inclusion is considered eligible to be treated as previously taxed earnings and profits (PTI) upon a subsequent distribution. In light of this distinction between section 367(b) and section 1248, the final regulations retain the rule in §1.367(b)–2(e) of the 1991 proposed regulations.

Final Regulation §1.367(b)–2(j): Sections 985 through 989

other approaches that could address the carryover of tax attributes related to a non-U.S. person’s holding period under section 367(b).

C. Specific Policies in Context of Foreign-to-Foreign Nonrecognition Transactions and Section 355 Distributions

Section 1.367(b)–4 addresses transactions in which a foreign corporation acquires the stock or assets of another foreign corporation in an exchange described in section 351 or a section 368(a)(1)(B), (C), (D), (E), (F) or (G) reorganization (foreign-to-foreign nonrecognition transactions). Section 1.367(b)–5 provides rules regarding a distribution by a foreign corporation of the stock or securities of a domestic or foreign corporation described in section 355. The historic policy objective of section 367(b) in both of these contexts has been to preserve the potential application of section 1248. Thus, the amount that would have been recharacterized as a dividend under section 1248 upon a disposition of the stock (section 1248 amount) generally must be included in income as a dividend at the time of the section 367(b) exchange to the extent such section 1248 amount would not be preserved immediately following the section 367(b) exchange.

The final regulations do not address all of the policy considerations raised by the application of the Subchapter C provisions to transactions described in §§1.367(b)–4 and 1.367(b)–5. For example, current rules regarding the carryover or separation of foreign corporations’ earnings and profits do not adequately consider the international aspects of the Code, most notably the foreign tax credit. Forthcoming proposed regulations will consider these issues. Until the IRS and Treasury promulgate such regulations, taxpayers should use a reasonable method (consistent with existing law and taking proper account of the purposes of the foreign tax credit regime) to determine the carryover and separation of earnings and profits and related foreign taxes.

Explanation of Provisions

The IRS received numerous comments on the 1991 proposed regulations. The following discussion summarizes the comments and changes to the 1991 pro

posed regulations.

A. §1.367(b)–1(c): Notice Requirements

Section 1.367(b)–1(c) of the 1991 proposed regulations required any person that realizes income in a section 367(b) exchange to file a notice with respect to the exchange, regardless of such person’s status as a U.S. person and its percentage ownership in the corporation that is a party to the section 367(b) exchange. Commentators criticized this notice requirement as overly broad. The 1998 regulations limited the notice requirement to shareholders that realize income and file a tax return under section 6012. The final regulations further revise the notice requirement and generally narrow its scope by requiring notice only with respect to persons and transactions that may be subject to an inclusion under the final regulations’ operative provisions.

B. §1.367(b)–2: Definitions and Special Rules

§1.367(b)–2(d): All Earnings and Profits Amount

Section 1.367(b)–2(d) of the 1991 proposed regulations generally defined “all earnings and profits amount” as the allocable share of net positive earnings and profits accrued by a foreign corporation during a shareholder’s holding period. The 1991 proposed regulations provided that the all earnings and profits amount is determined according to the attribution principles of section 1248. Because the section 1248 attribution rules incorporate the section 1223 holding period rules, commentators were concerned that the definition of all earnings and profits amount inappropriately included earnings and profits attributable to the holding period of non-U.S. persons by virtue of the rules of section 1223(2).

In response, the final regulations amend the definition of all earnings and profits amount to exclude amounts attributable to the holding period of non-U.S. persons. This modification applies to the extent the non-U.S. person was not directly or indirectly owned by U.S. persons with a 10 percent or greater interest when the earnings and profits accumulated. An example in the final regulations illustrates this new rule.

When applying the attribution princi

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Section 1.367(b)–2(k) of the 1991 proposed regulations provided rules regarding currency exchange inclusions or adjustments that result from a section 367(b) exchange. The final regulations apply the principles of the 1991 proposed regulations, but provide the following modifications.

The 1991 proposed regulations required an acquired corporation that participates in a transaction described in section 381(a) to change its functional currency if the acquiring corporation has a different functional currency. The rule was intended to ensure that taxpayers use the correct functional currency after a section 367(b) exchange. However, functional currency is determined separately for each qualified business unit (QBU). In addition, the functional currency of a QBU of either the acquired or acquiring corporation may change as a result of a section 367(b) exchange. Accordingly, the final regulations provide that a QBU is deemed to have automatically changed its functional currency when its functional currency, as determined after a section 367(b) exchange, is different than before the exchange. Thus, the QBU is required to make appropriate adjustments under §1.985–5.

The 1991 proposed regulations provided that, if an exchanging shareholder is required to include in income either the all earnings and profits amount or the section 1248 amount, then immediately before the exchange and solely for purposes of computing exchange gain or loss under section 986(c), the shareholder is treated as receiving a distribution of PTI from the appropriate foreign corporation. The purpose of this provision was to ensure that exchange gain or loss under section 986(c) is subject to current inclusion when the earnings of the foreign corporation are no longer deferred or to the extent a taxpayer does not retain its interest in PTI.

Section 1.367(b)–2(j)(2) of the final regulations expands the rules regarding the treatment of exchange gain or loss on PTI under section 986(c). An exchanging shareholder that is a U.S. person is required to recognize its section 986(c) gain or loss to the extent that deferral has ended with respect to a foreign corporation’s earnings (as can occur in the case of an inbound or foreign-to-foreign non

recognition transaction) or the U.S. person has a diminished interest in the PTI after the exchange (as can occur in the case of a section 355 distribution by a foreign corporation). A different rule applies when a U.S. person indirectly holds (through a foreign exchanging shareholder) its interest in the foreign corporation with regard to which the PTI inclusion is measured. In that case, the indirect U.S. shareholder does not recognize section 986(c) gain or loss at the time of the section 367(b) exchange. In order to preserve such section 986(c) gain or loss for future inclusion by the indirect U.S. shareholder, the foreign exchanging shareholder is treated as having received a distribution of the PTI.

Other rules under sections 985 through 989, such as the branch termination rules, may also apply to the transaction.

C. §1.367(b)–3: Repatriation of Foreign Corporate Assets in Certain Nonrecognition Transactions

Section 1.367(b)–3 provides rules with respect to inbound nonrecognition transactions.

§1.367(b)–3(b): Exchanges of Stock

Section 1.367(b)–3(b) of the 1991 proposed regulations generally provided that if an exchanging shareholder is either (i) a 10 percent U.S. shareholder of the foreign acquired corporation or (ii) a foreign corporation with respect to which a U.S. person is either a section 1248 shareholder or a domestic corporation that meets the stock ownership requirements of section 902, the shareholder must include in income as a deemed dividend the all earnings and profits amount attributable to its stock in the foreign acquired corporation. The final regulations generally retain this rule. However, in order to provide greater consistency among its various ownership thresholds, the final regulations revise §1.367(b)–3(b)(ii) so that §1.367(b)–3(b) applies to a foreign corporation with respect to which there is, in general, a 10 percent U.S. shareholder.

The 1991 proposed regulations provided that the same country dividend exception in section 954(c)(3)(A)(i) does not apply to an exchanging shareholder that is a CFC. Commentators criticized this rule, stating that a deemed dividend

under section 367(b) should not be treated more harshly than an actual dividend and that taxpayers can circumvent this rule by having a lower-tier foreign corporation distribute a dividend before an asset transfer. However, unlike a dividend distribution that qualifies for the same country dividend exception, an inbound asset transfer represents a current repatriation of earnings into the United States. Accordingly, the final regulations retain the rule in the 1991 proposed regulations that the same country dividend exception does not apply to an exchanging shareholder that is a CFC.

The 1991 proposed regulations generally required the recognition of exchange gain (or loss) to the extent that an exchanging shareholder’s capital account in a foreign acquired corporation appreciated (or depreciated) as a result of changes in currency exchange rates. Such gain (or loss) is reflected in the basis of assets when translated at the spot rate. The preamble to the 1991 proposed regulations invited comments regarding the calculation of such exchange gain (or loss), particularly in cases when a shareholder acquired the foreign corporate stock by purchase rather than in connection with the corporation’s formation. None of the comments suggested a method for determining and tracking shareholder capital accounts. Most comments focused on the potential complexity and compliance burdens created by the rule. After considering the administrability issues associated with the exchange gain (or loss) calculation, the final regulations do not adopt the provision requiring the recognition of exchange gain (or loss) on a shareholder’s capital account. However, the final regulations reserve the issue for further consideration.

Sections 7.367(b)–5(b) and 7.367(b)–7(c)(2)(ii) of the 1977 regulations, and §1.367(b)–3(b)(2)(iii) of the 1991 proposed regulations provided an exchanging shareholder with an opportunity to recognize the gain (but not the loss) that it realizes in the exchange (taxable exchange election), rather than including the all earnings and profits amount in income as a deemed dividend. This taxable exchange election, however, is inconsistent with the policies of section 367(b) that apply to inbound transactions. These policies, as previously discussed,

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are unrelated to an exchanging shareholder’s outside gain on its stock.

Moreover, when the all earnings and profits amount exceeds a shareholder’s gain on its stock, merely limiting the shareholder’s inclusion to its outside stock gain creates the potential for the duplication and importation of losses. See TAM 9003005 (September 28, 1989) (interpreting the 1977 regulations) (available at IRS Freedom of Information Act Reading Room, 1111 Constitution Avenue, NW., Washington, DC 20224). The 1991 proposed regulations attempted to address this aspect of the taxable exchange election by requiring various attributes of the foreign acquired corporation (such as basis in its assets) to be reduced (attribute reduction regime) to the extent the all earnings and profits amount exceeds an exchanging shareholder’s stock gain.

However, the taxable exchange election in the 1991 proposed regulations had other shortcomings. The election added substantial complexity to the regulations by requiring timely coordination between electing shareholders and the acquiring corporation to carry out the required attribute reductions. In addition, the attribute reduction regime can be unfair in situations involving more than one exchanging U.S. shareholder. For example, consider an inbound C, D, or F reorganization involving two U.S. shareholders of the foreign acquired corporation, one that makes the taxable exchange election (because its gain on the stock is less than its all earnings and profits amount) and one that does not. In connection with the electing shareholder’s taxable exchange election, the 1991 proposed regulations required a proportionate reduction in certain tax attributes of the foreign acquired corporation. This reduction effectively allowed the electing shareholder to transfer to the acquiring corporation the burden created by its decision not to include in income its full all earnings and profits amount and, thereby, to effectively shift a portion of this burden to the non-electing shareholder (that has already paid U.S. tax on its full share of the foreign corporation’s earnings and profits).

Finally, a taxable exchange election is not required by the statute. Section 367(b) directs the Secretary to prescribe regulations that provide the necessary or appropriate tax consequences that should

accompany the application of the Subchapter C provisions to transactions involving foreign corporations. Section 367(b)(2) specifically provides that the section 367(b) regulations may include the circumstances under which “gain shall be recognized currently or amounts included in gross income currently as a dividend, or both . . . .” Thus, the statute authorizes the IRS and Treasury to require an inclusion of amounts, as distinct from gain. As previously discussed, the all earnings and profits amount appropriately measures an exchanging shareholder’s income inclusion in connection with an inbound nonrecognition transaction.

After balancing the above considerations against the benefits of the taxable exchange election, the final regulations do not adopt the taxable exchange election. However, in order to provide taxpayers an opportunity to comment on this change to the 1977 regulations and the 1991 proposed regulations, the IRS and Treasury are concurrently issuing temporary and proposed regulations that provide the taxable exchange election in modified form. This election permits an exchanging shareholder to elect to treat a transaction as a taxable exchange, but modifies the attribute reduction regime by limiting its application to a section 332 liquidation or to an inbound asset reorganization in which the foreign acquired corporation is wholly owned (directly or indirectly) by one U.S. person. This limited application of the attribute reduction regime eliminates the potentially unfair results that can arise when attributes are reduced in a transaction involving multiple exchanging shareholders. This also reduces (although does not eliminate) the potential for the duplication and importation of losses that can arise in the absence of attribute reduction. The temporary regulation is effective for one year from the effective date of the final regulations.

§1.367(b)–3(c): Exchanges of Stock by Other U.S. Persons

Section 1.367(b)–3(c) of the 1991 proposed regulations provided a special rule for U.S. persons that are not subject to the §1.367(b)–3(b) requirement to include in income the all earnings and profits amount (generally, shareholders owning less than 10 percent of the foreign acquired corporation, hereinafter small

shareholders). The 1991 proposed regulations required these small shareholders to recognize the gain on their stock in the foreign acquired corporation. This rule was included because of administrative concerns, since small shareholders may not have sufficient information to calculate their all earnings and profits amounts. In addition, a foreign acquired corporation may not have adequate information about its small shareholders’ inclusions to properly adjust its earnings and profits for the deemed dividends that would arise in these situations.

Commentators requested that the final regulations provide small shareholders the option of including in income the all earnings and profits amount, rather than recognizing the gain on their stock. In response, the final regulations include such an election, provided that a small shareholder has sufficient information to substantiate its all earnings and profits amount and provided that the small shareholder furnishes proper certification to the foreign acquired corporation (or its successor in interest) so that the corporation can properly reduce its earnings and profits. Electing small shareholders must also comply with the section 367(b) notice requirement. A less extensive section 367(b) notice procedure is available if the foreign acquired corporation has never had earnings and profits that would result in any shareholder having an all earnings and profits amount.

Commentators also requested an election that would permit a domestic acquiring corporation to include in income the all earnings and profits amounts on behalf of the foreign acquired corporation’s small shareholders. The final regulations do not adopt this suggestion because of its substantial administrative difficulties. For example, it is unlikely that a publicly traded foreign corporation (or its domestic acquirer) could ascertain each small shareholder’s correct holding period in the stock of the foreign acquired corporation, which would be necessary to properly determine such a cumulative all earnings and profits amount inclusion.

The final regulations also include a new de minimis exception, which applies to small shareholders whose stock in the foreign acquired corporation has a fair market value below $50,000 on the date of the exchange. These shareholders are

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not required to include gain or a deemed dividend under the section 367(b) regulations. 3. §1.367(b)-3(d): Carryover of Certain Attributes

Section 1.367(b)–3(d) of the 1991 proposed regulations clarified that a domestic acquiring corporation may succeed to foreign taxes paid or accrued by a foreign acquired corporation that are eligible for credit under section 906. A domestic acquiring corporation may not succeed to any other foreign taxes paid or accrued by a foreign acquired corporation because the earnings that carry over to a domestic acquiring corporation (other than earnings related to the taxes eligible for credit under section 906) are not subject to double taxation at the corporate level. This rule is consistent with the general policy of section 367(b) to permit the carryover of corporate tax attributes only when appropriate. The final regulations retain the rules of §1.367(b)–3(d), and add an example that illustrates their application.

D. §1.367(b)–4: Acquisition of Foreign Corporate Stock or Assets by a Foreign Corporation in Certain Nonrecognition Transactions

Section 1.367(b)–4 of the 1991 proposed regulations addressed foreign-toforeign nonrecognition transactions. In general, if the exchange in such a transaction results in a section 1248 shareholder of the foreign acquired corporation losing its section 1248 shareholder status, §1.367(b)–4(b) required the exchanging shareholder to currently include its section 1248 amount in income as a deemed dividend. The 1991 proposed regulations generally did not require an income inclusion in circumstances when a section 1248 shareholder retains its status. In the case of a lower-tier transaction (where the exchanging shareholder is a foreign corporation), the section 1248 amount was not included as foreign personal holding company income (FPHCI) under section 954(c). This provision permitted deferral of the section 1248 amount by preserving such earnings and profits as earnings of the foreign corporation that is the exchanging shareholder. The final regulations retain these general rules.

§1.367(b)–4(b): Recognition of Income

Section 1.367(b)–4(b) of the 1991 proposed regulations provided an exception to its general rule if an exchanging shareholder receives stock of a domestic corporation. This provision, which the 1991 proposed regulations included in response to a criticism of the 1977 regulations, was intended to provide relief in cases when a domestic acquiring corporation issues its own stock in exchange for CFC stock and succeeds to the section 1248 amount allocable to the transferor U.S. shareholder. Because §1.367(b)–4(a) of the 1991 proposed regulations already limited the application of §1.367(b)–4 to an acquisition by a foreign corporation, such relief was unnecessary.

Moreover, the provision inadvertently did not require an inclusion of a section 1248 amount that may not be preserved immediately after the exchange. This could occur, for example, if a foreign acquiring corporation uses the stock of its domestic parent corporation to acquire the stock or assets of a foreign target corporation from a section 1248 shareholder. Accordingly, the final regulations do not adopt the 1991 proposed regulations’ provision regarding receipt of stock of a domestic corporation in a transaction described in §1.367(b)–4.

§1.367(b)–4(d): Special Rule for Applying Section 1248 to Subsequent Exchanges

The 1998 regulations revised the rules of the 1991 proposed regulations regarding the application of section 367(b) and section 1248 to exchanges that follow a §1.367(b)–4 exchange in which an exchanging shareholder is not required to include a section 1248 amount in income. Because of the limited scope of the 1998 regulations, its rule only addressed the application of section 367(b) and section 1248 following a stock transfer by a direct U.S. shareholder. The final regulations incorporate the principles of the 1998 regulations and expand their application to the class of transactions subject to §1.367(b)–4, including asset transfers and transactions in which the exchanging shareholder is a foreign corporation. The final regulations also address the interaction of these rules with section 964(e), by providing the extent to which they apply to subsequent section 964(e) sales and exchanges. Two new examples in the final

regulations, as well as an expanded restatement of the example provided in the 1998 regulations, illustrate the application of these rules.

Commentators also requested that the IRS and Treasury clarify the carryover of earnings and profits and tax accounts in transactions where an exchanging shareholder is not required to include a section 1248 amount, as well as the application of section 902 to distributions by a foreign acquiring corporation after such a section 367(b) exchange. The IRS and Treasury will address these issues in forthcoming proposed regulations.

E. §1.367(b)–5: Distributions of Stock Described in Section 355

§1.367(b)–5(b): Distribution by a Domestic Corporation

Section 1.367(b)–5(b) of the 1991 proposed regulations generally provided that a domestic corporation must recognize gain on a section 355 distribution of foreign stock to individuals. The final regulations retain this general rule, consistent with the recently promulgated final regulations under section 367(e) (governing a section 355 distribution by a domestic corporation of foreign stock to foreign persons).

Commentators requested that the final regulations clarify the proper method for determining whether a distributee is an individual. The same issue arises under section 367(e), and the final regulations adopt the approach of the section 367(e) regulations. Thus, a distributee is presumed to be an individual except to the extent that the distributing corporation certifies that the distributee is not an individual. However, a publicly traded distributing corporation may use a reasonable analysis with respect to distributees that are not five percent shareholders of publicly traded stock to demonstrate the number of distributees that are not individuals. A reasonable analysis includes a determination of the actual number of distributees that are not individuals or a reasonable statistical analysis of shareholder records and other relevant information. Section 1.367(b)–2(k) (§1.367(b)–2(l) of the 1991 proposed regulations) has also been amended to adopt the look-through provisions provided in §1.367(e)–1(b)(2) for purposes of determining the identity

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invalidate the section 355 transaction. Commentators thus argued in favor of not adopting the taxable distribution election in the final regulations.

The taxable distribution election is also not required by the statute. Section 367(b) directs the Secretary to prescribe regulations that provide the necessary or appropriate tax consequences that should accompany the application of the Subchapter C provisions to transactions involving foreign corporations. Section 367(b)(2) specifically provides that the section 367(b) regulations “shall include (but shall not be limited to) regulations dealing with the sale or exchange of stock or securities in a foreign corporation by a U.S. person. . . .” Accordingly, the section 367(b) regulations may address the tax consequences of a non-pro rata distribution to both participating and non-participating shareholders. In both cases, the diminution in a shareholder’s potential section 1248 amount following a section 355 transaction appropriately measures the shareholder’s inclusion with regard to a section 355 transaction involving a distributing corporation that is a controlled foreign corporation. Differing results depending on whether a shareholder is a participating shareholder or a non-participating shareholder can also be viewed as artificial, given that the distinction is often merely a function of alternative planning strategies.

In light of all of the above considerations, the final regulations do not adopt the taxable distribution election. As a result, all shareholders of a CFC that distributes stock on a non-pro rata basis must include in income the amount of any reduction in their section 1248 amount with respect to either the distributing or controlled corporation.

Final Regulation §1.367(b)–5(f): Exclusion of Deemed Dividend from FPHCI

Commentators noted that the 1991 proposed regulations did not automatically exclude a §1.367(b)–5(c) or (d) deemed dividend inclusion by an exchanging foreign corporate shareholder from FPHCI. Accordingly, the deemed dividend generally would be subpart F income and currently includible in income by a U.S. shareholder of the exchanging foreign corporation. As in the case of a lower-tier foreign-to-foreign transaction described

of distributees when the domestic distributing corporation stock is held by a partnership, trust or estate. 2. §1.367(b)–5(c): Pro Rata Distribution by a CFC

Section 1.367(b)–5(c) of the 1991 proposed regulations provided that, when a CFC distributes stock of a controlled corporation on a pro rata basis in a section 355 transaction, a distributee must reduce its post-distribution basis in either the distributing or controlled corporation stock to the extent its section 1248 amount attributable to such corporation is reduced as a result of the distribution. To the extent the reduction of the section 1248 amount exceeds the stock basis, the distributee must include the difference in income as a deemed dividend. The final regulations retain this general rule, subject to the following refinements.

The final regulations add new §1.367(b)–5(c)(3), which provides that the basis adjustment provided in §1.367(b)–2(e)(3)(ii) shall not apply if a deemed dividend is included in income pursuant to §1.367(b)–5(c). Under §1.367(b)–2(e)(3)(ii), a shareholder’s basis is increased by the amount of a deemed dividend inclusion. In the context of a §1.367(b)–5(c) inclusion, the §1.367(b)–2(e)(3)(ii) basis increase would undermine the purpose of the section 367(b) regulations, because the basis increase would correspondingly decrease the shareholder’s built-in gain, thereby reducing the section 1248 amount that is intended to be preserved after the transaction.

Furthermore, some taxpayers commented that the §1.367(b)–5(c)(2) basis reduction can lead to the creation of phantom gain; that is, it can leave a shareholder with a cumulative amount of postdistribution built-in gain in the stock of the distributing and controlled corporations that exceeds its predistribution builtin gain. As a result, commentators requested that a reduction in the basis in one of the corporations give rise to a corresponding increase in the basis of the stock of the other corporation. In response, §1.367(b)–5(c)(4) of the final regulations provides a basis redistribution rule, under which the basis of the stock of the distributing or controlled corporation (as applicable) is increased by the amount of the required decrease in basis in the other stock

under §1.367(b)–5(c)(2). However, basis cannot be increased above the fair market value of the stock and also cannot be increased to the extent the increase diminishes the postdistribution section 1248 amount with respect to such stock. This basis redistribution rule also applies with regard to deemed dividend inclusions under §1.367(b)–5(c)(2). An example in the final regulations illustrates the application of these new rules. 3. §1.367(b)–5(d): Non-Pro Rata Distribution by Controlled Foreign Corporation

Section 1.367(b)–5(d) of the 1991 proposed regulations provided that, if a CFC distributes controlled corporation stock on a non-pro rata basis, each distributee must include in income the amount of any reduction in its section 1248 amount with regard to either the distributing or controlled corporation. For this purpose, the 1991 proposed regulations treated a shareholder of the distributing corporation that does not exchange stock in the distributing corporation for stock in the controlled corporation (non-participating shareholder) as a distributee. The 1991 proposed regulations provided that a nonparticipating shareholder may make an election (taxable distribution election), under which the distributing and controlled corporations are not treated as corporations for purposes of gain (but not loss) recognition by all persons affected by the taxable status of the transaction. The preamble to the 1991 proposed regulations invited comments as to whether the benefits of the taxable distribution election to non-participating shareholders are outweighed by the potential adverse effects on the other shareholders.

In response, commentators uniformly criticized the taxable distribution election. They argued that the election was inequitable because it enabled a non-participating shareholder (who may be a small shareholder) to unilaterally and retroactively invalidate the section 355 transaction for all parties involved. Commentators also pointed out that the taxable distribution election could distort the economic incentives in cross-border restructurings by requiring participating shareholders to consider identifying and making contractual arrangements (which could include monetary arrangements) with each non-participating shareholder in order to prevent them from electing to

February 7, 2000 472 2000–6 I.R.B.

in §1.367(b)–4, the potential application of section 1248 can be preserved by excluding the deemed dividend from FPHCI. Thus, the final regulations adopt the suggestion and provide that a §1.367(b)–5(c) or (d) deemed dividend inclusion by a foreign corporation is not included in FPHCI under section 954(c).

1991 Proposed Regulation §1.367(b)–5(f): Adjustments to Earnings and Profits

Section 1.367(b)–5(f) of the 1991 proposed regulations provided rules regarding the allocation of earnings and profits of a foreign transferor corporation in connection with a section 355 distribution. After further consideration, the IRS and Treasury have not included §1.367(b)–5(f) of the 1991 proposed regulations in the final regulations. Forthcoming proposed regulations will more fully consider the allocation of earnings and profits in section 355 distributions where either (or both) the distributing or controlled corporation is a foreign corporation.

F. §1.367(b)–6: Effective Date

The final regulations apply to section 367(b) exchanges that occur on or after February 23, 2000. The preamble to the 1991 proposed regulations solicited comments on whether the final regulations should provide an election to apply the regulations retroactively to exchanges that occur on or after August 26, 1991 (the date the 1991 proposed regulations were published in the Fed- eral Register ). Given the length of time that has elapsed since the issuance of the 1991 proposed regulations, the IRS and Treasury do not believe that such an election would be appropriate. This determination is consistent with the 1998 revision to §1.367(b)–2(d) of the 1991 proposed regulations, which deleted the proposed special retroactive effective date for the definition of the all earnings and profits amount. A taxpayer may, however, elect to apply the final regulations to section 367(b) exchanges that occur (or occurred) before February 23, 2000, if the due date for the taxpayer’s timely filed Federal tax return (including extensions) for the taxable year in which the section 367(b) exchange occurs (or occurred) is after February 23, 2000.

Removed Provisions

These regulations finalize substantially all of the 1991 proposed regulations. In connection with the finalization of these regulations, the 1977 regulations (other than §7.367(b)–12) and the section 367(b) provisions contained in the 1998 regulations are removed. Section 7.367(b)–12 is retained to address distributions with respect to (or a disposition of) stock that was subject to certain provisions of the 1977 regulations in effect prior to February 23, 2000.

Special Analyses

Pursuant to section 7805(f) of the Code, the notice of proposed rulemaking preceding these regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on the impact of the proposed regulations on small business.

Drafting Information

The principal author of these regulations is Mark Harris of the Office of Associate Chief Counsel (International). However, other personnel from the IRS and Treasury Department participated in their development.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1, 7, and 602 are amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by revising the entry for §1.367(b)–2 and by adding entries in numerical order to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Section 1.367(b)–2 also issued under 26 U.S.C. 367(a) and (b).

Section 1.367(b)–3 also issued under 26 U.S.C. 367(a) and (b). * * *

Section 1.367(b)–5 also issued under 26 U.S.C. 367(a) and (b).

Section 1.367(b)–6 also issued under 26 U.S.C. 367(a) and (b). * * *

Par. 2. Section 1.367(a)–3 is amended as follows:

Paragraph (d)(3) Example 11, paragraph (ii), the third sentence, the reference “§7.367(b)–7(c)(1)(i) of this chapter” is removed and “§1.367(b)–4(b)” is added in its place.
Paragraph (d)(3) Example 11A, paragraph (ii), the second, third and fourth sentences are removed and a sentence is added in their place.
Paragraph (e)(2), in the third, fourth, and fifth sentences, the parenthetical “(as in effect before February 23, 2000, see 26 CFR part 1 revised as of April 1, 1999)” is added immediately after “§7.367(b)–7 of this chapter” each place it appears.
Paragraph (g)(2)(iv), the parenthetical “(as in effect before February 23, 2000, see 26 CFR part 1 revised as of April 1, 1999)” is added immediately after “7.367(b)–2(b) of this chapter.”

The revisions read as follows:

§1.367(a)–3 Treatment of transfers of stock or securities to foreign corpora- tions.

(d) * * *

(3) * * *

Example 11A . * * *

(ii) Result . * * * Assuming §1.367(b)–4(b) does not apply, there is no income inclusion under section 367(b), and the amount of the gain recognition agreement is $50.

Par. 3. Section 1.367(b)–0 is added to read as follows:

§1.367(b)–0 Table of contents.

This section lists the paragraphs contained in §§1.367(b)–0 through 1.367(b)–6.

2000–6 I.R.B. 473 February 7, 2000

(i) Rule. (ii) Examples. (2) Receipt by exchanging shareholder of preferred or other stock in certain instances. (i) Rule. (ii) Examples. (3) Certain recapitalizations. (c) Exclusion of deemed dividend from foreign personal holding company income. (1) Rule. (2) Example. (d) Rules for subsequent exchanges. (1) In general. (2) Subsequent dispositions by a foreign acquiring corporation. (3) Examples.

§1.367(b)–5 Distributions of stock de- scribed in section 355.

(a) In general. (1) Scope. (2) Treatment of distributees as exchanging shareholders. (b) Distribution by a domestic corporation. (1) General rule. (2) Section 367(e) transactions. (3) Determining whether distributees are individuals. (4) Applicable cross-references. (c) Pro rata distribution by a controlled foreign corporation. (1) Scope. (2) Adjustment to basis in stock and income inclusion. (3) Interaction with §1.367(b)–2(e)(3)(ii). (4) Basis redistribution. (d) Non-pro rata distribution by a controlled foreign corporation. (1) Scope. (2) Treatment of certain shareholders as distributees. (3) Inclusion of excess section 1248 amount by exchanging shareholder. (4) Interaction with §1.367(b)–2(e)(3)(ii). (i) Limited application. (ii) Interaction with predistribution amount. (e) Definitions. (1) Predistribution amount. (2) Postdistribution amount. (f) Exclusion of deemed dividend from foreign personal holding company income. (g) Examples.

§1.367(b)–1 Other transfers. (a) Scope. (b) General rules. (1) Rules. (2) Example. (c) Notice required. (1) In general. (2) Persons subject to section 367(b) notice. (3) Time and manner for filing notice. (i) United States persons described in §1.367(b)–1(c)(2). (ii) Foreign corporations described in §1.367(b)–1(c)(2). (4) Information required. (5) Abbreviated notice provision. (6) Supplemental published guidance.

§1.367(b)–2 Definitions and special rules.

(a) Controlled foreign corporation. (b) Section 1248 shareholder. (c) Section 1248 amount. (1) Rule. (2) Examples. (d) All earnings and profits amount. (1) General rule. (2) Rules for determining earnings and profits. (i) Domestic rules generally applicable. (ii) Certain adjustments to earnings and profits. (iii)Effect of section 332 liquidating distribution. (3) Amount attributable to a block of stock. (i) Application of section 1248 principles. (A) In general. ( 1 ) Rule. ( 2 ) Example. (B) Foreign shareholders. (ii) Limitation on amounts attributable to holding periods determined under section 1223. (A) Rule. (B) Example. (iii)Exclusion of lower-tier earnings. (e) Treatment of deemed dividends. (1) In general. (2) Consequences of dividend characterization. (3) Ordering rules. (4) Examples. (f) Deemed asset transfer and closing of taxable year in certain section 368(a)(1)(F) reorganizations. (1) Scope. (2) Deemed asset transfer.

(3) Other applicable rules. (4) Closing of taxable year. (g) Stapled stock under section 269B. (h) Section 953(d) domestication elections. (1) Effect of election. (2) Post-election exchanges. (i) Section 1504(d) elections. (j) Sections 985 through 989. (1) Change in functional currency of a qualified business unit. (i) Rule. (ii) Example. (2) Previously taxed earnings and profits. (i) Exchanging shareholder that is a United States person. (ii) Exchanging shareholder that is a foreign corporation. (3) Other rules. (k) Partnerships, trusts and estates.

§1.367(b)–3 Repatriation of foreign cor- porate assets in certain nonrecognition transactions.

(a) Scope. (b) Exchange of stock owned directly by a United States shareholder or by certain foreign corporate shareholders. (1) Scope. (2) United States shareholder. (3) Income inclusion. (i) Inclusion of all earnings and profits amount. (ii) Examples. (iii) Recognition of exchange gain or loss with respect to capital [reserved]. (4) [Reserved]. (c) Exchange of stock owned by a United States person that is not a United States shareholder. (1) Scope. (2) Requirement to recognize gain. (3) Election to include all earnings and profits amount. (4) De minimis exception. (5) Examples. (d) Carryover of certain foreign taxes. (1) Rule. (2) Example.

§1.367(b)–4 Acquisition of foreign cor- porate stock or assets by a foreign corpo- ration in certain nonrecognition transac- tions.

(a) Scope. (b) Income inclusion. (1) Exchange that results in loss of status as section 1248 shareholder.

February 7, 2000 474 2000–6 I.R.B.

successor in interest) on or before the date the section 367(b) notice is filed, so that appropriate corresponding adjustments can be made in accordance with the rules of §1.367(b)–2(e).

(ii) Foreign corporations described in §1.367(b)–1(c)(2) . Each United States person listed in this paragraph (c)(3)(ii) must file a section 367(b) notice with regard to a foreign corporation described in paragraph (c)(2) of this section. Such notice must be attached to a timely filed Federal tax return (including extensions) for the United States person’s taxable year in which income is realized in the section 367(b) exchange and, if the United States person is required to file a Form 5471 (Information Return of U.S. Persons With Respect To Certain Foreign Corporations), the section 367(b) notice must be attached to the Form 5471. The following persons are listed in this paragraph (c)(3)(ii)—

(A) United States shareholders (as defined in §1.367(b)–3(b)(2)) of foreign corporations described in paragraph (c)(2)(i) of this section; and

(B) Section 1248 shareholders of foreign corporations described in paragraph (c)(2)(iii) or (iv) of this section.

(4) Information required . Except as provided in paragraph (c)(5) of this section, a section 367(b) notice shall include the following information—

(i) A statement that the exchange is a section 367(b) exchange;

(ii) A complete description of the exchange;

(iii) A description of any stock, securities or other consideration transferred or received in the exchange;

(iv) A statement that describes any amount required, under the section 367(b) regulations, to be taken into account as income or loss or as an adjustment to basis, earnings and profits, or other tax attributes as a result of the exchange;

(v) Any information that is or would be required to be furnished with a Federal income tax return pursuant to regulations under section 332, 351, 354, 355, 356, 361 or 368 (whether or not a Federal income tax return is required to be filed), if such information has not otherwise been provided by the person filing the section 367(b) notice; (vi) Any information required to be furnished with respect to the exchange

§ 1.367(b)–6 Effective dates and coordi- nation rules.

(a) Effective date. (1) In general. (2) Exception. (b) Certain recapitalizations described in §1.367(b)–4(b)(3). (c) Use of reasonable method to comply with prior published guidance. (1) Prior exchanges. (2) Future exchanges. (d) Effect of removal of attribution rules.

Par. 4. Sections 1.367(b)–1 and 1.367(b)–2 are revised to read as follows: §1.367(b)–1 Other transfers.

(a) Scope . The regulations promulgated under section 367(b) (the section 367(b) regulations) set forth rules regarding the proper inclusions and adjustments that must be made as a result of an exchange described in section 367(b) (a section 367(b) exchange). A section 367(b) exchange is any exchange described in section 332, 351, 354, 355, 356 or 361, with respect to which the status of a foreign corporation as a corporation is relevant for determining the extent to which income shall be recognized or for determining the effect of the transaction on earnings and profits, basis of stock or securities, basis of assets, or other relevant tax attributes. Notwithstanding the preceding sentence, a section 367(b) exchange does not include a transfer to the extent the foreign corporation fails to be treated as a corporation by reason of section 367(a)(1). See §1.367(a)–3(b)(2)(ii) for an illustration of the interaction of section 367(a) and (b).

(b) General rules —(1) Rules . The following general rules apply under the section 367(b) regulations—

(i) A foreign corporation in a section 367(b) exchange is considered to be a corporation and, as a result, all of the related provisions (e.g., section 381) shall apply, except to the extent provided in the section 367(b) regulations; and

(ii) Nothing in the section 367(b) regulations shall permit—

(A) The nonrecognition of income that would otherwise be required to be recognized under another provision of the Internal Revenue Code or the regulations thereunder; or

(B) The recognition of a loss or deduction that would otherwise not be recognized under another provision of the In

ternal Revenue Code or the regulations thereunder.

(2) Example . The following example illustrates the rules of this paragraph (b):

Example —(i) Facts . DC, a domestic corporation, owns 90 percent of P, a partnership. The remaining 10 percent of P is owned by a person unrelated to DC. P owns all of the outstanding stock of FC, a controlled foreign corporation. FC liquidates into P.

(ii) Result . FC’s liquidation is not a transaction described in section 332. Nothing in the section 367(b) regulations, including §1.367(b)–2(k), permits FC’s liquidation to qualify as a liquidation described in section 332.

(c) Notice Required —(1) In general . A notice under this paragraph (c) (section 367(b) notice) must be filed with regard to any person described in paragraph (c)(2) of this section. A section 367(b) notice must be filed in the time and manner described in paragraph (c)(3) of this section and must include the information described in paragraph (c)(4) of this section.

(2) Persons subject to section 367(b) notice . The following persons are described in this paragraph (c)(2)—

(i) A shareholder described in §1.367(b)–3(b)(1) that realizes income in a transaction described in §1.367(b)–3(a);

(ii) A shareholder that makes the election described in §1.367(b)–3(c)(3);

(iii) A shareholder described in §1.367(b)–4(b)(1)(i)(A)( 1 ) or ( 2 ) that realizes income in a transaction described in §1.367(b)–4(a); and

(iv) A shareholder that realizes income in a transaction described in §1.367(b)–5(c) or 1.367(b)–5(d) and that is either–

(A) A section 1248 shareholder of the distributing or controlled corporation; or

(B) A foreign corporation with one or more shareholders that are described in paragraph (c)(2)(iv)(A) of this section.

(3) Time and manner for filing notice (i) United States persons described in §1.367(b)–1(c)(2) . A United States person described in paragraph (c)(2) of this section must file a section 367(b) notice attached to a timely filed Federal tax return (including extensions) for the person’s taxable year in which income is realized in the section 367(b) exchange. In the case of a shareholder that makes the election described in §1.367(b)–3(c)(3), notification of such election must be sent to the foreign acquired corporation (or its

2000–6 I.R.B. 475 February 7, 2000

under sections 6038, 6038A, 6038B, 6038C or 6046, or the regulations under those sections, if such information has not otherwise been provided by the person filing the section 367(b) notice; and

(vii) If applicable, a statement that the shareholder is making the election described in §1.367(b)–3(c)(3). This statement must include—

(A) A copy of the information the shareholder received from the foreign acquired corporation (or its successor in interest) establishing and substantiating the shareholder’s all earnings and profits amount with respect to the shareholder’s stock in the foreign acquired corporation; and

(B) A representation that the shareholder has notified the foreign acquired corporation (or its successor in interest) that the shareholder is making the election described in §1.367(b)–3(c)(3).

(5) Abbreviated notice provision . In the case of a foreign acquired corporation that has never had earnings and profits that would result in any shareholder having an all earnings and profits amount, a shareholder making the election described in §1.367(b)–3(c)(3) may satisfy the information requirements of paragraph (c)(4) of this section by filing a section 367(b) notice that includes– (i) A statement from the foreign acquired corporation (or its successor in interest) that the foreign acquired corporation has never had any earnings and profits that would result in any shareholder having an all earnings and profits amount; and

(ii) The information described in paragraphs (c)(4)(i) through (iii) of this section.

(6) Supplemental published guidance . The section 367(b) notice requirements may be updated or amended by revenue procedure or other published guidance. §1.367(b)–2 Definitions and special rules.

(a) Controlled foreign corporation . The term controlled foreign corporation means a controlled foreign corporation as defined in section 957 (taking into account section 953(c)).

(b) Section 1248 shareholder . The term section 1248 shareholder means any United States person that satisfies the ownership requirements of section 1248(a)(2) or (c)(2) with respect to a for

eign corporation.

(c) Section 1248 amount —(1) Rule . The term section 1248 amount with respect to stock in a foreign corporation means the net positive earnings and profits (if any) that would have been attributable to such stock and includible in income as a dividend under section 1248 and the regulations thereunder if the stock were sold by the shareholder. In the case of a transaction in which the shareholder is a foreign corporation (foreign shareholder), the following additional rules shall apply–

(i) The foreign shareholder shall be deemed to be a United States person for purposes of this paragraph (c), except that the foreign shareholder shall not be considered a United States person for purposes of determining whether the stock owned by the foreign shareholder is stock of a controlled foreign corporation, and

(ii) The foreign shareholder’s holding period in the stock of the foreign corporation shall be determined by reference to the period that the foreign shareholder’s section 1248 shareholders held (directly or indirectly) an interest in the foreign corporation. This paragraph (c)(1)(ii) applies in addition to the section 1248 regulations’ incorporation of section 1223 holding periods, as modified by §1.367(b)–4(d) (as applicable).

(2) Examples . The following examples illustrate the rules of this paragraph (c):

Example 1 —(i) Facts . DC, a domestic corporation, owns all of the outstanding stock of FC1, a controlled foreign corporation (CFC). FC1 owns all of the outstanding stock of FC2, a CFC. DC has always owned all of the stock of FC1, and FC1 has always owned all of the stock of FC2.

(ii) Result . Under this paragraph (c), DC’s section 1248 amount with respect to its FC1 stock is computed by reference to all of FC1’s and FC2’s earnings and profits. See section 1248(c)(2). Because FC1’s section 1248 shareholder (DC) always indirectly held all of the stock of FC2, FC1’s section 1248 amount with respect to its FC2 stock is computed by reference to all of FC2’s earnings and profits.

Example 2 —(i) Facts . DC, a domestic corporation, owns 40 percent of the outstanding stock of FC1, a foreign corporation. The other 60 percent of FC1 stock is owned (directly and indirectly) by foreign persons that are unrelated to DC. FC1 owns all of the outstanding stock of FC2, a foreign corporation. On January 1, 2001, DC purchases the remaining 60 percent of FC1 stock.

eign corporations (CFCs). See section 1248(a). Because FC1 is not considered a United States person for purposes of determining whether FC2 is a CFC, FC1’s section 1248 amount with respect to its FC2 stock is computed by reference to FC2’s earnings and profits that accumulated on or after January 1, 2001, the date FC2 became an actual CFC. Example 3 —(i) Facts . FC1, a foreign corporation, owns all of the outstanding stock of FC2, a foreign corporation. DC is a domestic corporation that is unrelated to FC1, FC2, and their direct and indirect owners. On January 1, 2001, DC purchases all of the outstanding stock of FC1.

(ii) Result . Under this paragraph (c), DC’s section 1248 amount with respect to its FC1 stock is computed by reference to FC1’s and FC2’s earnings and profits that accumulated on or after January 1, 2001, the first day DC held the stock of FC1. See section 1248(a). FC1’s section 1248 amount with respect to its FC2 stock is computed by reference to FC2’s earnings and profits that accumulated on or after January 1, 2001, the first day FC1’s section 1248 shareholder (DC) indirectly held the stock of FC2.

Example 4 —(i) Facts . DC, a domestic corporation, directly owns all of the outstanding stock of FC1 and FC2, controlled foreign corporations. DC has always owned all of the stock of FC1 and FC2. On January 1, 2001, DC contributes all of the stock of FC2 to FC1 in a nonrecognition exchange that does not require an income inclusion under the section 367(a) or 367(b) regulations. See §§1.367(a)–8 and 1.367(b)–4.

(ii) Result . Under this paragraph (c), DC’s section 1248 amount with respect to its FC1 stock is computed by reference to all of FC1’s and FC2’s earnings and profits. See section 1248(c)(2). Because FC1’s section 1248 shareholder (DC) always held (directly or indirectly) all of the stock of FC2, FC1’s section 1248 amount with respect to its FC2 stock is computed by reference to all of FC2’s earnings and profits

(d) All earnings and profits amount (1) General rule . The term all earnings and profits amount with respect to stock in a foreign corporation means the net positive earnings and profits (if any) determined as provided under paragraph (d)(2) of this section and attributable to such stock as provided under paragraph (d)(3) of this section. The all earnings and profits amount shall be determined without regard to the amount of gain that would be realized on a sale or exchange of the stock of the foreign corporation.

(2) Rules for determining earnings and profits —(i) Domestic rules generally ap- plicable . For purposes of this paragraph (d), except as provided in sections 312(k)(4) and (n)(8), 964 and 986, the earnings and profits of a foreign corporation for any taxable year shall be determined according to principles substantially similar to those applicable to domestic corporations.

February 7, 2000 476 2000–6 I.R.B.

(ii) Certain adjustments to earnings and profits . Notwithstanding paragraph (d)(2)(i) of this section, for purposes of this paragraph (d), the earnings and profits of a foreign corporation for any taxable year shall not include the amounts specified in section 1248(d). In the case of amounts specified in section 1248(d)(4), the preceding sentence requires that the earnings and profits for any taxable year be decreased by the net positive amount (if any) of earnings and profits attributable to activities described in section 1248(d)(4), and increased by the net reduction (if any) in earnings and profits attributable to activities described in section 1248(d)(4). (iii) Effect of section 332 liquidating distribution . The all earnings and profits amount with respect to stock of a corporation that distributes all of its property in a liquidation described in section 332 shall be determined without regard to the adjustments prescribed by section 312(a) and (b) resulting from the distribution of such property in liquidation, except that gain or loss realized by the corporation on the distribution shall be taken into account to the extent provided in section 312(f)(1). See §1.367(b)–3(b)(3)(ii) Ex- ample 3 .

(3) Amount attributable to a block of stock —(i) Application of section 1248 principles —(A) In general —( 1 ) Rule . The all earnings and profits amount with respect to stock of a foreign corporation is determined according to the attribution principles of section 1248 and the regulations thereunder. The attribution principles of section 1248 shall apply without regard to the requirements of section 1248 that are not relevant to the determination of a shareholder’s pro rata portion of earnings and profits. Thus, for example, the all earnings and profits amount is determined without regard to whether the foreign corporation was a controlled foreign corporation at any time during the five years preceding the section 367(b) exchange in question, without regard to whether the shareholder owned a 10 percent or greater interest in the stock, and without regard to whether the earnings and profits of the foreign corporation were accumulated in post-1962 taxable years or while the corporation was a controlled foreign corporation.

( 2 ) Example . The following example

illustrates the rules of this paragraph (d)(3)(i)(A):

Example —(i) Facts . On January 1, 2001, DC, a domestic corporation, purchases 9 percent of the outstanding stock of FC, a foreign corporation. On January 1, 2002, DC purchases an additional 1 percent of FC stock. On January 1, 2003, DC exchanges its stock in FC in a section 367(b) exchange in which DC is required to include the all earnings and profits amount in income. FC was not a controlled foreign corporation during the entire period DC held its FC stock.

(ii) Result . The all earnings and profits amount with respect to DC’s stock in FC is computed by reference to 9 percent of FC’s earnings and profits from January 1, 2001, through December 31, 2001, and by reference to 10 percent of FC’s earnings and profits from January 1, 2002, through January 1, 2003. (B) Foreign shareholders . In the case of a transaction in which the exchanging shareholder is a foreign corporation (foreign shareholder), the following additional rules shall apply–

( 1 ) The attribution principles of section 1248 shall apply without regard to whether the person directly owning the stock is a United States person; and

( 2 ) The foreign shareholder’s holding period in the stock of the foreign acquired corporation shall be determined by reference to the period that the foreign shareholder’s United States shareholders (as defined in §1.367(b)–3(b)(2)) held (directly or indirectly) an interest in the foreign acquired corporation. This paragraph (d)(3)(i)(B)( 2 ) applies in addition to the section 1248 regulations’ incorporation of section 1223 holding periods, as modified by paragraph (d)(3)(ii) of this section and §1.367(b)–4(d) (as applicable).

(ii) Limitation on amounts attributable to holding periods determined under sec- tion 1223 —(A) Rule . In applying the attribution principles of section 1248 and the regulations thereunder to determine the all earnings and profits amount with respect to the stock of a foreign corporation, earnings and profits attributable to a section 1223(2) holding period that relates to a period of direct ownership of the stock of the foreign corporation by a nonUnited States person shall not be included, except to the extent of earnings and profits attributable to a period when the stock of the foreign corporation was indirectly owned by United States shareholders (as defined in §1.367(b)–3(b)(2)).

(B) Example . The following example illustrates the rules of this paragraph

(d)(3)(ii):

Example —(i) Facts . (A) FC1 is a foreign corporation. The outstanding stock of FC1 is directly owned by the following unrelated persons: 20 percent by DP, a domestic partnership; 20 percent by DC, a domestic corporation; 20 percent by FC, a foreign corporation that is directly and indirectly owned by foreign persons; 20 percent by FP, a foreign partnership that is equally owned by 2 partners, DI, a United States citizen, and FI, a nonresident alien; and 20 percent by a variety of minority shareholders, none of whom owns, applying the ownership rules of section 958, 10 percent or more of the outstanding stock of FC (the small shareholders).

(B) FC1 owns all of the outstanding stock of FC2, a foreign corporation that is not a controlled foreign corporation subject to the rules of section 953(c). FC2 has net positive earnings and profits. In a reorganization described in section 368(a)(1)(B), DA, a domestic corporation, acquires all of the stock of FC2 from FC1 in exchange for DA voting stock.

(ii) Result . (A) Under section 1223(2), DA holds the stock of FC2 with a holding period that includes the period that FC2 was held by FC1. As a result, the rules of this paragraph (d)(3)(ii) apply for purposes of computing DA’s all earnings and profits amount.

(B) In applying the attribution principles of section 1248, earnings and profits attributable to a section 1223(2) holding period that refers to a period of direct ownership of the stock of a foreign corporation by a non-United States person are not included, except to the extent the stock of the foreign corporation was indirectly owned by United States shareholders as defined in §1.367(b)–3(b)(2). Accordingly, DA’s all earnings and profits amount does not include the FC2 earnings and profits attributable to FC, FI, and the small shareholders. DA’s all earnings and profits amount does include the FC2 earnings and profits attributable to DP, DC, and DI. See §1.367(b)–2(k) for rules concerning the treatment of partnerships under the section 367(b) regulations.

(iii) Exclusion of lower-tier earnings . In applying the attribution principles of section 1248 and the regulations thereunder to determine the all earnings and profits amount with respect to stock of a foreign corporation, the earnings and profits of subsidiaries of the foreign corporation shall not be taken into account notwithstanding section 1248(c)(2).

(e) Treatment of deemed dividends (1) In general . In certain circumstances these regulations provide that an exchanging shareholder shall include an amount in income as a deemed dividend. This paragraph provides rules for the treatment of the deemed dividend.

(2) Consequences of dividend charac- terization . A deemed dividend described in paragraph (e)(1) of this section shall be treated as a dividend for purposes of the Internal Revenue Code. The deemed dividend shall be considered as paid out of

2000–6 I.R.B. 477 February 7, 2000

the earnings and profits with respect to which the amount of the deemed dividend was determined. Thus, for example, a deemed dividend that is determined by reference to the all earnings and profits amount or the section 1248 amount will never be considered as paid out of (and therefore will never reduce) earnings and profits specified in section 1248(d), because such earnings and profits are excluded in computing the all earnings and profits amount (under paragraph (d)(2)(ii) of this section) and the section 1248 amount (under section 1248(d) and paragraph (c)(1) of this section). If the deemed dividend is determined by reference to the earnings and profits of a foreign corporation that is owned indirectly (i.e., through one or more tiers of intermediate owners) by the person that is required to include the deemed dividend in income, the deemed dividend shall be considered as having been paid by such corporation to such person through the intermediate owners, rather than directly to such person.

(3) Ordering rules . In the case of an exchange of stock in which the exchanging shareholder is treated as receiving a deemed dividend from a foreign corporation, the following ordering rules concerning the timing, treatment, and effect of such a deemed dividend shall apply. See also paragraph (j)(2) of this section.

(i) For purposes of the section 367(b) regulations, the gain realized by an exchanging shareholder shall be determined before increasing (as provided in paragraph (e)(3)(ii) of this section) the basis in the stock of the foreign corporation by the amount of the deemed dividend.

(ii) Except as provided in paragraph (e)(3)(i) of this section, the deemed dividend shall be considered to be received immediately before the exchanging shareholder’s receipt of consideration for its stock in the foreign corporation, and the shareholder’s basis in the stock exchanged shall be increased by the amount of the deemed dividend. Such basis increase shall be taken into account before determining the gain otherwise recognized on the exchange (for example, under section 356), the basis that the exchanging shareholder takes in the property that it receives in the exchange (under section 358(a)(1)), and the basis that the transferee otherwise takes in the

transferred stock (under section 362).

(iii) Except as provided in paragraph (e)(3)(i) of this section, the earnings and profits of the appropriate foreign corporation shall be reduced by the deemed dividend amount before determining the consequences of the recognition of gain in excess of the deemed dividend amount (for example, under section 356(a)(2) or sections 356(a)(1) and 1248).

(4) Examples . The following examples illustrate the rules of this paragraph (e):

Example 1 . DC, a domestic corporation, exchanges stock in FC, a foreign corporation, in a section 367(b) exchange in which DC includes the all earnings and profits amount in income as a deemed dividend. Under paragraph (e)(2) of this section, a deemed dividend is treated as a dividend for purposes of the Internal Revenue Code. As a result, if the requirements of section 902 are met, DC may qualify for a deemed paid foreign tax credit with respect to the deemed dividend that it receives from FC.

Example 2 . DC, a domestic corporation, exchanges stock in FC1, a foreign corporation that is a controlled foreign corporation, in a transaction in which DC is required to include the section 1248 amount in income as a deemed dividend. A portion of the section 1248 amount is determined by reference to the earnings and profits of FC1 (the uppertier portion of the section 1248 amount), and the remainder of the section 1248 amount is determined by reference to the earnings and profits of FC2, which is a wholly owned foreign subsidiary of FC1 (the lower-tier portion of the section 1248 amount). Under paragraph (e)(2) of this section, DC computes its deemed paid foreign tax credit as if the lower-tier portion of the section 1248 amount were distributed as a dividend by FC2 to FC1, and as if such portion and the upper-tier portion of the section 1248 amount were then distributed as a dividend by FC1 to DC.

Example 3 . DC, a domestic corporation, exchanges stock in FC, a foreign corporation that is a controlled foreign corporation, in a transaction in which DC realizes gain of $100 (prior to the application of the section 367(b) regulations). In connection with the transaction, DC is required to include $40 in income as a deemed dividend under the section 367(b) regulations. In addition to receiving property permitted to be received under section 354 without the recognition of gain, DC also receives cash in the amount of $70. Under paragraph (e)(3) of this section, the $40 deemed dividend increases DC’s basis in its FC stock before determining the gain to be recognized under section 356. Thus, in applying section 356, DC is considered to realize $60 of gain on the exchange, all of which is recognized under section 356(a)(1).

(f) Deemed asset transfer and closing of taxable year in certain section 368(a)(1)(F) reorganizations —(1) Scope . This paragraph applies to a reorganization described in section 368(a)(1)(F) in which the transferor cor

poration is a foreign corporation.

(2) Deemed asset transfer . In a reorganization described in paragraph (f)(1) of this section, there is considered to exist—

(i) A transfer of assets by the foreign transferor corporation to the acquiring corporation in exchange for stock (or stock and securities) of the acquiring corporation and the assumption by the acquiring corporation of the foreign transferor corporation’s liabilities;

(ii) A distribution of such stock (or stock and securities) by the foreign transferor corporation to its shareholders (or shareholders and security holders); and

(iii) An exchange by the foreign transferor corporation’s shareholders (or shareholders and security holders) of their stock (or stock and securities) for stock (or stock and securities) of the acquiring corporation.

(3) Other applicable rules . For purposes of this paragraph (f), it is immaterial that the applicable foreign or domestic law treats the acquiring corporation as a continuation of the foreign transferor corporation.

(4) Closing of taxable year. In a reorganization described in paragraph (f)(1) of this section, the taxable year of the foreign transferor corporation shall end with the close of the date of the transfer and the taxable year of the acquiring corporation shall end with the close of the date on which the transferor’s taxable year would have ended but for the occurrence of the reorganization if–

(i) The acquiring corporation is a domestic corporation; or

(ii) The foreign transferor corporation has effectively connected earnings and profits (as defined in section 884(d)) or accumulated effectively connected earnings and profits (as defined in section 884(b)(2)(B)(ii)). (g) Stapled stock under section 269B . For rules treating a foreign corporation as a domestic corporation if it and a domestic corporation are stapled entities, see section 269B. The deemed conversion of a foreign corporation to a domestic corporation under section 269B is treated as a reorganization under section 368(a)(1)(F).

(h) Section 953(d) domestication elec- tions —(1) Effect of election . A foreign corporation that elects under section 953(d) to be treated as a domestic corpo

February 7, 2000 478 2000–6 I.R.B.

ration shall be treated for purposes of section 367(b) as transferring, as of the first day of the first taxable year for which the election is effective, all of its assets to a domestic corporation in a reorganization described in section 368(a)(1)(F). Notwithstanding paragraph (d) of this section, for purposes of determining the consequences of the reorganization under §1.367(b)–3, the all earnings and profits amount shall not be considered to include earnings and profits accumulated in taxable years beginning before January 1, 1988. (2) Post-election exchanges . For purposes of applying section 367(b) to postelection exchanges with respect to a corporation that has made a valid election under section 953(d) to be treated as a domestic corporation, such corporation shall be treated as a domestic corporation as to earnings and profits that were taken into account at the time of the section 953(d) election or which accrue after such election, and shall be treated as a foreign corporation as to earnings and profits accumulated in taxable years beginning before January 1, 1988. Thus, for example, if the section 953(d) corporation subsequently transfers its assets to a domestic corporation (other than another section 953(d) corporation) in a transaction described in section 381(a), the rules of §1.367(b)–3 shall apply to such transaction to the extent of the section 953(d) corporation’s earnings and profits accumulated in taxable years beginning before January 1, 1988. (i) Section 1504(d) elections . An election under section 1504(d), which permits certain foreign corporations to be treated as domestic corporations, is treated as a transfer of property to a domestic corporation and will generally constitute a reorganization described in section 368(a)(1)(F). However, if an election under section 1504(d) is made with respect to a foreign corporation from the first day of the foreign corporation’s existence, then the foreign corporation shall be treated as a domestic corporation, and the section 367(b) regulations will not apply.

(j) Sections 985 through 989 —(1) Change in functional currency of a quali- fied business unit —(i) Rule . If, as a result of a transaction described in section 381(a), a qualified business unit (as de

fined in section 989(a)) (QBU) has a different functional currency determined under the rules of section 985(b) than it used prior to the transaction, then the QBU shall be deemed to have automatically changed its functional currency immediately prior to the transaction. A QBU that is deemed to change its functional currency pursuant to this paragraph (j) must make the adjustments described in §1.985–5.

(ii) Example . The following example illustrates the rule of this paragraph (j)(1):

Example —(i) Facts . DC, a domestic corporation, owns 100 percent of FC1, a foreign corporation. FC1 owns and operates a qualified business unit (QBU) (B1) in France, whose functional currency is the euro. FC2, an unrelated foreign corporation, owns and operates a QBU (B2) in France, whose functional currency is the dollar. FC2 acquires FC1’s assets (including B1) in a reorganization described in section 368(a)(1)(C). As a part of the reorganization, B1 and B2 combine their operations into one QBU. Applying the rules of section 985(b), the functional currency of the combined operations of B1 and B2 is the euro.

(ii) Result . FC2’s acquisition of FC1’s assets is a section 367(b) exchange that is described in section 381(a). Because the functional currency of the combined operations of B1 and B2 after the exchange is the euro, B2 is deemed to have automatically changed its functional currency to the euro immediately prior to the section 367(b) exchange. B2 must make the adjustments described in §1.985–5.

(2) Previously taxed earnings and profits —(i) Exchanging shareholder that is a United States person. If an exchanging shareholder that is a United States person is required to include in income either the all earnings and profits amount or the section 1248 amount under the provisions of §1.367(b)–3 or 1.367(b)–4, then immediately prior to the exchange, and solely for the purpose of computing exchange gain or loss under section 986(c), the exchanging shareholder shall be treated as receiving a distribution of previously taxed earnings and profits from the appropriate foreign corporation that is attributable (under the principles of section 1248) to the exchanged stock. If an exchanging shareholder that is a United States person is a distributee in an exchange described in §1.367(b)–5(c) or (d), then immediately prior to the exchange, and solely for the purpose of computing exchange gain or loss under section 986(c), the exchanging shareholder shall be treated as receiving a distribution of previously taxed earnings and profits from the appropriate foreign corporation to the extent such shareholder

has a diminished interest in such previously taxed earnings and profits after the exchange. The exchange gain or loss recognized under this paragraph (j)(2)(i) will increase or decrease the exchanging shareholder’s adjusted basis in the stock of the foreign corporation for purposes of computing gain or loss realized with respect to the stock on the transaction. The exchanging shareholder’s dollar basis with respect to each account of previously taxed income shall be increased or decreased by the exchange gain or loss recognized.

(ii) Exchanging shareholder that is a foreign corporation . If an exchanging shareholder that is a foreign corporation is required to include in income either the all earnings and profits amount or the section 1248 amount under the provisions of §1.367(b)–3 or 1.367(b)–4, then, immediately prior to the exchange, the exchanging shareholder shall be treated as receiving a distribution of previously taxed earnings and profits from the appropriate foreign corporation that is attributable (under the principles of section 1248) to the exchanged stock. If an exchanging shareholder that is a foreign corporation is a distributee in an exchange described in §1.367(b)–5(c) or (d), then the exchanging shareholder shall be treated as receiving (immediately prior to the exchange) a distribution of previously taxed earnings and profits from the appropriate foreign corporation. Such distribution shall be measured by the extent to which the exchanging shareholder’s direct or indirect United States shareholders (as defined in section 951(b)) have a diminished interest in such previously taxed earnings and profits after the exchange.

(3) Other rules . See sections 985 through 989 for other currency rules that may apply in connection with a section 367(b) exchange. (k) Partnerships, trusts and estates . In applying the section 367(b) regulations, stock of a corporation that is owned by a foreign partnership, trust or estate shall be considered as owned proportionately by its partners, owners, or beneficiaries under the principles of §1.367(e)–1(b)(2). Stock owned by an entity that is disregarded as an entity separate from its owner under §301.7701–3 is owned directly by the owner of such entity. In applying §1.367(b)–5(b), the principles of

2000–6 I.R.B. 479 February 7, 2000

§1.367(e)–1(b)(2) shall also apply to a domestic partnership, trust or estate.

Par. 5. Section 1.367(b)–3 is added to read as follows: §1.367(b)–3 Repatriation of foreign cor- porate assets in certain nonrecognition transactions.

(a) Scope . This section applies to an acquisition by a domestic corporation (the domestic acquiring corporation) of the assets of a foreign corporation (the foreign acquired corporation) in a liquidation described in section 332 or an asset acquisition described in section 368(a)(1).

(b) Exchange of stock owned directly by a United States shareholder or by cer- tain foreign corporate shareholders —(1) Scope . This paragraph (b) applies in the case of an exchanging shareholder that is either—

(i) A United States shareholder of the foreign acquired corporation; or

(ii) A foreign corporation with respect to which there are one or more United States shareholders.

(2) United States shareholder . For purposes of this section (and for purposes of the other section 367(b) regulation provisions that specifically refer to this paragraph (b)(2)), the term United States shareholder means any shareholder described in section 951(b) (without regard to whether the foreign corporation is a controlled foreign corporation), and also any shareholder described in section 953(c)(1)(A) (but only if the foreign corporation is a controlled foreign corporation subject to the rules of section 953(c)).

(3) Income inclusion —(i) Inclusion of all earnings and profits amount . An exchanging shareholder shall include in income as a deemed dividend the all earnings and profits amount with respect to its stock in the foreign acquired corporation. For the consequences of the deemed dividend, see §1.367(b)–2(e). Notwithstanding §1.367(b)–2(e), however, a deemed dividend from the foreign acquired corporation to an exchanging foreign corporate shareholder shall not qualify for the exception from foreign personal holding company income provided by section 954(c)(3)(A)(i), although it may qualify for the look-through treatment provided by section 904(d)(3) if the requirements of that section are met with respect to the deemed dividend.

(ii) Examples . The following exam

ples illustrate the rules of paragraph (b)(3)(i) of this section:

Example 1 —(i) Facts . DC, a domestic corporation, owns all of the outstanding stock of FC, a foreign corporation. The stock of FC has a value of $100, and DC has a basis of $30 in such stock. The all earnings and profits amount attributable to the FC stock owned by DC is $20, of which $15 is described in section 1248(a) and the remaining $5 is not (for example, because it accumulated prior to 1963). FC has a basis of $50 in its assets. In a liquidation described in section 332, FC distributes all of its property to DC, and the FC stock held by DC is canceled.

(ii) Result . Under paragraph (b)(3)(i) of this section, DC must include $20 in income as a deemed dividend from FC. Under section 337(a) FC does not recognize gain or loss in the assets that it distributes to DC, and under section 334(b), DC takes a basis of $50 in such assets. Because the requirements of section 902 are met, DC qualifies for a deemed paid foreign tax credit with respect to the deemed dividend that it receives from FC.

Example 2 —(i) Facts . DC, a domestic corporation, owns all of the outstanding stock of FC, a foreign corporation. The stock of FC has a value of $100, and DC has a basis of $30 in such stock. The all earnings and profits amount attributable to the FC stock owned by DC is $75. FC has a basis of $50 in its assets. In a liquidation described in section 332, FC distributes all of its property to DC, and the FC stock held by DC is canceled.

(ii) Result . Under paragraph (b)(3)(i) of this section, DC must include $75 in income as a deemed dividend from FC. Under section 337(a) FC does not recognize gain or loss in the assets that it distributes to DC, and under section 334(b), DC takes a basis of $50 in such assets. Because the requirements of section 902 are met, DC qualifies for a deemed paid foreign tax credit with respect to the deemed dividend that it receives from FC.

Example 3 —(i) Facts . DC, a domestic corporation, owns 80 percent of the outstanding stock of FC, a foreign corporation. DC has owned its 80 percent interest in FC since FC was incorporated. The remaining 20 percent of the outstanding stock of FC is owned by a person unrelated to DC (the minority shareholder). The stock of FC owned by DC has a value of $80, and DC has a basis of $24 in such stock. The stock of FC owned by the minority shareholder has a value of $20, and the minority shareholder has a basis of $18 in such stock. FC’s only asset is land having a value of $100, and FC has a basis of $50 in the land. Gain on the land would not generate earnings and profits qualifying under section 1248(d) for an exclusion from earnings and profits for purposes of section 1248. FC has earnings and profits of $20 (determined under the rules of §1.367(b)–2(d)(2)(i) and (ii)), $16 of which is attributable to the stock owned by DC under the rules of §1.367(b)–2(d)(3). FC subdivides the land and distributes to the minority shareholder land with a value of $20 and a basis of $10. As part of the same transaction, in a liquidation described in section 332, FC distributes the remainder of its land to DC, and the FC stock held by DC and the minority shareholder is canceled.

(ii) Result . Under section 336, FC must recognize the $10 of gain it realizes in the land it distributes to the minority shareholder, and under section

331 the minority shareholder recognizes its gain of $2 in the stock of FC. Such gain is included in income by the minority shareholder as a dividend to the extent provided in section 1248 if the minority shareholder is a United States person that is described in section 1248(a)(2). Under §1.367(b)–2(d)(2)(iii), the $10 of gain recognized by FC increases its earnings and profits for purposes of computing the all earnings and profits amount and, as a result, $8 of such increase (80 percent of $10) is considered to be attributable to the FC stock owned by DC under §1.367(b)–2(d)(3)(i)(A)(1). DC’s all earnings and profits amount with respect to its stock in FC is $24 (the $16 of initial all earnings and profits amount with respect to the FC stock held by DC, plus the $8 addition to such amount that results from FC’s recognition of gain on the distribution to the minority shareholder). Under paragraph (b)(3)(i) of this section, DC must include the $24 all earnings and profits amount in income as a deemed dividend from FC.

Example 4 —(i) Facts . DC1, a domestic corporation, owns all of the outstanding stock of DC2, a domestic corporation. DC1 also owns all of the outstanding stock of FC, a foreign corporation. The stock of FC has a value of $100, and DC1 has a basis of $30 in such stock. The assets of FC have a value of $100. The all earnings and profits amount with respect to the FC stock owned by DC1 is $20. In a reorganization described in section 368(a)(1)(D), DC2 acquires all of the assets of FC solely in exchange for DC2 stock. FC distributes the DC2 stock to DC1, and the FC stock held by DC1 is canceled.

(ii) Result . DC1 must include $20 in income as a deemed dividend from FC under paragraph (b)(3)(i) of this section. Under section 361, FC does not recognize gain or loss in the assets that it transfers to DC2 or in the DC2 stock that it distributes to DC1, and under section 362(b) DC2 takes a basis in the assets that it acquires from FC equal to the basis that FC had therein. Under §1.367(b)–2(e)(3)(ii) and section 358(a)(1), DC1 takes a basis of $50 (its $30 basis in the stock of FC, plus the $20 that was treated as a deemed dividend to DC1) in the stock of DC2 that it receives in exchange for the stock of FC. Under §1.367(b)–2(e)(3)(iii) and section 312(a), the earnings and profits of FC are reduced by the $20 deemed dividend.

Example 5 —(i) Facts . DC1, a domestic corporation, owns all of the outstanding stock of DC2, a domestic corporation. DC1 also owns all of the outstanding stock of FC1, a foreign corporation. FC1 owns all of the outstanding stock of FC2, a foreign corporation. The all earnings and profits amount with respect to the FC2 stock owned by FC1 is $20. In a reorganization described in section 368(a)(1)(D), DC2 acquires all of the assets and liabilities of FC2 in exchange for DC2 stock. FC2 distributes the DC2 stock to FC1, and the FC2 stock held by FC1 is canceled.

(ii) Result . FC1 must include $20 in income as a deemed dividend from FC2 under paragraph (b)(3)(i) of this section. The deemed dividend is treated as a dividend for purposes of the Internal Revenue Code as provided in §1.367(b)–2(e)(2); however, under paragraph (b)(3)(i) of this section the deemed dividend cannot qualify for the exception from foreign personal holding company income provided by section 954(c)(3)(A)(i), even if the pro

February 7, 2000 480 2000–6 I.R.B.

visions of that section would otherwise have been met in the case of an actual dividend.

Example 6 —(i) Facts . DC1, a domestic corporation, owns 99 percent of USP, a domestic partnership. The remaining 1 percent of USP is owned by a person unrelated to DC1. DC1 and USP each directly own 9 percent of the outstanding stock of FC, a foreign corporation that is not a controlled foreign corporation subject to the rule of section 953(c). In a reorganization described in section 368(a)(1)(C), DC2, a domestic corporation, acquires all of the assets and liabilities of FC in exchange for DC2 stock. FC distributes to its shareholders DC2 stock, and the FC stock held by its shareholders is canceled.

(ii) Result . (A) DC1 and USP are United States persons that are exchanging shareholders in a transaction described in paragraph (a) of this section. As a result, DC1 and USP are subject to the rules of paragraph (b) of this section if they qualify as United States shareholders as defined in paragraph (b)(2) of this section. Alternatively, if they do not qualify as United States shareholders as defined in paragraph (b)(2) of this section, DC1 and USP are subject to the rules of paragraph (c) of this section. Paragraph (b)(2) of this section defines the term United States shareholder to include any shareholder described in section 951(b) (without regard to whether the foreign corporation is a controlled foreign corporation). A shareholder described in section 951(b) is a United States person that is considered to own, applying the rules of section 958(a) and 958(b), 10 percent or more of the total combined voting power of all classes of stock entitled to vote of a foreign corporation. Under section 958(b), the rules of section 318(a), as modified by section 958(b) and the regulations thereunder, apply so that, in general, stock owned directly or indirectly by a partnership is considered as owned proportionately by its partners, and stock owned directly or indirectly by a partner is considered as owned by the partnership. Thus, under section 958(b), DC1 is treated as owning its proportionate share of FC stock held by USP, and USP is treated as owning all of the FC stock held by DC1.

(B) Accordingly, for purposes of determining whether DC1 is a United States shareholder under paragraph (b)(2) of this section, DC1 is considered as owning 99 percent of the 9 percent of FC stock held by USP. Because DC1 also owns 9 percent of FC stock directly, DC1 is considered as owning more than 10 percent of FC stock. DC1 is thus a United States shareholder of FC under paragraph (b)(2) of this section and, as a result, is subject to the rules of paragraph (b) of this section. However, for purposes of determining DC1’s all earnings and profits amount, DC1 is not treated as owning the FC stock held by USP. Under §1.367(b)–2(d)(3), DC1’s all earnings and profits amount is determined by reference to the 9 percent of FC stock that it directly owns.

(C) For purposes of determining whether USP is a United States shareholder under paragraph (b)(2) of this section, USP is considered as owning the 9 percent of FC stock held by DC1. Because USP also owns 9 percent of FC stock directly, USP is considered as owning more than 10 percent of FC stock. USP is thus a United States shareholder of FC under paragraph (b)(2) of this section and, as a result, is subject to the rules of paragraph (b)

of this section. However, for purposes of determining USP’s all earnings and profits amount, USP is not treated as owning the FC shares held by DC1. Under §1.367(b)–2(d)(3), USP’s all earnings and profits amount is determined by reference to the 9 percent of FC stock that it directly owns.

(iii) Recognition of exchange gain or loss with respect to capital . [Reserved]

(4) Reserved . For further guidance concerning section 367(b) exchanges occurring before February 24, 2001, see §1.367(b)–3T(b)(4).

(c) Exchange of stock owned by a United States person that is not a United States shareholder —(1) Scope . This paragraph (c) applies in the case of an exchanging shareholder that is a United States person not described in paragraph (b)(1)(i) of this section (i.e., a United States person that is not a United States shareholder of the foreign acquired corporation).

(2) Requirement to recognize gain . An exchanging shareholder described in paragraph (c)(1) of this section shall recognize realized gain (but not loss) with respect to the stock of the foreign acquired corporation.

(3) Election to include all earnings and profits amount . In lieu of the treatment prescribed by paragraph (c)(2) of this section, an exchanging shareholder described in paragraph (c)(1) of this section may instead elect to include in income as a deemed dividend the all earnings and profits amount with respect to its stock in the foreign acquired corporation. For the consequences of a deemed dividend, see §1.367(b)–2(e). Such election may be made only if–

(i) The foreign acquired corporation (or its successor in interest) has provided the exchanging shareholder information to substantiate the exchanging shareholder’s all earnings and profits amount with respect to its stock in the foreign acquired corporation; and

(ii) The exchanging shareholder complies with the section 367(b) notice requirement described in §1.367(b)–1(c), including the specific rules contained therein concerning the time and manner for electing to apply the rules of this paragraph (c)(3).

(4) De minimis exception . This paragraph (c) shall not apply in the case of an exchanging shareholder whose stock in the foreign acquired corporation has a fair market value of less than $50,000 on the

date of the section 367(b) exchange.

(5) Examples . The following examples illustrate the rules of this paragraph (c):

Example 1 —(i) Facts . DC1, a domestic corporation, owns 5 percent of the outstanding stock of FC, a foreign corporation that is not a controlled foreign corporation subject to the rule of section 953(c). Persons unrelated to DC1 own the remaining 95 percent of the outstanding stock of FC. DC1 has owned its 5 percent interest in FC since FC was incorporated. DC1’s stock in FC has a basis of $40,000 and a value of $100,000. The all earnings and profits amount with respect to DC1’s stock in FC is $50,000. In a reorganization described in section 368(a)(1)(C), DC2, a domestic corporation, acquires all of the assets and liabilities of FC in exchange for DC2 stock. FC distributes DC2 stock to its shareholders, and the FC stock held by its shareholders is canceled.

(ii) Alternate result 1 . If DC1 does not make the election described in paragraph (c)(3) of this section, then the general rule of paragraph (c)(2) of this section applies and DC1 must recognize its $60,000 gain in the FC stock. Under section 358(a)(1), DC1 has a $100,000 basis (its $40,000 basis in the FC stock, plus the $60,000 recognized gain) in the DC2 stock that it receives in exchange for its FC stock. Because DC1 is not a shareholder described in section 1248(a)(2), section 1248 does not apply to recharacterize any of DC1’s gain as a dividend.

(iii) Alternate result 2 . If DC1 makes a valid election under paragraph (c)(3) of this section, then DC1 must include in income as a deemed dividend the $50,000 all earnings and profits amount with respect to its FC stock. Under §1.367(b)–2(e)(3) and section 358(a)(1), DC1 has a $90,000 basis (its $40,000 basis in the FC stock, plus the $50,000 that was treated as a deemed dividend to DC1) in the DC2 stock that it receives in exchange for its FC stock. Because DC1 owns less than 10 percent of the voting stock of FC, DC1 does not qualify for a deemed paid foreign tax credit under section 902.

Example 2 —(i) Facts . The facts are the same as in Example 1, except that DC1’s stock in FC has a fair market value of $48,000 on the date DC1 receives the DC2 stock.

(ii) Result . Because DC1’s stock in FC has a fair market value of less than $50,000 on the date of the section 367(b) exchange, the de minimis exception of paragraph (c)(4) of this section applies. As a result, DC1 is not subject to the gain or income inclusion requirements of this paragraph (c).

(d) Carryover of certain foreign taxes —(1) Rule . Unused foreign tax credits allowable to the foreign acquired corporation under section 906 shall carry over to the domestic acquiring corporation and become allowable under section 901, subject to the limitations prescribed by the Internal Revenue Code (for example, sections 383, 904 and 907). The domestic acquiring corporation shall not succeed to any other foreign taxes paid or incurred by the foreign acquired corporation.

(2) Example . The following example

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illustrates the rules of this paragraph (d):

Example —(i) Facts . DC, a domestic corporation owns 100 percent of the outstanding stock of FC, a foreign corporation. FC has net positive earnings and profits, none of which are attributable to DC’s FC stock under §1.367(b)–2(d)(3). FC has paid foreign taxes that are not eligible for credit under section 906. In a liquidation described in section 332, FC distributes all of its property to DC, and the FC stock held by DC is canceled.

(ii) Result . The liquidation of FC into DC is a section 367(b) exchange. Thus, DC is subject to the section 367(b) regulations, and must file a section 367(b) notice pursuant to §1.367(b)–1(c). Pursuant to the provisions of paragraph (d)(1) of this section, the foreign taxes paid by FC do not carryover to DC because FC’s foreign taxes are not eligible for credit under section 906.

Par. 6. Section 1.367(b)–4 is revised to read as follows: §1.367(b)–4 Acquisition of foreign cor- porate stock or assets by a foreign corpo- ration in certain nonrecognition transac- tions.

(a) Scope . This section applies to an acquisition by a foreign corporation (the foreign acquiring corporation) of the stock or assets of another foreign corporation (the foreign acquired corporation) in an exchange described in section 351 or a reorganization described in section 368(a)(1)(B), (C), (D), (E), (F) or (G). See §1.367(a)–3(b)(2) for additional rules that may apply.

(b) Income inclusion . If an exchange is described in paragraph (b)(1)(i), (2)(i) or (3) of this section, the exchanging shareholder shall include in income as a deemed dividend the section 1248 amount attributable to the stock that it exchanges.

(1) Exchange that results in loss of sta- tus as section 1248 shareholder —(i) Rule . An exchange is described in this paragraph (b)(1)(i) if–

(A) Immediately before the exchange, the exchanging shareholder is—

( 1 ) A United States person that is a section 1248 shareholder with respect to the foreign acquired corporation; or

( 2 ) A foreign corporation, and a United States person is a section 1248 shareholder with respect to such foreign corporation and with respect to the foreign acquired corporation; and

(B) Either of the following conditions is satisfied—

( 1 ) Immediately after the exchange, the stock received in the exchange is not stock in a corporation that is a controlled foreign corporation as to which the United States person described in para

graph (b)(1)(i)(A) of this section is a section 1248 shareholder; or

( 2 ) Immediately after the exchange, the foreign acquiring corporation (or, in the case of a reorganization described in section 368(a)(1)(B), the foreign acquired corporation) is not a controlled foreign corporation as to which the United States person described in paragraph (b)(1)(i)(A) of this section is a section 1248 shareholder. (ii) Examples . The following examples illustrate the rules of this paragraph (b)(1):

Example 1 —(i) Facts . FC1 is a foreign corporation that is owned, directly and indirectly (applying the ownership rules of section 958), solely by foreign persons. DC is a domestic corporation that is unrelated to FC1. DC owns all of the outstanding stock of FC2, a foreign corporation. Thus, under §1.367(b)–2(a) and (b), DC is a section 1248 shareholder with respect to FC2, and FC2 is a controlled foreign corporation. Under §1.367(b)–2(c)(1), the section 1248 amount attributable to the stock of FC2 held by DC is $20. In a reorganization described in section 368(a)(1)(C), FC1 acquires all of the assets and assumes all of the liabilities of FC2 in exchange for FC1 voting stock. The FC1 voting stock received does not represent more than 50 percent of the voting power or value of FC1’s stock. FC2 distributes the FC1 stock to DC, and the FC2 stock held by DC is canceled.

(ii) Result . FC1 is not a controlled foreign corporation immediately after the exchange. As a result, the exchange is described in paragraph (b)(1)(i) of this section. Under paragraph (b) of this section, DC must include in income, as a deemed dividend from FC2, the section 1248 amount ($20) attributable to the FC2 stock that DC exchanged.

Example 2 —(i) Facts . The facts are the same as in Example 1, except that the voting stock of FC1, which is received by FC2 in exchange for its assets and distributed by FC2 to DC, represents more than 50 percent of the voting power of FC1’s stock under the rules of section 957(a).

(ii) Result . Paragraph (b)(1)(i) of this section does not apply to require inclusion in income of the section 1248 amount, because FC1 is a controlled foreign corporation as to which DC is a section 1248 shareholder immediately after the exchange.

Example 3 —(i) Facts. The facts are the same as in Example 1, except that FC2 receives and distributes voting stock of FP, a foreign corporation that is in control (within the meaning of section 368(c)) of FC1, instead of receiving and distributing voting stock of FC1.

(ii) Result . For purposes of section 367(a), the transfer is an indirect stock transfer subject to section 367(a). See §1.367(a)–3(d)(1)(iv). Accordingly, DC’s exchange of FC2 stock for FP stock under section 354 will be taxable under section 367(a) (and section 1248 will be applicable) if DC fails to enter into a gain recognition agreement in accordance with §1.367(a)–8. Under §1.367(a)–3(b)(2), if DC enters into a gain recognition agreement, the exchange will be subject to the provisions of section 367(b) and the regulations

thereunder, as well as section 367(a). If FP and FC1 are controlled foreign corporations as to which DC is a (direct or indirect) section 1248 shareholder immediately after the reorganization, then the section 367(b) result is the same as in Example 2 - that is, paragraph (b)(1)(i) of this section does not apply to require inclusion in income of the section 1248 amount. Under these circumstances, the amount of the gain recognition agreement would equal the amount of the gain realized on the indirect stock transfer. If FP or FC1 is not a controlled foreign corporation as to which DC is a (direct or indirect) section 1248 shareholder immediately after the exchange, then the section 367(b) result is the same as in Example 1 - that is, DC must include in income, as a deemed dividend from FC2, the section 1248 amount ($20) attributable to the FC2 stock that DC exchanged. Under these circumstances, the amount of the gain recognition agreement would equal the amount of the gain realized on the indirect stock transfer, less the $20 section 1248 amount inclusion.

Example 4 —(i) Facts . DC1, a domestic corporation, owns all of the outstanding stock of DC2, a domestic corporation. DC2 owns various assets including all of the outstanding stock of FC2, a foreign corporation. The stock of FC2 has a value of $100, and DC2 has a basis of $30 in such stock. The section 1248 amount attributable to the FC2 stock held by DC2 is $20. DC2 does not own any other stock in a foreign corporation. FC1 is a foreign corporation that is unrelated to DC1, DC2 and FC2. In a reorganization described in section 368(a)(1)(C), FC1 acquires all of the assets and liabilities of DC2 in exchange for FC1 voting stock that represents 20 percent of the outstanding voting stock of FC1. DC2 distributes the FC1 stock to DC1, and the DC2 stock held by DC1 is canceled. DC1 properly files a gain recognition agreement under §1.367(a)–8 to qualify for nonrecognition treatment under section 367(a) with respect to DC2’s transfer of the FC2 stock to FC1. See §1.367(a)–8(f)(2).

(ii) Result . Pursuant to paragraph (b)(1)(i)(A) of this section, DC2 is the exchanging shareholder that is a section 1248 shareholder with respect to FC2, the foreign acquired corporation. Immediately after the exchange, DC2 is not a section 1248 shareholder with respect to FC1, the corporation whose stock is received in the exchange (because the DC2 stock is canceled). Thus, paragraph (b)(1)(i)(B) of this section is satisfied and, as a result, paragraph (b)(1)(i) of this section applies to DC2’s section 361 exchange of FC2 stock. Accordingly, under paragraph (b) of this section, DC2 must include in income, as a deemed dividend from FC2, the section 1248 amount ($20) attributable to the FC2 stock that DC2 exchanges. This result arises without regard to whether FC1 and FC2 are controlled foreign corporations immediately after the exchange. For the tax treatment of DC2’s transfer of assets (other than stock) to FC1, see sections 367(a)(1) and (a)(3), and the regulations thereunder. Because the exchange is also described in section 361(a) or (b), see section 367(a)(5) and any regulations thereunder. If any of the assets transferred are intangible assets, see section 367(d) and the regulations thereunder.

(2) Receipt by exchanging shareholder of preferred or other stock in certain in- stances —(i) Rule . An exchange is described in this paragraph (b)(2)(i) if–

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(A) Immediately before the exchange, the foreign acquired corporation and the foreign acquiring corporations are not members of the same affiliated group (within the meaning of section 1504(a), but without regard to the exceptions set forth in section 1504(b), and substituting the words “more than 50” in place of the words “at least 80” in sections 1504(a)(2)(A) and (B)); (B) Immediately after the exchange, a domestic corporation meets the ownership threshold specified by section 902(a) or (b) such that it may qualify for a deemed paid foreign tax credit if it receives a distribution from the foreign acquiring corporation (directly or through tiers); and

(C) The exchanging shareholder receives preferred stock (other than preferred stock that is fully participating with respect to dividends, redemptions and corporate growth) in consideration for common stock or preferred stock that is fully participating with respect to dividends, redemptions and corporate growth, or, in the discretion of the Commissioner or the Commissioner’s delegate (and without regard to whether the stock exchanged is common stock or preferred stock), receives stock that entitles it to participate (through dividends, redemption payments or otherwise) disproportionately in the earnings generated by particular assets of the foreign acquired corporation or foreign acquiring corporation.

(ii) Examples . The following examples illustrate the rules of this paragraph (b)(2):

Example 1 —(i) Facts . FC1 is a foreign corporation. DC is a domestic corporation that is unrelated to FC1. DC owns all of the outstanding stock of FC2, a foreign corporation, and FC2 has no outstanding preferred stock. The value of FC2 is $100 and DC has a basis of $50 in the stock of FC2. Under §1.367(b)–2(c)(1), the section 1248 amount attributable to the stock of FC2 held by DC is $20. In a reorganization described in section 368(a)(1)(B), FC1 acquires all of the stock of FC2 and, in exchange, DC receives FC1 voting preferred stock that constitutes 10 percent of the voting stock of FC1 for purposes of section 902(a). Immediately after the exchange, FC1 and FC2 are controlled foreign corporations and DC is a section 1248 shareholder of FC1 and FC2, so paragraph (b)(1)(i) of this section does not require inclusion in income of the section 1248 amount.

(ii) Result . Pursuant to §1.367(a)–3(b)(2), the transfer is subject to both section 367(a) and section 367(b). Under §1.367(a)–3(b)(1), DC will not be subject to tax under section 367(a)(1) if it enters into

a gain recognition agreement in accordance with §1.367(a)–8. Even though paragraph (b)(1)(i) of this section does not apply to require inclusion in income by DC of the section 1248 amount, DC must nevertheless include the $20 section 1248 amount in income as a deemed dividend from FC2 under paragraph (b)(2)(i) of this section. Thus, if DC enters into a gain recognition agreement, the amount is $30 (the $50 gain realized less the $20 recognized under section 367(b)). If DC fails to enter into a gain recognition agreement, it must include in income under section 367(a)(1) the $50 of gain realized ($20 of which is treated as a dividend under section 1248). Section 367(b) does not apply in such case. Example 2 —(i) Facts . The facts are the same as in Example 1, except that DC owns all of the outstanding stock of FC1 immediately before the transaction.

(ii) Result . Both section 367(a) and section 367(b) apply to the transfer. Paragraph (b)(2)(i) of this section does not apply to require inclusion of the section 1248 amount. Under paragraph (b)(2)(i)(A) of this section, the transaction is outside the scope of paragraph (b)(2)(i) of this section because FC1 and FC2 are, immediately before the transaction, members of the same affiliated group (within the meaning of such paragraph). Thus, if DC enters into a gain recognition agreement in accordance with §1.367(a)–8, the amount of such agreement is $50. As in Example 1, if DC fails to enter into a gain recognition agreement, it must include in income $50, $20 of which will be treated as a dividend under section 1248.

Example 3 —(i) Facts . FC1 is a foreign corporation. DC is a domestic corporation that is unrelated to FC1. DC owns all of the outstanding stock of FC2, a foreign corporation. The section 1248 amount attributable to the stock of FC2 held by DC is $20. In a reorganization described in section 368(a)(1)(B), FC1 acquires all of the stock of FC2 in exchange for FC1 voting stock that constitutes 10 percent of the voting stock of FC1 for purposes of section 902(a). The FC1 voting stock received by DC in the exchange carries voting rights in FC1, but by agreement of the parties the shares entitle the holder to dividends, amounts to be paid on redemption, and amounts to be paid on liquidation, that are to be determined by reference to the earnings or value of FC2 as of the date of such event, and that are affected by the earnings or value of FC1 only if FC1 becomes insolvent or has insufficient capital surplus to pay dividends.

(ii) Result . Under §1.367(a)–3(b)(1), DC will not be subject to tax under section 367(a)(1) if it enters into a gain recognition agreement with respect to the transfer of FC2 stock to FC1. Under §1.367(a)–3(b)(2), the exchange will be subject to the provisions of section 367(b) and the regulations thereunder to the extent that it is not subject to tax under section 367(a)(1). Furthermore, even if DC would not otherwise be required to recognize income under this section, the Commissioner or the Commissioner’s delegate may nevertheless require that DC include the $20 section 1248 amount in income as a deemed dividend from FC2 under paragraph (b)(2)(i) of this section.

(3) Certain recapitalizations . An exchange pursuant to a recapitalization under section 368(a)(1)(E) shall be

deemed to be an exchange described in this paragraph (b)(3) if the following conditions are satisfied—

(i) During the 24-month period immediately preceding or following the date of the recapitalization, the corporation that undergoes the recapitalization (or a predecessor of, or successor to, such corporation) also engages in a transaction that would be described in paragraph (b)(2)(i) of this section but for paragraph (b)(2)(i)(C) of this section, either as the foreign acquired corporation or the foreign acquiring corporation; and

(ii) The exchange in the recapitalization is described in paragraph (b)(2)(i)(C) of this section.

(c) Exclusion of deemed dividend from foreign personal holding company in- come —(1) Rule . In the event the section 1248 amount is included in income as a deemed dividend by a foreign corporation under paragraph (b) of this section, such deemed dividend shall not be included as foreign personal holding company income under section 954(c).

(2) Example . The following example illustrates the rule of this paragraph (c):

Example —(i) Facts . FC1 is a foreign corporation that is owned, directly and indirectly (applying the ownership rules of section 958), solely by foreign persons. DC is a domestic corporation that is unrelated to FC1. DC owns all of the outstanding stock of FC2, a foreign corporation. FC2 owns all of the outstanding stock of FC3, a foreign corporation. Under §1.367(b)–2(c)(1), the section 1248 amount attributable to the stock of FC3 held by FC2 is $20. In a reorganization described in section 368(a)(1)(B), FC1 acquires from FC2 all of the stock of FC3 in exchange for FC1 voting stock. The FC1 voting stock received by FC2 does not represent more than 50 percent of the voting power or value of FC1’s stock.

(ii) Result . FC1 is not a controlled foreign corporation immediately after the exchange. Under paragraph (b)(1) of this section, FC2 must include in income, as a deemed dividend from FC3, the section 1248 amount ($20) attributable to the FC3 stock that FC2 exchanged. The deemed dividend is treated as a dividend for purposes of the Internal Revenue Code as provided in §1.367(b)–2(e)(2); however, under this paragraph (c) the deemed dividend is not foreign personal holding company income to FC2.

(d) Rules for subsequent exchanges (1) In general . If income is not required to be included under paragraph (b) of this section in a section 367(b) exchange described in paragraph (a) of this section (non-inclusion exchange) then, for purposes of applying section 367(b) or 1248 to subsequent exchanges, the determination of the earnings and profits

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attributable to an exchanging shareholder’s stock received in the non-inclusion exchange shall include a computation that refers to the exchanging shareholder’s pro rata interest in the earnings and profits of the foreign acquiring corporation (and, in the case of a stock transfer, the foreign acquired corporation) that accumulate after the noninclusion exchange, as well as its pro rata interest in the earnings and profits of the foreign acquired corporation that accumulated before the non-inclusion exchange. See also section 1248(c)(2)(D)(ii). The earnings and profits attributable to the stock received by an exchanging shareholder in the non-inclusion exchange shall not include any earnings and profits of the foreign acquiring corporation that accumulated before the non-inclusion exchange. In the case of a non-inclusion exchange in which the exchanging shareholder is a foreign corporation, this paragraph (d)(1) shall also apply for purposes of determining the earnings and profits attributable to the exchanging foreign corporation’s shareholders, as well as for purposes of determining the earnings and profits attributable to the exchanging foreign corporation when applying section 964(e) to subsequent sales or exchanges of the stock of the foreign acquiring corporation.

(2) Subsequent dispositions by a for- eign acquiring corporation . In the case of an exchange by a foreign acquiring corporation that is subject to section 367(b) or 964(e) and that follows a noninclusion exchange (as defined in paragraph (d)(1) of this section), the rules of paragraph (d)(1) of this section shall not apply. However, as a result of such a subsequent exchange, proportionate reductions shall be made to the earnings and profits that accumulated before the noninclusion exchange and that were attributed under paragraph (d)(1) of this section. Such reductions shall be made without regard to whether gain is recognized on the subsequent sale or exchange.

(3) Examples . The following examples illustrate the rules of this section:

Example 1 —(i) Facts . DC1, a domestic corporation, owns all of the outstanding stock of FC1, a foreign corporation. DC1 has owned all of the stock of FC1 since FC1’s formation. FC1 has $20 of earnings and profits, all of which is eligible for inclusion in the section 1248 amount attributable

to DC1’s stock in FC1. DC2, a domestic corporation, owns all of the outstanding stock of FC2, a foreign corporation. DC2 has owned all of the stock of FC2 since FC2’s formation. FC2 has $40 of earnings and profits, all of which is eligible for inclusion in the section 1248 amount attributable to DC2’s stock in FC2. DC1 and DC2 are unrelated. In a reorganization described in section 368(a)(1)(B), DC1 transfers all of the stock of FC1 to FC2 in exchange for 40 percent of FC2 stock. DC1 enters into a five-year gain recognition agreement under the provisions of §§1.367(a)–3(b) and 1.367(a)–8 with respect to its transfer of FC1 stock to FC2.

(ii) Result . (A) DC1’s transfer of FC1 to FC2 is not described in paragraph (b)(1)(i), (2)(i), or (3) of this section. As a result, DC1 is not required to include in income the section 1248 amount attributable to its FC1 stock and the rules of paragraph (d)(1) of this section apply. Thus, for purposes of applying section 367(b) or 1248 to subsequent exchanges of FC2 stock, the determination of the earnings and profits attributable to DC1’s stock in FC2 will include a computation that refers to 40 percent of the post-reorganization earnings and profits of FC1 and FC2, and that refers to 100 percent of the $20 of pre-reorganization earnings and profits of FC1. The earnings and profits attributable to DC1’s stock in FC2 will not include any of the $40 of earnings and profits accumulated by FC2 prior to the transaction. Those earnings and profits are attributable to DC2 under section 1248. However, paragraph (d)(1) of this section does not apply for purposes of applying section 367(b) or 964(e) to subsequent exchanges of FC1 stock by FC2. For these purposes, the determination of the earnings and profits attributable to FC2’s stock in FC1 is made under the principles of section 1248 and, as a result, includes a computation that refers to the $20 of earnings and profits attributable to FC2’s section 1223(2) holding period in the FC1 stock.

(B) In the event FC2 exchanges FC1 stock in a transaction that is subject to section 367(b) or 964(e), a proportionate reduction must be made to the $20 of earnings and profits that was previously attributed under paragraph (d)(1) of this section to DC1’s stock in FC2. Thus, for example, if FC2 sells 50 percent of its FC1 stock (at a time when there have been no other reductions that affect the $20 of FC1 earnings and profits), paragraph (d)(2) of this section requires DC1 to proportionately reduce the $20 of earnings and profits that was previously attributed to its FC2 stock (to $10). This reduction occurs without regard to whether FC2 recognizes gain on its sale of FC1 stock.

Example 2 —(i) Facts . The facts are the same as in Example 1, except that in a reorganization described in section 368(a)(1)(C), FC1 transfers all of its assets to FC2 in exchange for 40 percent of FC2 stock. FC1 then distributes the stock of FC2 to DC1, and the FC1 stock held by DC1 is canceled. None of FC1’s assets include stock.

(ii) Result . FC2’s acquisition of FC1 is not described in paragraph (b)(1)(i), (2)(i), or (3) of this section. As a result, DC1 is not required to include in income the section 1248 amount attributable to its FC1 stock and the rules of paragraph (d)(1) of this section apply. Thus, for purposes of applying section 367(b) or 1248 to subsequent exchanges,

the determination of the earnings and profits attributable to DC1’s stock in FC2 will include a computation that refers to 40 percent of the postreorganization earnings and profits of FC2, and that refers to 100 percent of the pre-reorganization earnings and profits of FC1. The earnings and profits attributable to DC1’s stock in FC2 will not include any of the $40 of earnings and profits accumulated by FC2 prior to the transaction. Those earnings and profits are attributable to DC2 under section 1248.

Example 3 —(i) Facts . DC1, a domestic corporation, owns all of the outstanding stock of FC1, a foreign corporation. FC1 owns all of the outstanding stock of FC3, a foreign corporation. DC1 has owned all of the stock of FC1 since FC1’s formation, and FC1 has owned all of the stock of FC3 since FC3’s formation. FC3 has $20 of earnings and profits, all of which is eligible for inclusion in the section 1248 amount attributable to DC1’s stock in FC1 and in the section 1248 amount attributable to FC1’s stock in FC3. Such earnings and profits are similarly eligible for inclusion as a dividend attributable to FC1’s stock in FC3 under section 964(e). DC2, a domestic corporation, owns all of the outstanding stock of FC2, a foreign corporation. DC2 has owned all of the stock of FC2 since FC2’s formation. FC2 has $40 of earnings and profits, all of which is eligible for inclusion in the section 1248 amount attributable to DC2’s stock in FC2. DC1 and DC2 are unrelated. In a reorganization described in section 368(a)(1)(B), FC1 transfers all of the stock of FC3 to FC2 in exchange for 40 percent of FC2 stock.

(ii) Result . (A) FC1’s transfer of FC3 to FC2 is not described in paragraph (b)(1)(i), (2)(i), or (3) of this section. As a result, FC1 is not required to include in income the section 1248 amount attributable to its FC3 stock and the rules of paragraph (d)(1) of this section apply. Thus, for purposes of applying section 367(b) or 1248 to subsequent exchanges of FC1 stock, the determination of the earnings and profits attributable to DC1’s stock in FC1 will include a computation that refers to 40 percent of the post-reorganization earnings and profits of FC2 and FC3, and that refers to 100 percent of the $20 of pre-reorganization earnings and profits of FC3. The earnings and profits attributable to FC1’s stock in FC2 will not include any of the $40 of earnings and profits accumulated by FC2 prior to the transaction. Those earnings and profits are attributable to DC2 under section 1248. For purposes of applying section 367(b) or 964(e) to subsequent exchanges of FC2 stock, the determination of the earnings and profits attributable to FC1’s stock in FC2 will include a computation that refers to 40 percent of the post-reorganization earnings and profits of FC2 and FC3, and that refers to 100 percent of the $20 of pre-reorganization earnings and profits of FC3. The earnings and profits attributable to FC1’s interest in FC2 do not include any of the $40 of earnings and profits accumulated by FC2 prior to the transaction. However, paragraph (d)(1) of this section does not apply for purposes of applying section 367(b) or 964(e) to subsequent exchanges of FC3 stock by FC2. For these purposes, the determination of the earnings and profits attributable to FC2’s stock in FC3 is made under the principles of section 1248 and, as a result, includes a computation that refers

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(4) Basis redistribution . If a distributee reduces the basis in the stock of the distributing or controlled corporation (or has an inclusion with respect to such stock) under paragraph (c)(2) of this section, the distributee shall increase its basis in the stock of the other corporation by the amount of the basis decrease (or deemed dividend inclusion) required by paragraph (c)(2) of this section. However, the distributee’s basis in such stock shall not be increased above the fair market value of such stock and shall not be increased to the extent the increase diminishes the distributee’s postdistribution amount with respect to such corporation.

(d) Non-pro rata distribution by a con- trolled foreign corporation —(1) Scope . This paragraph (d) applies to a distribution described in section 355 in which the distributing corporation is a controlled foreign corporation and in which the stock of the controlled corporation is not distributed pro rata to each of the distributing corporation’s shareholders.

(2) Treatment of certain shareholders as distributees . For purposes of the section 367(b) regulations, all persons owning stock of the distributing corporation immediately after a transaction described in paragraph (d)(1) of this section shall be treated as distributees of such stock. For other applicable rules, see paragraph (a)(2) of this section.

(3) Inclusion of excess section 1248 amount by exchanging shareholder . If the distributee’s postdistribution amount (as defined in paragraph (e)(2) of this section) with respect to the distributing or controlled corporation is less than the distributee’s predistribution amount (as defined in paragraph (e)(1) of this section) with respect to such corporation, then the distributee shall include in income as a deemed dividend the amount of the difference. For purposes of this paragraph (d)(3), if a distributee owns no stock in the distributing or controlled corporation immediately after the distribution, the distributee’s postdistribution amount with respect to such corporation shall be zero.

(4) Interaction with §1.367(b)–2(e)(3)(ii) (i) Limited application . The basis increase provided in §1.367(b)–2(e)(3)(ii) shall apply to a deemed dividend that is included in income pursuant to paragraph (d)(3) of this section only to the extent that such basis increase does not increase the distributee’s basis above

to the $20 of earnings and profits attributable to FC2’s section 1223(2) holding period in the FC3 stock.

(B) In the event FC2 exchanges FC3 stock in a transaction that is subject to section 367(b) or 964(e), a proportionate reduction must be made to the $20 of earnings and profits that was previously attributed under paragraph (d)(1) of this section to DC1’s stock in FC1 (for purposes of subsequent application of section 367(b) or 1248) as well as to FC1’s stock in FC2 (for purposes of subsequent application of section 367(b) or 964(e)). Thus, for example, if FC2 sells 50 percent of its FC3 stock (at a time when there have been no other reductions that affect the $20 of FC3 earnings and profits), paragraph (d)(2) of this section requires DC1 and FC1 to proportionately reduce the $20 of earnings and profits that was previously attributed to their FC1 and FC2 stock, respectively (to $10). These reductions occur without regard to whether FC2 recognizes gain on its sale of FC3 stock.

Par. 7. Sections 1.367(b)–5 and 1.367(b)–6 are added to read as follows: §1.367(b)–5 Distributions of stock de- scribed in section 355.

(a) In general —(1) Scope . This section provides rules relating to a distribution described in section 355 and to which section 367(b) applies. For purposes of this section, the terms distributing corpora- tion, controlled corporation, and distribu- tee have the same meaning as used in section 355 and the regulations thereunder.

(2) Treatment of distributees as ex- changing shareholders . For purposes of the section 367(b) regulations, all distributees in a transaction described in paragraph (b), (c), or (d) of this section shall be treated as exchanging shareholders that realize income in a section 367(b) exchange.

(b) Distribution by a domestic corpo- ration —(1) General rule . In a distribution described in section 355, if the distributing corporation is a domestic corporation and the controlled corporation is a foreign corporation, the following general rules shall apply–

(i) If the distributee is a corporation, then the controlled corporation shall be considered to be a corporation; and

(ii) If the distributee is an individual, then, solely for purposes of determining the gain recognized by the distributing corporation, the controlled corporation shall not be considered to be a corporation, and the distributing corporation shall recognize any gain (but not loss) realized on the distribution.

(2) Section 367(e) transactions . The rules of paragraph (b)(1) of this section shall not apply to a foreign distributee to

the extent gain is recognized under section 367(e)(1) and the regulations thereunder.

(3) Determining whether distributees are individuals . All distributees in a distribution described in paragraph (b)(1) of this section are presumed to be individuals. However, the shareholder identification principles of §1.367(e)–1(d) (including the reporting procedures in §1.367(e)–1(d)(2) and (3)) shall apply for purposes of rebutting this presumption.

(4) Applicable cross-references . For rules with respect to a distributee that is a partnership, trust or estate, see §1.367(b)–2(k). For additional rules relating to a distribution of stock of a foreign corporation by a domestic corporation, see section 1248(f) and the regulations thereunder. For additional rules relating to a distribution described in section 355 by a domestic corporation to a foreign distributee, see section 367(e)(1) and the regulations thereunder.

(c) Pro rata distribution by a con- trolled foreign corporation —(1) Scope . This paragraph (c) applies to a distribution described in section 355 in which the distributing corporation is a controlled foreign corporation and in which the stock of the controlled corporation is distributed pro rata to each of the distributing corporation’s shareholders.

(2) Adjustment to basis in stock and in- come inclusion . If the distributee’s postdistribution amount (as defined in paragraph (e)(2) of this section) with respect to the distributing or controlled corporation is less than the distributee’s predistribution amount (as defined in paragraph (e)(1) of this section) with respect to such corporation, then the distributee’s basis in such stock immediately after the distribution (determined under the normal principles of section 358) shall be reduced by the amount of the difference. However, the distributee’s basis in such stock shall not be reduced below zero, and to the extent the foregoing reduction would have reduced basis below zero, the distributee shall instead include such amount in income as a deemed dividend from such corporation.

(3) Interaction with §1.367(b)–2(e)(3)(ii) . The basis increase provided in §1.367(b)–2(e)(3)(ii) shall not apply to a deemed dividend that is included in income pursuant to paragraph (c)(2) of this section.

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the fair market value of such stock and does not diminish the distributee’s postdistribution amount with respect to such corporation.

(ii) Interaction with predistribution amount . For purposes of this paragraph (d), the distributee’s predistribution amount (as defined in paragraph (e)(1) of this section) shall be determined without regard to any basis increase permitted under paragraph (d)(4)(i) of this section.

(e) Definitions —(1) Predistribution amount . For purposes of this section, the predistribution amount with respect to a distributing or controlled corporation is the distributee’s section 1248 amount (as defined in §1.367(b)–2(c)(1)) computed immediately before the distribution (and after any section 368(a)(1)(D) transfer connected with the section 355 distribution), but only to the extent that such amount is attributable to the distributing corporation and any corporations controlled by it immediately before the distribution (the distributing group) or the controlled corporation and any corporations controlled by it immediately before the distribution (the controlled group), as the case may be, under the principles of §§1.1248–1(d)(3), 1.1248–2 and 1.1248–3. However, the predistribution amount with regard to the distributing group shall be computed without taking into account the distributee’s predistribution amount with respect to the controlled group.

(2) Postdistribution amount . For purposes of this section, the postdistribution amount with respect to a distributing or controlled corporation is the distributee’s section 1248 amount (as defined in §1.367(b)–2(c)(1)) with respect to such stock, computed immediately after the distribution (but without regard to paragraph (c) or (d) of this section (whichever is applicable)). The postdistribution amount under this paragraph (e)(2) shall be computed before taking into account the effect (if any) of any inclusion under section 356(a) or (b).

(f) Exclusion of deemed dividend from foreign personal holding company income . In the event an amount is included in income as a deemed dividend by a foreign corporation under paragraph (c) or (d) of this section, such deemed dividend shall not be included as foreign personal holding company income under section 954(c).

(g) Examples . The following examples illustrate the rules of this section:

Example 1 —(i) Facts . USS, a domestic corporation, owns 40 percent of the outstanding stock of FD, a controlled foreign corporation (CFC). USS has owned the stock since FD was incorporated, and FD has always been a CFC. USS has a basis of $80 in its FD stock, which has a fair market value of $200. FD owns 100 percent of the outstanding stock of FC, a foreign corporation. FD has owned the stock since FC was incorporated. Neither FD nor FC own stock in any other corporation. FD has earnings and profits of $0 and a fair market value of $250 (not considering its ownership of FC). FC has earnings and profits of $300, none of which is described in section 1248(d), and a fair market value of $250. In a pro rata distribution described in section 355, FD distributes to USS stock in FC worth $100; thereafter, USS’s FD stock is worth $100 as well.

(ii) Result —(A) FD’s distribution is a transaction described in paragraph (c)(1) of this section. Under paragraph (c)(2) of this section, USS must compare its predistribution amounts with respect to FD and FC to its respective postdistribution amounts. Under paragraph (e)(1) of this section, USS’s predistribution amount with respect to FD or FC is its section 1248 amount computed immediately before the distribution, but only to the extent such amount is attributable to FD or FC. Under §1.367(b)–2(c)(1), USS’s section 1248 amount computed immediately before the distribution is $120, all of which is attributable to FC. Thus, USS’s predistribution amount with respect to FD is $0, and its predistribution amount with respect to FC is $120. These amounts are computed as follows: If USS had sold its FD stock immediately before the transaction, it would have recognized $120 of gain ($200 fair market value å $80 basis). All of the gain would have been treated as a dividend under section 1248, and all of the section 1248 amount would have been attributable to FC (based on USS’s pro rata share of FC’s earnings and profits (40 percent x $300)).

(B) Under paragraph (e)(2) of this section, USS’s postdistribution amount with respect to FD or FC is its section 1248 amount with respect to such corporation, computed immediately after the distribution (but without regard to paragraph (c) of this section). Under §1.367(b)–2(c)(1), USS’s section 1248 amounts computed immediately after the distribution with respect to FD and FC are $60 and $0, respectively. These amounts, which are USS’s postdistribution amounts, are computed as follows: Under the normal principles of section 358, USS allocates its $80 predistribution basis in FD between FD and FC according to the stock blocks’ relative values, yielding a $40 basis in each block. If USS sold its FD stock immediately after the distribution, none of the resulting gain would be treated as a dividend under section 1248. If USS sold its FC stock immediately after the distribution, it would have a $60 gain ($100 fair market value å $40 basis), all of which would be treated as a dividend under section 1248.

(C) The basis adjustment and income inclusion rules of paragraph (c)(2) of this section apply to the extent of any difference between USS’s postdistribution and predistribution amounts. In the case of FD, there is no difference between the two amounts and, as a result, no adjustment or income inclusion is required. In the case of FC, USS’s

postdistribution amount is $60 less than its predistribution amount. Accordingly, under paragraph (c)(2) of this section, USS is required to reduce its basis in its FC stock from $40 to $0 and include $20 in income as a deemed dividend from FC. Under paragraph (c)(3) of this section, the basis increase provided in §1.367(b)–2(e)(3)(ii) does not apply with regard to the $20 deemed dividend. Under the rules of paragraph (c)(4) of this section, USS increases its basis in FD by the amount by which it decreased its basis in FC, as well as by the amount of its deemed dividend inclusion ($40 + $40 + $20 = $100).

Example 2 —(i) Facts . USS1 and USS2, domestic corporations, each own 50 percent of the outstanding stock of FD, a controlled foreign corporation (CFC). USS1 and USS2 have owned their FD stock since it was incorporated, and FD has always been a CFC. USS1 and USS2 each have a basis of $500 in their FD stock, and the fair market value of each block of FD stock is $750. FD owns 100 percent of the outstanding stock of FC, a foreign corporation. FD owned the stock since FC was incorporated. Neither FD nor FC own stock in any other corporation. FD has earnings and profits of $0 and a fair market value of $750 (not considering its ownership of FC). FC has earnings and profits of $500, none of which is described in section 1248(d), and a fair market value of $750. In a non-pro rata distribution described in section 355, FD distributes all of the stock of FC to USS2 in exchange for USS2’s FD stock.

(ii) Result —(A) FD’s distribution is a transaction described in paragraph (d)(1) of this section. Under paragraph (d)(2) of this section, USS1 is considered a distributee of FD stock. Under paragraph (d)(3) of this section, USS1 and USS2 must compare their predistribution amounts with respect to FD and FC stock to their respective postdistribution amounts. Under paragraph (e)(1) of this section, USS1’s predistribution amount with respect to FD or FC is USS1’s section 1248 amount computed immediately before the distribution, but only to the extent such amount is attributable to FD or FC. USS2’s predistribution amount is determined in the same manner. Under §1.367(b)–2(c)(1), USS1 and USS2 each have a section 1248 amount computed immediately before the distribution of $250, all of which is attributable to FC. Thus, USS1 and USS2 each have a predistribution amount with respect to FD of $0, and each have a predistribution amount with respect to FC of $250. These amounts are computed as follows: If either USS1 or USS2 had sold its FD stock immediately before the transaction, it would have recognized $250 of gain ($750 fair market value å $500 basis). All of the gain would have been treated as a dividend under section 1248, and all of the section 1248 amount would have been attributable to FC (based on USS1’s and USS2’s pro rata shares of FC’s earnings and profits (50 percent x $500)).

(B) Under paragraph (d)(3) of this section, a distributee that owns no stock in the distributing or controlled corporation immediately after the distribution has a postdistribution amount with regard to that stock of zero. Accordingly, USS2 has a postdistribution amount of $0 with respect to FD and USS1 has a postdistribution amount of $0 with

February 7, 2000 486 2000–6 I.R.B.

§§7.367(b)–9 and 7.367(b)–10(h) of this chapter, as in effect prior to February 23, 2000 (see 26 CFR part 1 revised as of April 1, 1999), attributed earnings and profits to the stock of a foreign corporation in connection with an exchange described in section 351, 354, 355, or 356 before February 23, 2000, the foreign corporation shall continue to be subject to the rules of §7.367(b)–12 of this chapter in the event of any subsequent exchanges and distributions with respect to such stock, notwithstanding the fact that such subsequent exchange or distribution occurs on or after the effective date described in paragraph (a) of this section.

§§1.367(b)–7 through 1.367(b)–9

[Removed]

Par. 8. Sections 1.367(b)–7 through 1.367(b)–9 are removed. Par. 9. Section 1.381(b)–1, paragraph (a)(1), the second sentence is amended by removing the reference “7.367(b)–1(e)” and adding “1.367(b)–2(f)” in its place.

PART 7—TEMPORARY INCOME TAX REGULATIONS UNDER THE TAX REFORM ACT OF 1976

Par. 10. The authority citation for part 7 is amended by removing the entries for §§7.367(b)–1, 7.367(b)–2, 7.367(b)–3, 7.367(b)–4, 7.367(b)–5, 7.367(b)–6, 7.367(b)–7, 7.367(b)–8, 7.367(b)–9, 7.367(b)–10, 7.367(b)–11, and 7.367(b)–13; and continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * * Par. 11. Sections 7.367(b)–1 through 7.367(b)–11 and 7.367(b)–13 are removed as of February 23, 2000.

Par. 12. Section 7.367(b)–12 is amended by revising paragraph (a) to read as follows: §7.367(b)–12 Subsequent treatment of amounts attributed or included in income (temporary).

(a) Application . This section applies to distributions with respect to, or a disposition of, stock–

(1) To which, in connection with an exchange occurring before February 23, 2000, an amount has been attributed pursuant to §7.367(b)–9 or 7.367(b)–10 (as in effect prior to February 23, 2000, see 26 CFR part 1 revised as of April 1, 1999); or

respect to FC. Under paragraph (e)(2) of this section, USS1’s postdistribution amount with respect to FD is its section 1248 amount with respect to such corporation, computed immediately after the distribution (but without regard to paragraph (d) of this section). USS2’s postdistribution amount with respect to FC is determined in the same manner. Under §1.367(b)–2(c)(1), USS1’s section 1248 amount computed immediately after the distribution with respect to FD is $0 and USS2’s section 1248 amount computed immediately after the distribution with respect to FC is $250. These amounts, which are USS1’s and USS2’s postdistribution amounts, are computed as follows: After the non-pro rata distribution, USS1 owns all the stock of FD and USS2 owns all the stock of FC. If USS1 sold its FD stock immediately after the distribution, none of the resulting $250 gain ($750 fair market value å $500 basis) would be treated as a dividend under section 1248. If USS2 sold its FC stock immediately after the distribution, it would have a $250 gain ($750 fair market value å $500 basis), all of which would be treated as a dividend under section 1248.

(C) The income inclusion rule of paragraph (d)(3) of this section applies to the extent of any difference between USS1’s and USS2’s postdistribution and predistribution amounts. In the case of USS2, there is no difference between the two amounts with respect to either FD or FC and, as a result, no income inclusion is required. In the case of USS1, there is no difference between the two amounts with respect to its FD stock. However, USS1’s postdistribution amount with respect to FC is $250 less than its predistribution amount. Accordingly, under paragraph (d)(3) of this section, USS1 is required to include $250 in income as a deemed dividend. Under §1.367(b)–2(e)(2), the $250 deemed dividend is considered as having been paid by FC to FD, and by FD to USS1, immediately prior to the distribution. This deemed dividend increases USS1’s basis in FD ($500 + $250 = $750). §1.367(b)–6 Effective dates and coordi- nation rules.

(a) Effective date —(1) In general . Sections 1.367(b)–1 through 1.367(b)–5, and this section, apply to section 367(b) exchanges that occur on or after February 23, 2000. (2) Exception . A taxpayer may, however, elect to have §§1.367(b)–1 through 1.367(b)–5, and this section, apply to section 367(b) exchanges that occur (or occurred) before February 23, 2000, if the due date for the taxpayer’s timely filed Federal tax return (including extensions) for the taxable year in which the section 367(b) exchange occurs (or occurred) is after February 23, 2000. The election under this paragraph (a)(2) will be valid only if–

(i) The electing taxpayer makes the election on a timely filed section 367(b) notice;

(ii) In the case of an exchanging shareholder that is a foreign corporation, the election is made on the section 367(b) notice that is filed by each of its shareholders listed in §1.367(b)–1(c)(3)(ii); and

(iii) The electing taxpayer provides notice of the election to all corporations (or their successors in interest) whose earnings and profits are affected by the election on or before the date the section 367(b) notice is filed. (b) Certain recapitalizations described in §1.367(b)–4(b)(3) . In the case of a recapitalization described in §1.367(b)–4(b)(3) that occurred prior to July 20, 1998, the exchanging shareholder shall include the section 1248 amount on its tax return for the taxable year that includes the exchange described in §1.367(b)–4(b)(3)(i) (and not in the taxable year of the recapitalization), except that no inclusion is required if both the recapitalization and the exchange described in §1.367(b)–4(b)(3)(i) occurred prior to July 20, 1998.

(c) Use of reasonable method to com- ply with prior published guidance —(1) Prior exchanges . The taxpayer may use a reasonable method to comply with the following prior published guidance to the extent such guidance relates to section 367(b): Notice 88–71 (1988–2 C.B. 374); Notice 89–30 (1989–1 C.B. 670); and Notice 89–79 (1989–2 C.B. 392) (see §601.601(d)(2) of this chapter). This rule applies to section 367(b) exchanges that occur (or occurred) before February 23, 2000, or, if a taxpayer makes the election described in paragraph (a)(2) of this section, for section 367(b) exchanges that occur (or occurred) before the date described in paragraph (a)(2) of this section. This rule also applies to section 367(b) exchanges and distributions described in paragraph (d) of this section.

(2) Future exchanges . Section 367(b) exchanges that occur on or after February 23, 2000, (or, if a taxpayer makes the election described in paragraph (a)(2) of this section, for section 367(b) exchanges that occur on or after the date described in paragraph (a)(2) of this section) are governed by the section 367(b) regulations and, as a result, paragraph (c)(1) of this section shall not apply.

(d) Effect of removal of attribution rules . To the extent that the rules under

2000–6 I.R.B. 487 February 7, 2000

(2) In respect of which, before February 23, 2000, an amount has been included in income or added to earnings and profits pursuant to §7.367(b)–7 or 7.367(b)–10 (as in effect prior to February 23, 2000, see 26 CFR part 1 revised as of April 1, 1999).

PART 602—OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 13. The authority citation for part

602 continues to read as follows: Authority: 26 U.S.C. 7805. Par. 14. In §602.101, paragraph (b) is amended in the table by adding an entry in numerical order to read as follows: §602.101 OMB Control numbers.

(b) * * *

Jonathan Talisman, Acting Assistant Secretary

of the Treasury.

(Filed by the Office of the Federal Register on January 21, 2000, 8:45 a.m., and published in the issue of the Federal Register for January 24, 2000, 65 F.R. 3589)

John M. Dalrymple, Acting Deputy Commissioner

of Internal Revenue.

Approved December 22, 1999.

CFR part or section where Current OMB identified and described control No.

1.367(b)–1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-1271

submit comments on the collection of information and the accuracy of the estimated burden, and suggestions for reducing this burden, please refer to REG–116048–99, page 584, the preamble to the cross-referencing notice of proposed rulemaking published in the Proposed Rules section of this issue of the Federal Register .

Books or records relating to a collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103.

Background

Section 367.—Foreign Corporations

26 CFR 1.367(b)–3T: Repatriation of foreign corporate assets in certain nonrecognition transactions (temporary).

T.D. 8863

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 1 and 602

Stock Transfer Rules: Supplemental Rules

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations.

SUMMARY: This document contains temporary regulations that provide an election for certain taxpayers engaged in certain exchanges described in section 367(b). These regulations provide guidance for taxpayers that make the specified election in order to determine the extent to which income must be included and certain corresponding adjustments must be made. The text of the temporary regulations also serves as the text of the proposed regulations set forth in the notice of proposed rulemaking on this subject in

REG–116048–99 on page 584.

DATES: Effective Date . These regulations are effective as of February 23, 2000. Applicability Date . These regulations apply to section 367(b) exchanges that occur on or after February 23, 2000.

FOR FURTHER INFORMATION CONTACT: Mark D. Harris, (202) 622-3860 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

These regulations are being issued without prior notice and public procedure pursuant to the Administrative Procedure Act (5 U.S.C. 553). For this reason, the collection of information contained in these regulations has been reviewed and, pending receipt and evaluation of public comments, approved by the Office of Management and Budget under control number 1545-1666. Responses to this collection of information is mandatory.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid OMB control number.

For further information concerning this collection of information, and where to

February 7, 2000 488 2000–6 I.R.B.

regulations is estimated to be only 20 per year. Therefore, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required.

Pursuant to section 7805(f) of the Code, these temporary regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact.

Drafting Information

***** - *** * ***

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding entries in numerical order to read in part as follows:

Authority: 26 U.S.C. 7805 * * * Section 1.367(b)–3T also issued under 26 U.S.C. 367(a) and (b). * * * Par. 2. Section 1.367(b)–3T is added to read as follows: §1.367(b)–3T Repatriation of foreign cor- porate assets in certain nonrecognition transactions (temporary).

(a) through (b)(3). [Reserved]. For further guidance, see §1.367(b)–3(a) through (b)(3).

(4) Election of taxable exchange treat- ment —(i) Rules —(A) In general . In lieu of the treatment prescribed by §1.367(b)–3(b)(3)(i), an exchanging shareholder described in §1.367(b)–3(b)(1) may instead elect to recognize the gain (but not loss) that it realizes in the exchange (taxable exchange election). To make a taxable exchange election, the following requirements must be satisfied–

( 1 ) The exchanging shareholder (and its direct or indirect owners that would be affected by the election, in the case of an exchanging shareholder that is a foreign corporation) reports the exchange in a manner consistent therewith (see, e.g., sections 954(c)(1)(B)(i), 1001 and 1248);

under sections 367(a) and (b) (the 1998 regulations). The 1998 regulations addressed transactions under section 367(b) only to the extent the transactions are also subject to the stock transfer rules of section 367(a). Thus, the 1977 regulations have remained in effect to the extent not superseded by the 1998 regulations. The preamble to the 1998 regulations stated that the IRS and Treasury would issue guidance at a later date to address the portions of the 1991 proposed regulations related to section 367(b) that were not addressed in the 1998 regulations.

The IRS and Treasury adopted §§1.367(b)–1 through 1.367(b)–6 as final regulations under section 367(b) (see T.D. 8862, page 466). These temporary regulations relate to certain provisions of the 1991 proposed regulations not adopted in the final section 367(b) regulations T.D. 8862.

General Purpose

These temporary regulations address the elimination of an election available to certain taxpayers under the 1991 proposed regulations that was not adopted in the final section 367(b) regulations T.D. 8862.

Specific Provisions

A. §1.367(b)–3T(b)(4): Election of taxable exchange treatment

Section 1.367(b)–3 of the 1991 proposed regulations addressed transactions in which a foreign corporation transfers assets to a domestic corporation pursuant to a Subchapter C nonrecognition provision. These transactions include a section 332 liquidation of a foreign corporation into a domestic parent corporation and an asset reorganization, such as a C, D or F reorganization, of a foreign corporation into a domestic corporation. The 1991 proposed regulations required a U.S. shareholder of a foreign acquired corporation (or, in certain cases, a foreign subsidiary of the U.S. shareholder) to currently include in income the allocable portion of the foreign acquired corporation’s earnings and profits accumulated during the U.S. shareholder’s holding period (all earnings and profits amount). The final section 367(b) regulations T.D. 8862 adopted this general rule.

Sections 7.367(b)–5(b) and 7.367(b)–7(c)(2)(ii) of the 1977 regulations and §1.367(b)–3(b)(2)(iii) of the 1991 proposed regulations provided an exception to this rule, which permitted an exchanging shareholder to elect to recognize the gain (but not the loss) that it realizes in the exchange (taxable exchange election), rather than include the all earnings and profits amount in income. To the extent the all earnings and profits amount exceeds a shareholder’s stock gain, the 1991 proposed regulations further required the foreign acquired corporation to reduce various tax attributes that would otherwise carryover to the domestic acquiring corporation (attribute reduction regime). The final regulations T.D. 8862 did not adopt the taxable exchange election.

In order to provide taxpayers an opportunity to comment on this change, these temporary regulations provide the taxable exchange election in modified form. The modified election permits an exchanging shareholder to elect to treat a transaction as a taxable exchange, but limits application of the attribute reduction regime to a section 332 liquidation or to an inbound asset reorganization in which the foreign acquired corporation is wholly owned (directly or indirectly) by one U.S. person. These temporary regulations apply to section 367(b) exchanges that occur between February 23, 2000, and February 24, 2001.

Further Explanation

For a more detailed discussion regarding section 367(b), see T.D. 8862.

Special Analyses

It has been determined that these Temporary regulations are not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. Further it is hereby certified pursuant to sections 603(a) and 605(b) of the Regulatory Flexibility Act that the collection of information in these regulations will not have a significant economic impact on a substantial number of small entities. This certification is based upon the fact that the number of section 367(b) exchanges that require reporting under these

2000–6 I.R.B. 489 February 7, 2000

section 332, FC distributes all of its property to DC, and the FC stock held by DC is canceled. Rather than including in income as a deemed dividend the all earnings and profits amount of $30 as provided in §1.367(b)–3(b)(3)(i), DC instead elects taxable exchange treatment under paragraph (b)(4)(i)(A) of this section.

(ii) Result . DC recognizes the $20 of gain it realizes on its stock in FC. Of this $20 amount, $19 is included in income by DC as a dividend pursuant to section 1248(a). (For the source of the remaining $1 of gain recognized by DC, see section 865. For the treatment of the $1 for purposes of the foreign tax credit limitation, see generally section 904(d)(2)(A)(i).) Because the transaction is described in section 332 and because the all earnings and profits amount with respect to the FC stock held by DC ($30) exceeds by $10 the income recognized by DC ($20), the attribute reduction rules of paragraph (b)(4)(i)(B) of this section apply. Accordingly, the $10 excess earnings and profits amount is applied to reduce the basis of the tangible depreciable assets of FC, beginning with those assets with the shortest class lives. Under section 337(a) FC does not recognize gain or loss in the assets that it distributes to DC, and under section 334(b) (which is applied taking into account the basis reduction prescribed by paragraph (b)(4)(i)(A)( 3 ) of this section) DC takes a basis of $30 in the land and $70 in the tangible depreciable assets that it receives from FC.

(ii) Effective date . This paragraph (b)(4) applies for section 367(b) exchanges that occur between February 23, 2000, and February 24, 2001 . (c) and (d) [Reserved]. For further guidance, see §1.367(b)–3(c) through (d).

Par. 3. The authority citation for part 602 continues to read as follows: Authority: 26 U.S.C. 7805. Par. 4. In §602.101, paragraph (b) is amended as follows:

Removing the following entries from the table: §602.101 OMB Control numbers.

(b) * * * 2. Adding the following entry in numerical order to the table to read as follows:

( 2 ) The notification requirements of paragraph (b)(4)(i)(C) of this section are satisfied; and

( 3 ) The adjustments described in paragraph (b)(4)(i)(B) of this section are made when the following circumstances are present–

( i ) The transaction is described in section 332 or is an asset acquisition described in section 368(a)(1), with regard to which one U.S. person owns (directly or indirectly) 100 percent of the foreign acquired corporation; and

( ii ) The all earnings and profits amount described in §1.367(b)–3(b)(3)(i) with respect to the exchange exceeds the gain recognized by the exchanging shareholder.

(B) Attribute reduction —( 1 ) Reduc- tion of NOL carryovers . The amount by which the all earnings and profits amount exceeds the gain recognized by the exchanging shareholder (the excess earnings and profits amount) shall be applied to reduce the net operating loss carryovers (if any) of the foreign acquired corporation to which the domestic acquiring corporation would otherwise succeed under section 381(a) and (c)(1). See also Rev. Rul. 72–421 (1972–2 C.B. 166) (see §601.601(d)(2) of this chapter).

( 2 ) Reduction of capital loss carry- overs . After the application of paragraph (b)(4)(i)(B)( 1 ) of this section, any remaining excess earnings and profits amount shall be applied to reduce the capital loss carryovers (if any) of the foreign acquired corporation to which the domestic acquiring corporation would otherwise succeed under section 381(a) and (c)(3).

( 3 ) Reduction of basis . After the application of paragraph (b)(4)(i)(B)(2) of this section, any remaining excess earnings and profits amount shall be applied to re

duce (but not below zero) the basis of the assets (other than dollar-denominated money) of the foreign acquired corporation that are acquired by the domestic acquiring corporation. Such remaining excess earnings and profits amount shall be applied to reduce the basis of such assets in the following order: first, tangible depreciable or depletable assets, according to their class lives (beginning with those assets with the shortest class life); second, other non-inventory tangible assets; third, intangible assets that are amortizable; and finally, the remaining assets of the foreign acquired corporation that are acquired by the domestic acquiring corporation. Within each of these categories, if the total basis of all assets in the category is greater than the excess earnings and profits amount to be applied against such basis, the taxpayer may choose to which specific assets in the category the basis reduction first applies.

(C) Notification . The exchanging shareholder shall elect to apply the rules of this paragraph (b)(4)(i) by attaching a statement of its election to its section 367(b) notice. See §1.367(b)–1(c) for the rules concerning filing a section 367(b) notice.

(D) Example . The following example illustrates the rules of this paragraph (b)(4)(i):

Example —(i) Facts . DC, a domestic corporation, owns all of the outstanding stock of FC, a foreign corporation. The stock of FC has a value of $100, and DC has a basis of $80 in such stock. The assets of FC are one parcel of land with a value of $60 and a basis of $30, and tangible depreciable assets with a value of $40 and a basis of $80. FC has no net operating loss carryovers or capital loss carryovers. The all earnings and profits amount with respect to the FC stock owned by DC is $30, of which $19 is described in section 1248(a) and the remaining $11 is not (for example, because it was earned prior to 1963). In a liquidation described in

CFR part or section where Current OMB identified and described control No.

7.367(b)–1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-0026 7.367(b)–3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-0026 7.367(b)–7 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-0026 7.367(b)–9 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-0026 7.367(b)–10 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-0026

February 7, 2000 490 2000–6 I.R.B.

§602.101 OMB Control numbers.

(b) * * *

John M. Dalrymple, Acting Deputy Commissioner

of Internal Revenue.

Approved December 22, 1999.

Jonathan Talisman, Acting Assistant Secretary

of the Treasury.

(Filed by the Office of the Federal Register on January 21, 2000, 8:45 a.m., and published in the issue of the Federal Register for January 24, 2000, 65 F.R. 3586)

CFR part or section where Current OMB identified and described control No.

1.367(b)–3T . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-1666

Section 382.—Limitation on Net Operating Loss Carryforwards and Certain Built-In Losses Following Ownership Change

The adjusted applicable federal long-term rate is set forth for the month of February 2000. See Rev. Rul. 2000–9, page 497.

Section 412.—Minimum Funding Standards

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of February 2000. See Rev. Rul. 2000–9, page 497.

Section 467.—Certain Payments for the Use of Property or Services

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of February 2000. See Rev. Rul. 2000–9, page 497.

Section 468.—Special Rules for Mining and Solid Waste Reclamation and Closing Costs

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of February 2000. See Rev. Rul. 2000–9, page 497.

Section 482.—Allocation of Income and Deductions Among Taxpayers

Federal short-term, mid-term, and long-term rates are set forth for the month of February 2000. See Rev. Rul. 2000–9, page 497.

Section 483.—Interest on Certain Deferred Payments

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of February 2000. See Rev. Rul. 2000–9, page 497.

Section 642.—Special Rules for Credits and Deductions

Federal short-term, mid-term, and long-term rates are set forth for the month of February 2000. See Rev. Rul. 2000–9, page 497.

Section 807.—Rules for Certain Reserves

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of February 2000. See Rev. Rul. 2000–9, page 497.

Section 846.—Discounted Unpaid Lossed Defined

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of February 2000. See Rev. Rul. 2000–9, page 497.

Section 936.—Puerto Rico and Possessions Tax Credit

26 CFR 1.936–11: New lines of business prohibited.

T.D. 8868

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

Termination of Puerto Rico and Possession Tax Credit; New Lines of Business Prohibited

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document amends the Income Tax Regulations by removing temporary regulations that provide guidance regarding the addition of a substantial new line of business by a possessions corporation that is an existing credit claimant and adding final regulations. These regulations are necessary to implement changes made by the Small Business Job Protection Act of 1996.

DATES: Effective Date . These regulations are effective January 25, 2000.

FOR FURTHER INFORMATION CONTACT: Daniel S. Karen, (202) 874-1490, or Jacob Feldman, (202) 622-3830 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

Section 1601(a) of the Small Business Job Protection Act of 1996, Public Law 104-188, 110 Stat. 1755 (1996), amended the Internal Revenue Code by adding section 936(j). Section 936(j) generally repeals the Puerto Rico and possession tax credit for taxable years beginning after December 31, 1995. However, the section provides grandfather rules under which a corporation that is an existing credit claimant would be eligible to claim credits for a transition period. The Puerto

2000–6 I.R.B. 491 February 7, 2000

Rico and possession tax credit and the Puerto Rico economic activity credit phase out for these existing credit claimants ending with the last taxable year beginning before January 1, 2006.

For taxable years beginning after December 31, 1995 and before January 1, 2006, the Puerto Rico and possession tax credit and the Puerto Rico economic activity credit apply only to a corporation that qualifies as an existing credit claimant (as defined in section 936(j)(9)(A)). The determination of whether a corporation is an existing credit claimant is made separately for each possession. A possessions corporation that adds a substantial new line of business (other than in a qualifying acquisition of all the assets of a trade or business of an existing credit claimant) after October 13, 1995, ceases to be an existing credit claimant as of the beginning of the taxable year during which such new line of business is added. Therefore, a possessions corporation that ceases to be an existing credit claimant either because it has added a substantial new line of business, or because a new line of business becomes substantial, during a taxable year may not claim the Puerto Rico and possession tax credit or the Puerto Rico economic activity credit for that taxable year or any subsequent taxable year.

On August 19, 1998, T.D. 8778, 1998–36 I.R.B. 4 were published in the Federal Register (63 FR 44387). A cross referenced Notice of Proposed Rulemaking was also published in the Federal Reg- ister, REG–115446–97 (1998–36 I.R.B. 23

[63 FR 44416]) on the same date. Three comments were received with respect to the Notice. No hearing was requested and none was held. The temporary regulations are, therefore, adopted as proposed with the following changes, as explained, below.

Explanation of Revisions and Summary of Comments

Minor and conforming changes were made in these final regulations. Several changes were also made in the final regulations with regard to the three comments that were received on the Notice of Proposed Rulemaking.

The first comment received addressed the issue as to whether the leasing of some of the assets of an existing credit

claimant would result in a new line of business under section 936(j)(9)(B) with respect to the leasing activity. In response to the comment, the final regulations provide that the leasing out of assets by an existing credit claimant (and the employees necessary to operate the leased assets) will not be treated as a new line of business provided that (1) the existing credit claimant used the leased assets in an active trade or business for at least five years, (2) the existing credit claimant does not through its own officers or staff of employees perform management or operational functions (but not including operational functions performed through leased employees) with respect to the leased assets, and (3) the existing credit claimant does not perform marketing functions with respect to the leasing of the assets. The income from the leasing of assets will not be income from the active conduct of a trade or business, and therefore, the existing credit claimant may not receive a possession tax credit with respect to such income.

A second comment asked for clarification as to whether a taxpayer seeking to be treated as an existing credit claimant through the acquisition of the assets of an existing credit claimant pursuant to section 936(j)(9)(A)(ii) must acquire all the assets of the acquired corporation even in cases in which the existing credit claimant has more than one trade or business. The final regulations have been clarified to conform to the language of section 936(j)(9)(A)(ii) and provide that an acquiring corporation need only acquire all the assets of a single trade or business to be treated as an existing credit claimant.

The third comment asked for clarification as to when the assets of a trade or business are measured for purposes of satisfying the requirement that all the assets of a trade or business must be acquired from an existing credit claimant in order to satisfy section 936(j)(9)(A)(ii). Specifically, the comment expressed concern that assets of an existing credit claimant may be sold or otherwise disposed of between October 13, 1995, the date on which existing credit claimant status is established, and the date of acquisition. In response to the comment, the final regulations provide that the assets of a trade or business of an existing credit claimant are determined on the date of acquisition pro

vided that the transferee actively conducts a trade or business in the possession with the acquired assets.

Special Analyses

It has been determined that this final regulation is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to this regulation, and because the regulation does not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Internal Revenue Code, the preceding notice of proposed rulemaking was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its effect on small business.

Drafting Information

The principal author of this regulation is Daniel S. Karen of the Office of the Associate Chief Counsel (International), within the office of Chief Counsel, IRS. However, other personnel from the IRS and the Department of the Treasury participated in the development of this regulation.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by removing the entry for 1.936–11T and by adding an entry in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * * Section 1.936–11 also issued under 26 U.S.C. 936(j). * * * §1.936–11T [Removed]

Par. 2. Section 1.936–11T is removed. Par. 3. Section 1.936–11 is added to read as follows: §1.936–11 New lines of business prohib- ited.

(a) In general . A possessions corporation that is an existing credit claimant, as defined in section 936(j)(9)(A) and this

February 7, 2000 492 2000–6 I.R.B.

section, that adds a substantial new line of business during a taxable year, or that has a new line of business that becomes substantial during the taxable year, loses its status as an existing credit claimant for that year and all years subsequent.

(b) New line of business —(1) In gen- eral . A new line of business is any business activity of the possessions corporation that is not closely related to a pre-existing business of the possessions corporation. The term closely related is defined in paragraph (b)(2) of this section. The term pre-existing business is defined in paragraph (b)(3) of this section.

(2) Closely related . To determine whether a new activity is closely related to a pre-existing business of the possessions corporation all the facts and circumstances must be considered, including those set forth in paragraphs(b)(2)(i)(A) through (G) of this section.

(i) Factors . The following factors will help to establish that a new activity is closely related to a pre-existing business activity of the possessions corporation—

(A) The new activity provides products or services very similar to the products or services provided by the pre-existing business;

(B) The new activity markets products and services to the same class of customers;

(D) The new activity requires the use of similar operating assets;

(E) The new activity’s economic success depends on the success of the pre-existing business;

(F) The new activity is of a type that would normally be treated as a unit with the pre-existing business in the business’ accounting records; and

(G) The new activity and the pre-existing business are regulated or licensed by the same or similar governmental authority.

(ii) Safe harbors . An activity is not a new line of business if—

(A) If the activity is within the same six-digit North American Industry Classification System (NAICS) code (or fourdigit Standard Industrial Classification (SIC) code). The similarity of the NAICS or SIC codes may not be relied upon to

determine whether the activity is closely related to a pre-existing business where the code indicates a miscellaneous category;

(C) If the pre-existing business is making a component product or end-product form, as defined in §1.936–5(a)(1),Q&A1, and the new business activity is making an integrated product, or an end-product form with fewer excluded components, that is not within the same six-digit NAICS code (or four-digit SIC code) as the pre-existing business solely because the component product and the integrated product (or two end-product forms) have different enduses.

(3) Pre-existing business —(i) In gen- eral . Except as provided in paragraph (b)(3)(ii) of this section, a business activity is a pre-existing business of the existing credit claimant if—

(A) The existing credit claimant was actively engaged in the activity within the possession on or before October 13, 1995; and

(B) The existing credit claimant had elected the benefits of the Puerto Rico and possession tax credit pursuant to an election which was in effect for the taxable year that included October 13, 1995.

(ii) Acquisition of an existing credit claimant . (A) If all the assets of one or more trades or businesses of a corporation of an existing credit claimant are acquired by an affiliated or non-affiliated existing credit claimant which carries on the business activity of the predecessor existing credit claimant, the acquired business activity will be treated as a pre-existing business of the acquiring corporation. A non-affiliated acquiring corporation will not be bound by any section 936(h) election made by the predecessor existing credit claimant with respect to that business activity.

(B) Where all of the assets of one or more trades or businesses of a corporation of an existing credit claimant are acquired by a corporation that is not an existing credit claimant, the acquiring corporation may make a section 936(e) election for the taxable year in which the assets are

(B) If the new activity is within the same five-digit NAICS code (or threedigit SIC code) and the facts relating to the new activity also satisfy at least three of the factors listed in paragraphs (b)(2)(i)(A) through (G) of this section; or

acquired with the following effects—

( 1 ) The acquiring corporation will be treated as an existing credit claimant for the year of acquisition;

( 2 ) The activity will be considered a pre-existing business of the acquiring corporation;

( 3 ) The acquiring corporation will be deemed to satisfy the rules of section 936(a)(2) for the year of acquisition; and ( 4 ) After making an election under section 936(e), a non- affiliated acquiring corporation will not be bound by elections under sections 936(a)(4) and (h) made by the predecessor existing credit claimant.

(C) For purposes of this section the assets of a trade or business are determined at the time of acquisition provided that the transferee actively conducts the trade or business acquired.

(D) A mere change in the stock ownership of a possessions corporation will not affect its status as an existing credit claimant for purposes of this section.

(4) Leasing of Assets .—(i) The leasing of assets (and employees to operate leased assets) will not, for purposes of this section, be considered a new line of business of the existing credit claimant if—

(A) the existing credit claimant used the leased assets in an active trade or business for at least five years;

(B) the existing credit claimant does not through its own officers or staff of employees perform management or operational functions (but not including operational functions performed through leased employees) with respect to the leased assets; and

(ii) Any income from the leasing of assets not considered a new line of business pursuant to paragraph (b)(4)(i) of this section will not be income from the active conduct of a trade or business (and, therefore, the existing credit claimant may not receive a possession tax credit with respect to such income).

(5) Timing rule . The tests for a new line of business in this paragraph (whether the new activity is closely related to a pre-existing business) are applied only at the end of the taxable year during which the new activity is added.

2000–6 I.R.B. 493 February 7, 2000

stantial as of the earlier of—

(i) The taxable year in which the possessions corporation derives more than 15 percent of its gross income from that new line of business (gross income test); or

(ii) The taxable year in which the possessions corporation directly uses in that new line of business more than 15 percent of its assets (assets test).

(2) Gross income test . The denominator in the gross income test is the amount that is the gross income of the possessions corporation for the current taxable year, while the numerator is the amount that is the gross income of the new line of business for the current taxable year. The gross income test is applied at the end of each taxable year. For purposes of this test, if a new line of business is added late in the taxable year, the income is not to be annualized in that year. In the case of a new line of business acquired through the purchase of assets, the gross income of such new line of business for the taxable year of the acquiring corporation that includes the date of acquisition is determined from the date of acquisition through the end of the taxable year. In the case of a consolidated group election made pursuant to section 936(i)(5), the test applies on a company by company basis and not on a consolidated basis.

(3) Assets test —(i) Computation . The denominator is the adjusted tax basis of the total assets of the possessions corporation for the current taxable year. The numerator is the adjusted tax basis of the total assets utilized in the new line of business for the current taxable year. The assets test is computed annually using all assets including cash and receivables.

(ii) Exception . A new line of business of a possessions corporation will not be treated as substantial as a result of meeting the assets test if an event that is not reasonably anticipated causes assets used in the new line of business of the possessions corporation to exceed 15 percent of the adjusted tax basis of the possessions corporation’s total assets. For example, an event that is not reasonably anticipated would include the destruction of plant and equipment of the pre-existing business due to a hurricane or other natural disaster, or other similar circumstances beyond the control of the possessions corporation. The expiration of a patent is not such an event and will not permit use of this ex

ception.

(d) Examples . The following examples illustrate the rules described in paragraphs (a), (b), and (c) of this section. In the following examples, X Corp. is an existing credit claimant unless otherwise indicated:

Example 1 . X Corp. is a pharmaceutical corporation which manufactured bulk chemicals (a component product). In March 1997, X Corp. began to also manufacture pills (e.g., finished dosages or an integrated product). The new activity provides products very similar to the products provided by the pre-existing business. The new activity is of a type that is normally conducted in the same business location as the pre-existing business. The activity’s economic success depends on the success of the preexisting business. The manufacture of bulk chemicals is in NAICS code 325411, Medicinal and Botanical Manufacturing, while the manufacture of the pills is in NAICS code 325412, Pharmaceutical Preparation Manufacturing. Although the products have a different end-use, may be marketed to a different class of customers, and may not use similar operating assets, they are within the same five-digit NAICS code and the activity also satisfies paragraphs (b)(2)(i)(A), (C), and (E) of this section. The manufacture of the pills by X Corp. will be considered closely related to the manufacture of the bulk chemicals. Therefore, X Corp. will not be considered to have added a new line of business for purposes of paragraph (b) of this section because it falls within the safe harbor rule of (b)(2)(ii)(B).

Example 2 . X Corp. currently manufactures printed circuit boards in a possession. As a result of a technological breakthrough, X Corp. could produce the printed circuit boards more efficiently if it modified its existing production methods. Because demand for its products was high, X Corp. expanded when it modified its production methods. After these modifications to the facilities and production methods, the products produced through the new technology were in the same six-digit NAICS code as products produced previously by X Corp. See paragraph (b)(2)(ii)(A) of this section. Therefore, X Corp. will not be considered to have added a new line of business for purposes of paragraph (b) of this section because it falls within the safe harbor rule of (b)(2)(ii)(A).

Example 3 . X Corp. has manufactured Device A in Puerto Rico for a number of years and began to manufacture Device B in Puerto Rico in 1997. Device A and Device B are both used to conduct electrical current to the heart and are both sold to cardiologists. There is no significant change in the type of activity conducted in Puerto Rico after the transfer of the manufacturing of Device B to Puerto Rico. Similar manufacturing equipment, manufacturing processes and skills are used in the manufacture of both devices. Both are regulated and licensed by the Food and Drug Administration. The economic success of Device B is dependent upon the success of Device A only to the extent that the liability and manufacturing prowess with respect to one reflects favorably on the other. Depending upon the heart abnormality, the cardiologist may choose to use Device A, Device B or both on a patient. The manufacture of Device B is treated as a unit with the manufacture of Device A in X Corp.’s accounting records.

The manufacture of Device A is in the six-digit NAICS code 339112, Surgical and Medical Instrument Manufacturing. The manufacture of Device B is in the six-digit NAICS code 334510, Electromedical and electrotherapeutic Apparatus Manufacturing. (The manufacture of Device A is in the fourdigit SIC code 3845, Electromedical and Electrotherapeutic Apparatus. The manufacture of Device B is in the four-digit SIC code 3841, Surgical and Medical Instruments and Apparatus.) The safe harbor of paragraph (b)(2)(ii)(B) of this section applies because the two activities are within the same three-digit SIC code and Corp. X satisfies paragraphs (b)(2)(i)(A), (B), (C), (D), (F), and (G) of this section.

Example 4 . X Corp. has been manufacturing house slippers in Puerto Rico since 1990. Y Corp. is a U.S. corporation that is not affiliated with X Corp. and is not an existing credit claimant. Y Corp. has been manufacturing snack food in the United States. In 1997, X Corp. purchased the assets of Y Corp. and began to manufacture snack food in Puerto Rico. House slipper manufacturing is in the six-digit NAICS code 316212 (Four-digit SIC code 3142, House Slippers). The manufacture of snack foods falls under the six-digit NAICS code 311919, Other Snack Food Manufacturing (fourdigit SIC code 2052, Cookies and Crackers (pretzels)). Because these activities are not within the same five or six digit NAICS code (or the same three or four-digit SIC code), and because snack food is not an integrated product that contains house slippers, the safe harbor of paragraph (b)(2)(ii) of this section cannot apply. Considering all the facts and circumstances, including the seven factors of paragraph (b)(2)(i) of this section, the snack food manufacturing activity is not closely related to the manufacture of house slippers, and is a new line of business, within the meaning of paragraph (b) of this section.

Example 5 . X Corp., a calendar year taxpayer, is an existing credit claimant that has elected the profit-split method for computing taxable income. P Corp. was not an existing credit claimant and manufactured a product in a different five-digit NAICS code than the product manufactured by X Corp. In 1997, X Corp. acquired the stock of P Corp. and liquidated P Corp. in a tax-free liquidation under section 332, but continued the business activity of P Corp. as a new business segment. Assume that this new business segment is a new line of business within the meaning of paragraph (c) of this section. In 1997, X Corp. has gross income from the active conduct of a trade or business in a possession computed under section 936(a)(2) of $500 million and the adjusted tax basis of its assets is $200 million. The new business segment had gross income of $60 million, or 12 percent of the X Corp. gross income, and the adjusted basis of the new segment’s assets was $20 million, or 10 percent of the X Corp. total assets. In 1997, X Corp. does not derive more than 15 percent of its gross income, or directly use more that 15 percent of its total assets, from the new business segment. Thus, the new line of business acquired from P Corp. is not a substantial new line of business within the meaning of paragraph (c) of this section, and the new activity will not cause X Corp. to lose its status as an existing credit claimant during 1997. In 1998, however, the gross income of X Corp. grew to $750 million while the gross income

February 7, 2000 494 2000–6 I.R.B.

part of a straddle that involves an option on that stock or substantially identical stock or securities. Under section 1092(c)(4), however, writing a QCC option and owning the optioned stock is not treated as a straddle for purposes of section 1092.

In order to be a QCC, a call option must, among other things, be exchange-traded and not be deep in the money. An option is deep in the money if the strike price of the option is lower than the lowest qualified bench mark for the stock. This bench mark is generally the highest available strike price for an option on the stock that is less than the applicable stock price.

At the time the QCC provisions were enacted, exchange-traded options were available only at standardized maturity dates and strike price intervals. This fixed-interval system was a basic assumption of the Congressional plan for QCCs and, more specifically, was the foundation for the definition of a deep-in-the-money option.

Certain options exchanges have begun to trade equity options with flexible terms. Unlike standardized exchangetraded options, these options could have strike prices at other than fixed intervals. For this reason, there is concern that the strike prices established for equity options with flexible terms could impact the bench-mark system for standardized exchange-traded options.

The proposed regulations provide that strike prices established by equity options with flexible terms are not taken into account in determining whether options that are not equity options with flexible terms are deep in the money. Thus, the existence of strike prices established by equity options with flexible terms does not affect the lowest qualified bench mark, as determined under section 1092(c)(4)(D), for an equity option with standardized terms.

One commentator was concerned that usage of the phrase “existence of strike prices established by equity options without standardized terms” might be interpreted as requiring actual trading at a particular strike price. The commentator suggested that the regulation be modified to discuss the availability of a strike price for equity options with flexible terms rather than the existence of a strike price established by equity options with flexible terms. This suggestion has been incorporated into the final regulation.

of the new line of business grew to $150 million, or 20% of the X Corp. 1998 gross income. Thus, in 1998, the new line of business is substantial within the meaning of paragraph (c) of this section, and X Corp. loses its status as an existing credit claimant for 1998 and all years subsequent.

(e) Loss of status as existing credit claimant . An existing credit claimant that adds a substantial new line of business in a taxable year, or that has a new line of business that becomes substantial in a taxable year, loses its status as an existing credit claimant for that year and all years subsequent.

(f) Effective date —(1) General rule . This section applies to taxable years of a possessions corporation beginning on or after January 25, 2000.

(2) Election for retroactive application . Taxpayers may elect to apply retroactively all the provisions of this section for any open taxable year beginning after December 31, 1995. Such election will be effective for the year of the election and all subsequent taxable years. This section will not apply to activities of pre-existing businesses for taxable years beginning before January 1, 1996.

David Mader, Acting Deputy Commissioner

of Internal Revenue.

AGENCY: Internal Revenue Service (IRS), Treasury

ACTION: Final regulations.

SUMMARY: This document contains final regulations providing guidance on the application of the rules governing qualified covered calls. The new rules address concerns that were created by the introduction of new financial instruments after the enactment of the qualified covered call rules. The final regulations will provide guidance to taxpayers writing qualified covered calls.

EFFECTIVE DATE: These regulations are effective January 25, 2000.

FOR FURTHER INFORMATION CONTACT: Pamela Lew of the Office of Assistant Chief Counsel (Financial Institutions and Products), (202) 622-3950 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

On June 25, 1998, the IRS published in the Federal Register proposed regulations REG–104641–97 (1998–29 I.R.B. 9 [63 F.R. 34616]) addressing whether strike prices available for equity options with flexible terms affect the definition of a qualified covered call (QCC) under section 1092(c)(4) for equity options with standardized terms. No requests to speak at a public hearing were received, and no public hearing was held.

Two written comments were received. These comments focused on whether equity options with flexible terms should be eligible for QCC treatment. After considering these comments, the IRS and Treasury have decided to address the eligibility of equity options with flexible terms and certain other equity options for QCC treatment in other forthcoming guidance.

One of the comments also suggested a clarifying change to the text of the proposed regulations. After revising the regulation to take into account this comment, the proposed regulations are adopted by this Treasury decision.

Explanation of Provisions

Section 1092(c) defines a straddle as offsetting positions with respect to personal property. Under section 1092(d)(3), stock is personal property if the stock is

Approved January 12, 2000.

Jonathan Talisman, Acting Assistant Secretary

of the Treasury.

(Filed by the Office of the Federal Register on January 21, 2000, 8:45 a.m., and published in the issue of the Federal Register for January 25, 2000, 65 F.R. 3814)

Section 1092.—Straddles

26 CFR 1.1092(c)–1: Equity options with flexible terms.

T.D. 8866

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

Equity Options With Flexible Terms; Special Rules and Definitions

2000–6 I.R.B. 495 February 7, 2000

this section) or other market which the Secretary determines has rules adequate to carry out the purposes of section 1092 and is—

(A) Substantially identical to the equity options described in paragraph (d)(1)(i) of this section; and

(B) Approved by the Securities and Exchange Commission in a Securities Exchange Act Release.

(2) Securities Exchange Act Release means a release issued by the Securities and Exchange Commission. To determine identifying information for releases referenced in paragraph (d)(1) of this section, including release titles, identification numbers, and issue dates, contact the Office of the Secretary, Securities and Exchange Commission, 450 5th Street, NW., Washington, DC 20549. To obtain a copy of a Securities Exchange Act Release, submit a written request, including the specific release identification number, title, and issue date, to Securities and Exchange Commission, Attention Public Reference, 450 5th Street, NW., Washington, DC 20549.

(e) Effective date . These regulations apply to equity options with flexible terms entered into on or after January 25, 2000.

Approved January 17, 2000.

Jonathan Talisman, Acting Assistant Secretary

of the Treasury.

(Filed by the Office of the Federal Register on January 21, 2000, 8:45 a.m., and published in the issue of the Federal Register for January 25, 2000, 65 F.R. 3812)

Section 1274.—Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property

(Also Sections 42, 280G, 382, 412, 467, 468, 482, 483, 642, 807, 846, 1288, 7520, 7872.)

Federal rates; adjusted federal rates; adjusted federal long-term rate, and the long-term exempt rate. For purposes of sections 1274, 1288, 382, and other sections of the Code, tables set forth the

Special Analyses

Drafting Information

The principal author of these regulations is Pamela Lew, Office of Assistant Chief Counsel (Financial Institutions and Products). However, other personnel from the IRS and Treasury Department participated in their development.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding an entry in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * * Section 1.1092(c)–1 also issued under 26 U.S.C. 1092(c)(4)(H). * * * Par. 2. Section 1.1092(c)–1 is added to read as follows: §1.1092(c)–1 Equity options with flexible terms.

(a) In general . Section 1092(c)(4) provides an exception to the general rule that a straddle exists if a taxpayer holds stock and writes a call option on that stock. Under section 1092(c)(4), the ownership of stock and the issuance of a call option meeting certain requirements result in a qualified covered call, which is exempted from the general straddle rules of section 1092. This section addresses the consequences of the availability of equity op

tions with flexible terms under the qualified covered call rules.

(b) No effect on lowest qualified bench mark for standardized options . The availability of strike prices for equity options with flexible terms does not affect the determination of the lowest qualified bench mark, as defined in section 1092(c)(4)(D), for an option that is not an equity option with flexible terms.

(1) Equity option with flexible terms means an equity option—

(i) That is described in any of the following Securities Exchange Act Releases—

(A) Self-Regulatory Organizations; Order Approving Proposed Rule Changes and Notice of Filing and Order Granting Accelerated Approval of Amendments by the Chicago Board Options Exchange, Inc. and the Pacific Stock Exchange, Inc., Relating to the Listing of Flexible Equity Options on Specified Equity Securities, Securities Exchange Act Release No. 34–36841 (Feb. 21, 1996); or (B) Self-Regulatory Organizations; Order Approving Proposed Rule Changes and Notice of Filing and Order Granting Accelerated Approval of Amendment Nos. 2 and 3 to the Proposed Rule Change by the American Stock Exchange, Inc., Relating to the Listing of Flexible Equity Options on Specified Equity Securities, Securities Exchange Act Release No. 34–37336 (June 27, 1996); or (C) Self-Regulatory Organizations; Order Approving Proposed Rule Change and Notice of Filing and Order Granting Accelerated Approval of Amendment Nos. 2, 4 and 5 to the Proposed Rule Change by the Philadelphia Stock Exchange, Inc., Relating to the Listing of Flexible Exchange Traded Equity and Index Options, Securities Exchange Act Release No. 34–39549 (Jan. 23, 1998); or

(D) Any changes to the SEC releases described in paragraphs (d)(1)(i)(A) through (C) of this section that are approved by the Securities and Exchange Commission; or

(ii) That is traded on any national securities exchange which is registered with the Securities and Exchange Commission (other than those described in the SEC Releases set forth in paragraph (d)(1)(i) of

Robert E. Wenzel, Deputy Commissioner

of Internal Revenue.

February 7, 2000 496 2000–6 I.R.B.

rates for February 2000.

Rev. Rul. 2000–9

This revenue ruling provides various prescribed rates for federal income tax purposes for February 2000 (the current month.) Table 1 contains the short-term, mid-term, and long-term applicable federal rates (AFR) for the current month for

purposes of section 1274(d) of the Internal Revenue Code. Table 2 contains the short-term, mid-term, and long-term adjusted applicable federal rates (adjusted AFR) for the current month for purposes of section 1288(b). Table 3 sets forth the adjusted federal long-term rate and the long-term tax-exempt rate described in section 382(f). Table 4 contains the ap propriate percentages for determining the low-income housing credit described in section 42(b)(2) for buildings placed in service during the current month. Finally, Table 5 contains the federal rate for determining the present value of an annuity, an interest for life or for a term of years, or a remainder or a reversionary interest for purposes of section 7520.

Applicable Federal Rates (AFR) for February 2000

Period for Compounding

Annual Semiannual Quarterly Monthly

Short-Term

AFR 6.20% 6.11% 6.06% 6.03% 110% AFR 6.83% 6.72% 6.66% 6.63% 120% AFR 7.46% 7.33% 7.26% 7.22% 130% AFR 8.10% 7.94% 7.86% 7.81%

Mid-Term

AFR 6.56% 6.46% 6.41% 6.37% 110% AFR 7.24% 7.11% 7.05% 7.01% 120% AFR 7.90% 7.75% 7.68% 7.63% 130% AFR 8.58% 8.40% 8.31% 8.26% 150% AFR 9.92% 9.69% 9.58% 9.50% 175% AFR 11.63% 11.31% 11.15% 11.05%

Long-Term

AFR 6.77% 6.66% 6.61% 6.57% 110% AFR 7.46% 7.33% 7.26% 7.22% 120% AFR 8.15% 7.99% 7.91% 7.86% 130% AFR 8.85% 8.66% 8.57% 8.51%

REV. RUL. 2000–9 TABLE 2

Adjusted AFR for February 2000

Period for Compounding

Annual Semiannual Quarterly Monthly

Short-term adjusted AFR 4.19% 4.15% 4.13% 4.11%

Mid-term adjusted AFR 4.87% 4.81% 4.78% 4.76%

Long-term adjusted AFR 5.73% 5.65% 5.61% 5.58%

2000–6 I.R.B. 497 February 7, 2000

REV. RUL. 2000–9 TABLE 3

Rates Under Section 382 for February 2000

Adjusted federal long-term rate for the current month 5.73%

Long-term tax-exempt rate for ownership changes during the current month (the highest of the adjusted federal long-term rates for the current month and the prior two months.)

REV. RUL. 2000–9 TABLE 4

Appropriate Percentages Under Section 42(b)(2)

for February 2000

5.73%

Appropriate percentage for the 70% presentvalue low-income housing credit 8.57%

Appropriate percentage for the 30% presentvalue low-income housing credit 3.67%

REV. RUL. 2000–9 TABLE 5

Rate Under Section 7520 for February 2000

Applicable federal rate for determining the present value of an annuity, an interest for life or a term of years, or a remainder or reversionary interest 8.0%

The collections of information contained in these final regulations have been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under control number 15451590. Responses to these collections of information are required to determine the manner in which a corporate subsidiary of an S corporation will be treated under the Internal Revenue Code.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid control number assigned by the Office of Management and Budget.

The estimated annual burden per respondent/recordkeeper varies from 45 minutes to 1 hour, depending on individual circumstances, with an estimated average of 57 minutes.

Section 1288.—Treatment of Original Issue Discounts on Tax Exempt Obligations

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of February 2000. See Rev. Rul. 2000–9, page 497.

Section 1361.—S Corporation Defined

26 CFR 1.351–2: Definitions relating to S corporation subsidiaries.

T.D. 8869

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 1, 301, and 602

Subchapter S Subsidiaries

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations that relate to the treatment of corporate subsidiaries of S corporations and interpret the rules added to the Internal Revenue Code by section 1308 of the Small Business Job Protection Act of 1996. These regulations provide the public with guidance needed to comply with applicable law and will affect S corporations and their shareholders.

DATES: Effective Date : These regulations are effective January 20, 2000.

Applicability Date : For dates of applicability, see §§1.1361–4(a)(3)(iii), 1.1361–4(a)(5)(i), 1.1361–5(c)(2), 1.1361–6, 1.1362–8(e), and 301.6109–1(i)(4).

FOR FURTHER INFORMATION CONTACT: Jeanne M. Sullivan (202)6223050 (not a toll-free number) or David J. Sotos (202)622-3050 (Subchapter S); Michael N. Kaibni (202)622-7550 (Subchapter C) (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

February 7, 2000 498 2000–6 I.R.B.

with the legislative history of the QSub provisions, conform the results of the deemed liquidation to the results that would obtain if an actual liquidation occurred, and follow the approach taken in other provisions of the tax law. In T.D. 8844, (1999–50 I.R.B. 661) published on November 29, 1999 (64 FR 66580), rules for elective changes in the classification of an entity for Federal tax purposes also provide that the tax treatment of a change in the classification of an entity by election is determined under all relevant provisions of the Internal Revenue Code and general principles of tax law, including the step transaction doctrine.) Accordingly, the final regulations provide that general principles of tax law, including step transaction, apply to determine the tax consequences of the transactions that include a QSub election. The final regulations provide examples illustrating the results of applying step transaction in the context of a QSub election.

The final regulations also provide for an extended transition period during which step transaction will be suspended. During the extended transition period, it is anticipated that proposed regulations published in the Federal Register on June 14, 1999, relating to the tax treatment of partially controlled subsidiaries under section 368(a)(1)(C) (64 FR 31770), will be finalized. These regulations generally reverse the IRS’s position that the acquisition of assets of a partially controlled subsidiary does not qualify as a tax-free reorganization under section 368(a)(1)(C). See Bausch & Lomb Optical Co. v. Commissioner, 30 T.C. 602 (1958), aff’d 267 F.2d 75 (2d Cir.), cert. denied, 361 U.S. 835 (1959); Rev. Rul. 54–396, 1954–2 C.B. 147. The regulations provide that preexisting ownership of a portion of a target corporation’s stock by an acquiring corporation generally will not prevent the solely for voting stock requirement in a “C” reorganization from being satisfied. See also Notice 2000–1, 2000–2 I.R.B. 288, which provides that the proposed regulations, when finalized, will provide that the regulations generally will apply to transactions occurring after December 31, 1999, with an exception for transactions pursuant to binding agreements. The finalization of these regulations will provide additional certainty as to the tax consequences of making a QSUB election in situations where an S corporation acquires the remainder of a partially con

Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503.

Books or records relating to this collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103.

Background

On April 22, 1998, the IRS published REG–251698–96, 1998–20 I.R.B. 14 (63 FR 19864) concerning the treatment of corporate subsidiaries of S corporations. The regulations interpreted rules added to the Internal Revenue Code (Code) by section 1308 of the Small Business Job Protection Act of 1996, Public Law 104–188, 110 Stat. 1755 (the Act), as amended by section 1601 of the Taxpayer Relief Act of 1997, Public Law 105–34, 111 Stat. 788 (the 1997 Act). The Act modified section 1361 of the Code to permit an S corporation (1) to own 80 percent or more of the stock of a C corporation, and (2) to elect to treat a wholly owned subsidiary as a qualified subchapter S subsidiary (QSub). The 1997 Act made a technical correction to section 1361 to provide regulatory authority to make exceptions to the general tax treatment of an election to be a QSub.

Written comments were received in response to the notice of proposed rulemaking, and a public hearing was held on October 14, 1998. After consideration of all the comments, the proposed regulations under sections 1361, 1362, and 1374 are adopted, as revised by this Treasury decision. The comments received and the revisions are discussed below. In addition, regulations under section 6109 are adopted to provide additional guidance consistent with the QSub provisions.

On January 13, 1997, the IRS published Notice 97–4, 1997–1 C.B. 351, to provide a temporary procedure for making a QSub (formerly QSSS) election. Taxpayers should continue to follow Notice 97–4 when making a QSub election until the QSub election form is published.

Explanation of Provisions

Step Transaction Doctrine

a. QSub Election

The proposed regulations provide that, when an S corporation makes a valid QSub election with respect to a subsidiary, the subsidiary is deemed to have liquidated into the parent S corporation immediately before the QSub election is effective. The tax treatment of this liquidation, alone or in the context of any larger transaction (for example, a transaction that also includes the acquisition of the subsidiary’s stock), generally is determined under all relevant provisions of the Code and general principles of tax law, including the step transaction doctrine. However, the proposed regulations include a special transition rule that applies to certain elections effective prior to the date that is 60 days after publication of final regulations in the Federal Register . The transition rule suspends the application of the step transaction doctrine with respect to the acquisition of stock followed by a QSub election in cases where the S corporation and the subsidiary are related (as described in section 267(b)) prior to the acquisition of the subsidiary’s stock.

Commentators expressed concern over the application of the step transaction doctrine to transactions that include the deemed liquidation that occurs as the result of a QSub election. These commentators argued that applying step transaction to the acquisition of stock that precedes a QSub election can cause the transaction to be recast as an asset acquisition under section 368 with results that may be inconsistent with the expectations of some taxpayers. Under step transaction principles, for example, if, pursuant to a plan, a shareholder contributes the stock of one wholly owned S corporation (S2) to another wholly owned S corporation (S1), and makes a QSub election for S2, the transaction generally would be a reorganization under section 368(a)(1)(D), with the possibility of gain recognition under section 357(c). See generally, Rev. Rul. 67–274 (1967–2 C.B. 141). In the opinion of these commentators, the legislative history of the QSub provisions indicates that the deemed liquidation that is incident to a QSub election should be respected as an independent, taxfree liquidation under section 332, rather than recast under the principles of the step transaction doctrine.

After consideration of all of the comments, Treasury and the IRS believe that the proposed regulations are consistent

2000–6 I.R.B. 499 February 7, 2000

tion

Under section 332(a), no gain or loss shall be recognized on the receipt by a corporation of property distributed in complete liquidation of another corporation if the requirements of section 332(b) are satisfied. Those requirements include the adoption of a plan of liquidation at a time when the corporation receiving the distribution owns 80 percent or more of the stock of the liquidating corporation. A QSub election results in a constructive liquidation for Federal tax purposes. Formally adopting a plan of liquidation for the QSub, however, is potentially incompatible with the QSub provisions of the Code, which allow the state-law entity to continue to exist while liquidating only for Federal tax purposes. In order to provide tax treatment for the constructive liquidation incident to a QSub election that is compatible with the requirements of section 332, the proposed regulations include a provision that the making of a QSub election satisfies the requirement of adopting a plan of liquidation.

One commentator asked that the regulations provide a safe harbor with respect to the timing of the adoption of the plan of liquidation for purposes of section 332. The commentator argued that, where the acquisition of stock followed by the deemed liquidation does not constitute a reorganization (after appropriate application of step-transaction principles), the regulations should provide that, for purposes of applying section 332 to the liquidation incident to a QSub election, the S corporation will be deemed to adopt a plan of liquidation for its subsidiary as of the effective date of the election, which should not precede the acquisition by the S corporation of 100 percent of the stock of the subsidiary.

The timing of the adoption of the plan of liquidation is important in the context of section 332 because only liquidating distributions to a corporation that owns 80 percent or more of the stock of the subsidiary when the plan is adopted qualify for tax-free treatment. A QSub election cannot be effective until the parent S corporation owns 100 percent of the subsidiary. Thus, the constructive liquidation incident to a QSub election cannot commence before that level of ownership is attained. Furthermore, providing certainty with respect to the deemed timing

trolled subsidiary in exchange for stock of the S corporation and immediately thereafter elects QSUB status with respect to the subsidiary.

b. QSUB Termination

Section 1361(b)(3)(C) provides that, if a QSUB election terminates, the corporation is treated as a new corporation acquiring all of its assets (and assuming all of its liabilities) from the S corporation in exchange for stock of the new corporation immediately before the termination. The proposed regulations provide that the tax treatment of this transaction or of a larger transaction that includes this transaction will be determined under the Code and general principles of tax law, including the step transaction doctrine. The proposed regulations include examples illustrating the application of the step transaction doctrine in the context of the termination of a QSUB election.

Commentators recommended that step transaction not apply to the termination of a QSUB election. Those commentators argue that the application of the step transaction doctrine causes inappropriate tax results in some situations. One example cited is the sale of 21 percent of the stock of a QSUB, thereby terminating the QSUB election. Under step transaction principles, the deemed formation of a new corporation that occurs as a result of the QSub termination fails to qualify under section 351 because the S corporation parent is not in control of the new corporation as defined in section 368(c) after the disposition. As a result of the failure to qualify under section 351, gain would be recognized on all of the QSub’s assets.

Treasury and the IRS believe that it is appropriate to apply the step transaction doctrine to the termination of a QSub election. Applying the step transaction principles to the control requirement of section 351 after the disposition of QSub stock is completed is consistent with the legislative history of the QSub termination provisions. S. Rep. No. 104–281, 104 ^th Cong., 2d Sess. 52 n.59 (1996). Moreover, in many cases, application of the step transaction doctrine will provide a more taxpayer favorable result than giving separate effect to each step. This may occur, for example, if 100 percent of the stock of a QSub is sold. In that case, applying step transaction principles would result in a fair market value basis for the

former QSub’s assets, rather than a lower carryover basis that would result (absent a section 338 election) from treating the deemed formation of the new corporation as an independent step qualifying under section 351. In order to assist taxpayers to understand the effect of QSub terminations, the final regulations include two examples that illustrate the contrasting tax consequences of purchasing 21 percent of the stock of a QSub as opposed to the tax consequences of contributing property to the QSub in exchange for 21 percent of the former QSub’s stock. The final regulations include additional examples illustrating the consequences of revoking the QSub election prior to sale of the QSub’s stock and of merging a QSub into a disregarded entity prior to such sale. 2. “F” Reorganizations During the Tran- sition Period .

As noted above, commentators generally oppose applying the step transaction doctrine to the acquisition of the stock of a corporation followed immediately by a QSub election. Some commentators, however, suggested that, for policy and other reasons, during the transition period, the formation of a new shell S corporation (Newco) by the shareholders of an existing S corporation, followed by the contribution of the stock of the existing S corporation to Newco, coupled with an immediate QSub election for the existing corporation, should be characterized as a reorganization under section 368(a)(1)(F) if all of the other requisites of that section are met. Treating the transaction as an “F” reorganization (as opposed to a stock acquisition followed by a section 332 liquidation) can be beneficial to taxpayers. For example, the existing S corporation’s taxable year does not close if it undergoes an “F” reorganization.

In light of the underlying purpose of the transition rule as a relief provision for the benefit of taxpayers, during the extended transition period provided in the final regulations, the IRS will not challenge taxpayers who, through application of the step transaction doctrine to an acquisition of stock followed by a QSub election, obtain tax treatment similar to that applied in a valid reorganization under section 368(a)(1)(F) if, without regard to the transition rule, the transaction would properly qualify as such a reorganization. 3. Timing of Adoption of Plan of Liquida-

February 7, 2000 500 2000–6 I.R.B.

of the adoption of the plan of liquidation facilitates the efficient administration and use of the QSub provisions. Accordingly, to provide tax treatment of a QSub election that is compatible with the requirements of section 332, the final regulations provide that, for purposes of satisfying the requirement of section 332(b) that the parent corporation own stock in the subsidiary meeting the requirements of section 1504(a)(2) on the date of adoption of the plan of liquidation of the subsidiary, the plan of liquidation is deemed adopted immediately before the deemed liquidation incident to a QSub election unless a formal plan of liquidation that contemplates the filing of the QSub election is adopted on an earlier date. (Although no similar rule is contained in the rules for elective changes in the classification of an entity for Federal tax purposes, Treasury and the IRS intend to amend those regulations to include such a rule.) However, if as a result of the application of general tax principles the transactions that include the QSub election are treated as an asset acquisition, section 332 is not applicable and this rule has no relevance. 4. Insolvent Subsidiaries In general, section 332 does not apply to the liquidation of an insolvent corporation, because the parent corporation does not receive at least partial payment for the stock of its subsidiary. See, e.g., §1.332–2(b) and Rev. Rul. 68–602 (1968–2 C.B. 135). One commentator recommended that a QSub election made for an insolvent subsidiary be eligible for tax-free treatment under section 332. The commentator argued that the legislative history of the QSub provisions makes it clear that a QSub election should qualify as a liquidation under section 332 unless regulations provide otherwise and that taxpayers may be unaware of the harsh results of making a QSub election for an insolvent corporation.

Treasury and the IRS do not agree that the legislative history indicates that section 332 applies to the liquidation of an insolvent corporation. In order to assist taxpayers, an example illustrates the effect of a QSub election for an insolvent corporation. 5. Definition of Stock of the QSub Commentators recommended that, for purposes of determining whether a subsidiary is wholly owned by the parent S

corporation, arrangements that are not considered to be stock under the oneclass-of-stock rules of §1.1361–1(l) should be disregarded. The commentators noted that applying the principles of these regulations would provide certainty with respect to the subsidiary’s eligibility to be a QSub and avoid difficult debt/equity determinations.

The final regulations adopt the position recommended by the commentators. The final regulations provide that, for purposes of determining whether the deemed liquidation of the subsidiary qualifies under section 332, the deemed exercise of an option under §1.1504–4 and any instrument, obligation, or arrangement that would not be considered stock under the one-classof-stock rules of §1.1361–1(l) are disregarded in determining if the stock ownership requirements of section 332(b) are met. For example, an option that would not be treated as stock under §1.1361–1, but that would be treated as exercised under §1.1504–4, is disregarded. Similarly, if a QSub election terminates, in determining the applicability of section 351, the determination of whether stock ownership of the newly formed corporation satisfies the control requirement of section 368(c) is made without regard to instruments, obligations, or other arrangements that are not treated as stock for purposes of the 100 percent stock ownership requirement for the election.

The rule regarding options under §1.1504–4 is included for purposes of applying section 332 because section 332 explicitly incorporates the affiliation rules of section 1504. See §1.1504–4(a)(1) (the option rules apply to all provisions under the Code and the regulations to which affiliation within the meaning of section 1504(a) is relevant). The affiliation rules are not relevant for purposes of applying the rules regarding the 100 percent stock ownership requirement in section 1361(b)(3)(B)(i). Accordingly, the rule concerning the treatment of stock in applying the 100 percent stock ownership requirement does not refer to the option rules under §1.1504–4. 6. Section 1374 and Excess Loss Ac- counts

Commentary on the proposed regulations identified certain discrepancies in the treatment of tiered groups of corporations when QSub elections are made for

some or all of the members of the group and certain unintended implications of the sentence added to §1.1374–8(b) in the proposed regulations. a. Section 1374

Section 1374(d)(8) and §1.1374–8(a) generally provide that, if an S corporation acquires assets in a transaction in which the S corporation’s basis in the assets is determined (in whole or in part) by reference to a C corporation’s basis in the assets (or any other property) (a section 1374(d)(8) transaction), section 1374 applies to the net recognized built-in gain attributable to the assets acquired in such a transaction. Section 1.1374–8(b) provides that, for purposes of the tax imposed under section 1374(d)(8), a separate determination of tax is made with respect to the assets the S corporation acquires in one section 1374(d)(8) transaction from the assets the S corporation acquires in another section 1374(d)(8) transaction and from the assets the corporation held when it became an S corporation.

A corporation’s section 1374 attributes (loss carryforwards, credits, and credit carryforwards as provided in §1.1374–1(c)) may be used only to reduce the section 1374 tax imposed on the disposition of assets held by the S corporation at the time it converted from C status. Likewise, section 1374 attributes acquired in one section 1374(d)(8) transaction may be used only to reduce tax on the disposition of assets acquired in that transaction. This results in separate section 1374 pools for purposes of calculating the tax imposed by section 1374.

One commentator noted that §1.1374–8(b) of the proposed regulations implies that a QSub election for two or more corporations results in a section 1374(d)(8) transaction for each subsidiary and that this implication is contrary to the general timing rules of §1.1361–4(b)(1). Those general timing rules provide that the deemed liquidation of a tiered group of C corporations that elect S and QSub status effective on the same day occurs at the close of the day before the effective date of the elections, while the parent is a C corporation. As a result of the operation of the general timing rules, there is a single section 1374 pool when the parent corporation’s S election is effective. Moreover, the commentator noted that a

2000–6 I.R.B. 501 February 7, 2000

literal reading of §1.1374–8(b) of the proposed regulations may cause the assets of an S corporation that is acquired by a C corporation to become subject to section 1374 when the acquiring C corporation immediately makes an S election for itself and a QSub election for the acquired S corporation. Finally, the commentator requested that the final regulations provide that when an S corporation acquires a tiered group of corporations and makes QSub elections effective on the same date for some or all of the corporations, the assets deemed acquired by the S corporation will be treated as acquired in a single section 1374(d)(8) transaction, consistent with the apparent intent of the general timing rules of §1.1361–4(b)(1) of the proposed regulations. b. Excess loss accounts

Section 1.1502–19 of the Income Tax Regulations provides rules requiring, in certain instances, a member (X) of a consolidated group of corporations to include in income its excess loss account (ELA) in the stock of another member (Y) of the group. An ELA reflects X’s negative adjustments with respect to Y’s stock to the extent the negative adjustments exceed X’s basis in the stock. An ELA must be included in X’s income if X is treated as disposing of Y’s stock. See §1.1502–19(b)(1). A merger or liquidation of X into an S corporation or an S election by X is treated as a disposition that triggers income recognition with respect to an ELA in Y stock. In contrast, X’s income or gain in certain cases is subject to any nonrecognition or deferral rules applicable, including section 332. As a result, if Y liquidates into X in a transaction subject to section 332, there is no income recognition with respect to an ELA in Y’s stock. See §1.1502–19(b)(2)(i).

Under the general timing rules of §1.1361–4(b)(1), if the common parent elects S status, the deemed liquidations of the subsidiary members of the consolidated group for which QSub elections are made (effective on the same date as the S election) occur as of the close of the day before the QSub elections are effective, while the S electing parent corporation is still a C corporation. As a result, there is no triggering of income with respect to ELAs in the stock of the subsidiary corporations if the liquidations qualify under section 332. In contrast, if a consolidated group of corporations is acquired by an S

corporation and the acquiring S corporation makes QSub elections for the parent and members of the consolidated group, a deemed liquidation of the parent prior to the deemed liquidation of other members of the consolidated group may be a disposition that triggers income recognition with respect to ELAs in the subsidiaries’ stock. c. Modifications adopted in the final regulations

The final regulations remove the proposed amendment to §1.1374–8(b). Furthermore, an amendment to the general timing rules under §1.1361–4(b)(1) for acquired S corporations clarifies that an acquired S corporation liquidates into an acquiring corporation as of the beginning of the day of acquisition, after the parent’s S election, if any, is effective. There is no section 1374(d)(8) transaction when an S corporation acquires assets from another S corporation, if the acquired S corporation has no C corporation history. The modification to the timing rule also clarifies that there is no period during which an acquired S corporation is a C corporation if the QSub election is made effective as of the time of the acquisition.

As noted in the commentary, the order of the deemed liquidations for a tiered group of corporations for which QSub elections are made (effective on the same date) is significant for purposes of section 1374 and under §1.1502–19. In many situations, it is preferable to have the deemed liquidations occur in order from the lowest tier subsidiary to the highest tier subsidiary, a bottom-up liquidation order. As a result of that ordering, the final liquidation of the highest tier subsidiary results in a single section 1374 pool for the group. In addition, in the case of a consolidated group of corporations, because the deemed liquidation of the common parent follows the deemed liquidation of its subsidiaries, there is no deconsolidation for purposes of §1.1502–19 and no triggering of ELAs. In other circumstances, however, a top to bottom liquidation of a tiered group of subsidiaries may be preferable. Therefore, the final regulations allow the S corporation to specify the order of the deemed liquidations when QSub elections are made (effective on the same day) for a tiered group of subsidiaries. In default of an election, the deemed liquidations occur in succession on the effective date of the election, beginning with the lowest tier subsidiary.

Timing One commentator noted a potential lack of coordination in the regulations that determine the timing of the termination of the S election of an acquired S corporation and the deemed liquidation incident to a QSub election for that S corporation. The commentator acknowledged that the intent of the proposed regulations is to provide that an acquired S corporation for which a QSub election is made effective immediately on acquisition should have no intervening C period.

Other timing issues can arise with respect to the termination of a QSub election. The regulations provide rules that govern the timing of the deemed liquidation incident to a QSub election and of the termination of a QSub election. The regulations also provide examples illustrating those rules. The regulations generally are intended to provide that a corporation may move between S and QSub status without an intervening C period, if the appropriate election is made effective as of the termination of the previous S or QSub election. The regulations are coordinated with provisions under section 338 and §§1.1362–2 and 1.1502–76 that have differing timing provisions. 8. Inadvertent QSub Election and Inad- vertent Termination Relief

One commentator requested that the regulations provide inadvertent invalid QSub election relief similar to the relief that is available under section 1362(f) for inadvertent invalid S elections and inadvertent S terminations. The proposed regulations include a provision indicating that inadvertent QSub termination relief may be available under standards established by the Commissioner for inadvertent termination of an S election under §1.1362–4.

The QSub provisions include no section analogous to section 1362(f) that allows the IRS to determine that a corporation is a QSub during a period when the corporation does not satisfy the requirement of section 1361(b)(3)(B)(i). For example, if the parent corporation inadvertently transfers one share of QSub stock to another person, the QSub election terminates. The subsidiary is not eligible to have a QSub election in effect for the period during which the parent does not own 100 percent of its stock. If the QSub election terminates because of the inadvertent

February 7, 2000 502 2000–6 I.R.B.

termination of the parent’s S election, however, relief may be available under section 1362(f). A favorable determination under that section causes the subsidiary to continue to satisfy the requirements of section 1361(b)(3)(B)(ii) during the period when the parent is accorded relief for inadvertent termination of its S election. Moreover, if the parent fails to make a timely QSub election, relief may be available under the procedures applicable under §301.9100–1 and §301.9100–3.

The final regulations do not include the provision relating to the inadvertent termination of a QSub election. The removal of that provision is not intended to suggest that relief under section 1362(f) is not available in appropriate circumstances (such as those discussed above), but is intended to avoid confusion with respect to the scope of the IRS’s statutory authority under section 1362(f). 9. Ordering Rule for Termination of QSub Elections

Commentators requested that the final regulations provide an ordering rule for the simultaneous termination of QSub elections as the result of the termination of an upper-tier subsidiary’s QSub election. The final regulations provide that the terminations occur in succession, beginning with the upper-tier subsidiary, and include examples to illustrate the effect of simultaneous QSub terminations. 10. Banking Provisions Consistent with the proposed regulations, the final regulations provide that any special rules applicable to banks under the Code continue to apply separately to banks as if the deemed liquidation incident to a QSub election had not occurred (the banking provisions). Commentators requested that the banking provisions be retroactive to the effective date of the Act, by election. As authorized by section 1601 of the 1997 Act, and as first announced in Notice 97–5 (1997–1 C.B. 352), the final regulations provide that the banking provisions apply to taxable years beginning after December 31, 1996. This rule applies to all taxpayers and is not subject to an election. The banking provisions also include a reference to other published guidance for section 265(b); see Rev. Rul. 90–44 (1990–1 C.B. 54, 57). 11. Taxpayer Identifying Numbers The regulations provide clarification

regarding employer identification numbers (EINs) for QSubs. The regulations restate the general rules that (1) when an entity’s classification changes as a result of an election, it retains its EIN; and (2) unless regulations or published guidance provide otherwise, a disregarded entity (including a QSub) must use its owner’s EIN for Federal tax purposes.

Notice 99–6 (1999–3 I.R.B. 12) provides guidance that, under limited circumstances, a disregarded entity may use its own EIN. If a QSub wishes to use its own EIN in accordance with Notice 99–6 but did not have an EIN prior to becoming a QSub, it must apply for a new EIN.

If a subsidiary’s QSub election terminates, the new corporation formed as a result of that termination must use its own EIN for Federal tax purposes. If the new corporation had an EIN before the effective date of its QSub election or during its QSub status, it should use that EIN. Otherwise, the new corporation must apply for a new EIN. 12. Effective Date and Transition rules The regulations generally apply to taxable years that begin on or after January 20, 2000; however, taxpayers may elect to apply the regulations in whole, but not in part (aside from those sections with special dates of applicability), for taxable years beginning on or after January 1, 2000 , provided the corporation and all affected taxpayers apply the regulations in a consistent manner. To make the election, the corporation and all affected taxpayers must file a return or an amended return that is consistent with these rules for the taxable year for which the election is made. For purposes of this section, affected taxpayers means all taxpayers whose returns are affected by the election to apply the regulations. The rules relating to the treatment of banks apply to all taxable years beginning after December 31, 1996; see §1.1361–4(a)(3)(iii). The provision relating to transitional relief from the step transaction applies to certain QSub elections effective on or before the end of calendar year 2000; see §1.1361–4(a)(5)(i). Section 1.1361– 5(c)(2), relating to automatic consent for an S or QSub election made for a corporation whose QSub election has terminated within the five-year period described in section 1361(b)(3)(D), applies to certain QSub elections effective after December 31, 1996. Section

301.6109–1(i), relating to EINs, applies on or after January 20, 2000.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. It is hereby certified that the collection of information in these regulations will not have a significant impact on a substantial number of small businesses. This certification is based upon the fact that the economic burden imposed on taxpayers by the collection of information and recordkeeping requirements of these regulations is insignificant. For example, the estimated average annual burden per respondent is less than one hour. Furthermore, most taxpayers will only have to respond to the requests for information contained in §§1.1361–3 and 1.1361–5 one time in the life of the corporation. Therefore, a Regulatory Flexibility Analysis is not required under the Regulatory Flexibility Act (5 U.S.C. chapter 6). Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking preceding these regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Drafting Information

The principal authors of these regulations are Jeanne M. Sullivan and David J. Sotos of the Office of the Assistant Chief Counsel (Passthroughs & Special Industries); and Michael N. Kaibni of the Office of the Assistant Chief Counsel (Corporate). However, other personnel from the IRS and Treasury Department participated in their development.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1, 301, and 602 are amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in part as follows:

2000–6 I.R.B. 503 February 7, 2000

Authority: 26 U.S.C. 7805 * * * Par. 2. Amend §1.1361–0 as follows: 1.Revise the introductory text. 2.Remove the entry for §1.1361–1(d)(3).

3.Add entries for §§1.1361–2, 1.1361–3, 1.1361–4, 1.1361–5, and 1.1361–6. The revisions and additions read as follows: §1.1361–0 Table of contents .

This section lists captions contained in §§1.1361–1, 1.1361–2, 1.1361–3, 1.1361–4, 1.1361–5, and 1.1361–6.

§1.1361–2 Definitions relating to S corporation subsidiaries.

(a) In general. (b) Stock treated as held by S corporation. (c) Straight debt safe harbor. (d) Examples. §1.1361–3 QSub election . (a) Time and manner of making election. (1) In general. (2) Manner of making election. (3) Time of making election. (4) Effective date of election. (5) Example. (6) Extension of time for making a QSub election. (b) Revocation of QSub election. (1) Manner of revoking QSub election. (2) Effective date of revocation. (3) Revocation after termination. (4) Revocation before QSub election effective.

§1.1361–4 Effect of QSub election.

(a) Separate existence ignored. (1) In general. (2) Liquidation of subsidiary. (i) In general. (ii) Examples (iii)Adoption of plan of liquidation. (iv) Example. (v) Stock ownership requirements of section 332. (3) Treatment of banks. (i) In general. (ii) Examples. (iii)Effective date. (4) Treatment of stock of QSub. (5) Transitional relief. (i) General rule. (ii) Examples. (b) Timing of the liquidation.

(1) In general. (2) Application to elections in tiered situations. (3) Acquisitions. (i) In general. (ii) Special rules for acquired S corporations. (4) Coordination with section 338 election. (c) Carryover of disallowed losses and deductions. (d) Examples.

§1.1361–5 Termination of QSub election.

(a) In general. (1) Effective date. (2) Information to be provided upon termination of QSub election by failure to qualify as a QSub. (3) QSub joins a consolidated group. (4) Examples. (b) Effect of termination of QSub election. (1) Formation of new corporation. (i) In general. (ii) Termination for tiered QSubs. (2) Carryover of disallowed losses and deductions. (3) Examples. (c) Election after QSub termination. (1) In general. (2) Exception. (3) Examples.

§1.1361–6 Effective date.

Par. 3. Amend §1.1361–1 as follows:

Revise paragraph (b)(1)(i).
Remove paragraph (d)(1)(i).
Redesignate paragraphs (d)(1)(ii), (d)(1)(iii), (d)(1)(iv), and (d)(1)(v) as paragraphs (d)(1)(i), (d)(1)(ii), (d)(1)(iii), and (d)(1)(iv), respectively.
Revise newly designated paragraph (d)(1)(i).
Remove paragraph (d)(3).
Revise the first sentence of paragraph (e)(1).

The revisions read as follows:

§1.1361–1 S corporation defined.

(b) * * * (1) * * * (i) More than 75 shareholders (35 for taxable years beginning before January 1, 1997);

(d) * * * (1) * * * (i) For taxable years beginning on or after January 1, 1997, a financial institution that uses the reserve method of accounting for bad debts described in section 585 (for taxable years beginning prior to January 1, 1997, a financial institution to which section 585 applies (or would apply but for section 585(c)) or to which section 593 applies);

(e) * * * (1) General rule . A corporation does not qualify as a small business corporation if it has more than 75 shareholders (35 for taxable years beginning prior to January 1, 1997). * * *

Par. 4. Add §§1.1361–2, 1.1361–3, 1.1361–4, 1.1361–5, and 1.1361–6 to read as follows:

§1.1361–2 Definitions relating to S corporation subsidiaries.

(a) In general . The term qualified sub- chapter S subsidiary (QSub) means any domestic corporation that is not an ineligible corporation (as defined in section 1361(b)(2) and the regulations thereunder), if—

(1) 100 percent of the stock of such corporation is held by an S corporation; and

(2) The S corporation properly elects to treat the subsidiary as a QSub under §1.1361–3.

(b) Stock treated as held by S corpora- tion . For purposes of satisfying the 100 percent stock ownership requirement in section 1361(b)(3)(B)(i) and paragraph (a)(1) of this section—

(1) Stock of a corporation is treated as held by an S corporation if the S corporation is the owner of that stock for Federal income tax purposes; and

(2) Any outstanding instruments, obligations, or arrangements of the corporation which would not be considered stock for purposes of section 1361(b)(1)(D) if the corporation were an S corporation are not treated as outstanding stock of the QSub.

(c) Straight debt safe harbor . Section 1.1361–1(l)(5)(iv) and (v) apply to an obligation of a corporation for which a QSub election is made if that obligation would satisfy the definition of straight debt in §1.1361–1(l)(5) if issued by the S

February 7, 2000 504 2000–6 I.R.B.

statement must be signed by a person authorized to sign the S corporation’s return required to be filed under section 6037.

(2) Effective date of revocation . The revocation of a QSub election is effective on the date specified on the revocation statement or on the date the revocation statement is filed if no date is specified. The effective date specified on the revocation statement cannot be more than two months and 15 days prior to the date on which the revocation statement is filed and cannot be more than 12 months after the date on which the revocation statement is filed. If a revocation statement specifies an effective date more than two months and 15 days prior to the date on which the statement is filed, it will be effective two months and 15 days prior to the date it is filed. If a revocation statement specifies an effective date more than 12 months after the date on which the statement is filed, it will be effective 12 months after the date it is filed.

(3) Revocation after termination . A revocation may not be made after the occurrence of an event that renders the subsidiary ineligible for QSub status under section 1361(b)(3)(B).

(4) Revocation before QSub election ef- fective . For purposes of Section 1361(b)(3)(D) and §1.1361–5(c) (five-year prohibition on re-election), a revocation effective on the first day the QSub election was to be effective will not be treated as a termination of a QSub election.

§1.1361–4 Effect of QSub election.

(a) Separate existence ignored —(1) In general . Except as otherwise provided in paragraph (a)(3) of this section, for Federal tax purposes—

(i) A corporation which is a QSub shall not be treated as a separate corporation; and

(ii) All assets, liabilities, and items of income, deduction, and credit of a QSub shall be treated as assets, liabilities, and items of income, deduction, and credit of the S corporation.

(2) Liquidation of subsidiary —(i) In general . If an S corporation makes a valid QSub election with respect to a subsidiary, the subsidiary is deemed to have liquidated into the S corporation. Except as provided in paragraph (a)(5) of this section, the tax treatment of the liquidation or of a larger transaction that includes

corporation.

(d) Examples . The following examples illustrate the application of this section:

Example 1 . X, an S corporation, owns 100 percent of Y, a corporation for which a valid QSub election is in effect for the taxable year. Y owns 100 percent of Z, a corporation otherwise eligible for QSub status. X may elect to treat Z as a QSub under section 1361(b)(3)(B)(ii).

Example 2 . Assume the same facts as in Example 1, except that Y is a business entity that is disregarded as an entity separate from its owner under §301.7701–2(c)(2) of this chapter. X may elect to treat Z as a QSub.

Example 3 . Assume the same facts as in Example 1, except that Y owns 50 percent of Z, and X owns the other 50 percent. X may elect to treat Z as a QSub.

Example 4 . Assume the same facts as in Example 1, except that Y is a C corporation. Although Y is a domestic corporation that is otherwise eligible to be a QSub, no QSub election has been made for Y. Thus, X is not treated as holding the stock of Z. Consequently, X may not elect to treat Z as a QSub.

Example 5 . Individuals A and B own 100 percent of the stock of corporation X, an S corporation, and, except for C’s interest (described below), X owns 100 percent of corporation Y, a C corporation. Individual C holds an instrument issued by Y that is considered to be equity under general principles of tax law but would satisfy the definition of straight debt under §1.1361–1(l)(5) if Y were an S corporation. In determining whether X owns 100 percent of Y for purposes of making the QSub election, the instrument held by C is not considered outstanding stock. In addition, under §1.1361–1(l)(5)(v), the QSub election is not treated as an exchange of debt for stock with respect to such instrument, and §1.1361–1(l)(5)(iv) applies to determine the tax treatment of payments on the instrument while Y’s QSub election is in effect.

§1.1361–3 QSub election.

(a) Time and manner of making elec- tion —(1) In general . The corporation for which the QSub election is made must meet all the requirements of section 1361(b)(3)(B) at the time the election is made and for all periods for which the election is to be effective.

(2) Manner of making election . Except as provided in section 1361(b)(3)(D) and §1.1361–5(c) (five-year prohibition on reelection), an S corporation may elect to treat an eligible subsidiary as a QSub by filing a completed form to be prescribed by the IRS. The election form must be signed by a person authorized to sign the S corporation’s return required to be filed under section 6037. Unless the election form provides otherwise, the election must be submitted to the service center where the subsidiary filed its most recent tax return (if applicable), and, if an S cor

poration forms a subsidiary and makes a valid QSub election (effective upon the date of the subsidiary’s formation) for the subsidiary, the election should be submitted to the service center where the S corporation filed its most recent return.

(3) Time of making election . A QSub election may be made by the S corporation parent at any time during the taxable year.

(4) Effective date of election . A QSub election will be effective on the date specified on the election form or on the date the election form is filed if no date is specified. The effective date specified on the form cannot be more than two months and 15 days prior to the date of filing and cannot be more than 12 months after the date of filing. For this purpose, the definition of the term month found in §1.1362–6(a)(2)(ii)(C) applies. If an election form specifies an effective date more than two months and 15 days prior to the date on which the election form is filed, it will be effective two months and 15 days prior to the date it is filed. If an election form specifies an effective date more than 12 months after the date on which the election is filed, it will be effective 12 months after the date it is filed.

(5) Example . The following example illustrates the application of paragraph (a)(4) of this section:

Example. X has been a calendar year S corporation engaged in a trade or business for several years. X acquires the stock of Y, a calendar year C corporation, on April 1, 2002. On August 10, 2002, X makes an election to treat Y as a QSub. Unless otherwise specified on the election form, the election will be effective as of August 10, 2002. If specified on the election form, the election may be effective on some other date that is not more than two months and 15 days prior to August 10, 2002, and not more than 12 months after August 10, 2002.

(6) Extension of time for making a QSub election . An extension of time to make a QSub election may be available under the procedures applicable under §§301.9100–1 and 301.9100–3 of this chapter.

(b) Revocation of QSub election —(1) Manner of revoking QSub election . An S corporation may revoke a QSub election under section 1361 by filing a statement with the service center where the S corporation’s most recent tax return was properly filed. The revocation statement must include the names, addresses, and taxpayer identification numbers of both the parent S corporation and the QSub, if any. The

2000–6 I.R.B. 505 February 7, 2000

the liquidation will be determined under the Internal Revenue Code and general principles of tax law, including the step transaction doctrine. Thus, for example, if an S corporation forms a subsidiary and makes a valid QSub election (effective upon the date of the subsidiary’s formation) for the subsidiary, the transfer of assets to the subsidiary and the deemed liquidation are disregarded, and the corporation will be deemed to be a QSub from its inception.

(ii) Examples . The following examples illustrate the application of this paragraph (a)(2)(i) of this section:

Example 1 . Corporation X acquires all of the outstanding stock of solvent corporation Y from an unrelated individual for cash and short-term notes. Thereafter, as part of the same plan, X immediately makes an S election and a QSub election for Y. Because X acquired all of the stock of Y in a qualified stock purchase within the meaning of section 338(d)(3), the liquidation described in paragraph (a)(2) of this section is respected as an independent step separate from the stock acquisition, and the tax consequences of the liquidation are determined under sections 332 and 337.

Example 2 . Corporation X, pursuant to a plan, acquires all of the outstanding stock of corporation Y from the shareholders of Y solely in exchange for 10 percent of the voting stock of X. Prior to the transaction, Y and its shareholders are unrelated to X. Thereafter, as part of the same plan, X immediately makes an S election and a QSub election for Y. The transaction is a reorganization described in section 368(a)(1)(C), assuming the other conditions for reorganization treatment (e.g., continuity of business enterprise) are satisfied.

Example 3 . After the expiration of the transition period provided in paragraph (a)(5)(i) of this section, individual A, pursuant to a plan, contributes all of the outstanding stock of Y to his wholly owned S corporation, X, and immediately causes X to make a QSub election for Y. The transaction is a reorganization under section 368(a)(1)(D), assuming the other conditions for reorganization treatment (e.g., continuity of business enterprise) are satisfied. If the sum of the amount of liabilities of Y treated as assumed by X exceeds the total of the adjusted basis of the property of Y, then section 357(c) applies and such excess is considered as gain from the sale or exchange of a capital asset or of property which is not a capital asset, as the case may be.

(iii) Adoption of plan of liquidation . For purposes of satisfying the requirement of adoption of a plan of liquidation under section 332, unless a formal plan of liquidation that contemplates the QSub election is adopted on an earlier date, the making of the QSub election is considered to be the adoption of a plan of liquidation immediately before the deemed liquidation described in paragraph (a)(2)(i) of this section.

(iv) Example . The following example

illustrates the application of paragraph (a)(2)(iii) of this section:

Example . Corporation X owns 75 percent of a solvent corporation Y, and individual A owns the remaining 25 percent of Y. As part of a plan to make a QSub election for Y, X causes Y to redeem A’s 25 percent interest on June 1 for cash and makes a QSub election for Y effective on June 3. The making of the QSub election is considered to be the adoption of a plan of liquidation immediately before the deemed liquidation. The deemed liquidation satisfies the requirements of section 332.

(v) Stock ownership requirements of section 332 . The deemed exercise of an option under §1.1504–4 and any instruments, obligations, or arrangements that are not considered stock under §1.1361–2(b)(2) are disregarded in determining if the stock ownership requirements of section 332(b) are met with respect to the deemed liquidation provided in paragraph (a)(2)(i) of this section.

(3) Treatment of banks —(i) In gen- eral. If an S corporation is a bank, or if an S corporation makes a valid QSub election for a subsidiary that is a bank, any special rules applicable to banks under the Internal Revenue Code continue to apply separately to the bank parent or bank subsidiary as if the deemed liquidation of any QSub under paragraph (a)(2) of this section had not occurred (except as other published guidance may apply section 265(b) and section 291(a)(3) and (e)(1)(B) not only to the bank parent or bank subsidiary but also to any QSub deemed to have liquidated under paragraph (a)(2) of this section). For any QSub that is a bank, however, all assets, liabilities, and items of income, deduction, and credit of the QSub, as determined in accordance with the special bank rules, are treated as assets, liabilities, and items of income, deduction, and credit of the S corporation. For purposes of this paragraph (a)(3)(i), the term bank has the same meaning as in section 581.

(ii) Examples . The following examples illustrate the application of this paragraph (a)(3):

Example 1 . X, an S corporation, is a bank as defined in section 581. X owns 100 percent of Y and Z, corporations for which valid QSub elections are in effect. Y is a bank as defined in section 581, and Z is not a financial institution. Pursuant to paragraph (a)(3)(i) of this section, any special rules applicable to banks under the Internal Revenue Code continue to apply separately to X and Y and do not apply to Z. Thus, for example, section 265(b), which provides special rules for interest expense deductions of banks, applies separately to X and Y. That is, X and Y each must make a separate determi

nation under section 265(b) of interest expense allocable to tax-exempt interest, and no deduction is allowed for that interest expense. Section 265(b) does not apply to Z except as published guidance may provide otherwise.

Example 2 . X, an S corporation, is a bank holding company and thus is not a bank as defined in section 581. X owns 100 percent of Y, a corporation for which a valid QSub election is in effect. Y is a bank as defined in section 581. Pursuant to paragraph (a)(3)(i) of this section, any special rules applicable to banks under the Internal Revenue Code continue to apply to Y and do not apply to X. However, all of Y’s assets, liabilities, and items of income, deduction, and credit, as determined in accordance with the special bank rules, are treated as those of X. Thus, for example, section 582(c), which provides special rules for sales and exchanges of debt by banks, applies only to sales and exchanges by Y. However, any gain or loss on such a transaction by Y that is considered ordinary income or ordinary loss pursuant to section 582(c) is treated as ordinary income or ordinary loss of X.

(iii) Effective date . This paragraph (a)(3) applies to taxable years beginning after December 31, 1996.

(4) Treatment of stock of QSub . Except for purposes of section 1361(b)(3)(B)(i) and §1.1361–2(a)(1), the stock of a QSub shall be disregarded for all Federal tax purposes.

(5) Transitional relief —(i) General rule . If an S corporation and another corporation (the related corporation) are persons specified in section 267(b) prior to an acquisition by the S corporation of some or all of the stock of the related corporation followed by a QSub election for the related corporation, the step transaction doctrine will not apply to determine the tax consequences of the acquisition. This paragraph (a)(5) shall apply to QSub elections effective before January 1, 2001.

(ii) Examples . The following examples illustrate the application of this paragraph (a)(5):

Example 1 . Individual A owns 100 percent of the stock of X, an S corporation. X owns 79 percent of the stock of Y, a solvent corporation, and A owns the remaining 21 percent. On May 4, 1998, A contributes its Y stock to X in exchange for X stock. X makes a QSub election with respect to Y effective immediately following the transfer. The liquidation described in paragraph (a)(2) of this section is respected as an independent step separate from the stock acquisition, and the tax consequences of the liquidation are determined under sections 332 and 337. The contribution by A of the Y stock qualifies under section 351, and no gain or loss is recognized by A, X, or Y.

Example 2 . Individual A owns 100 percent of the stock of two solvent S corporations, X and Y. On May 4, 1998, A contributes the stock of Y to X. X makes a QSub election with respect to Y immediately following the transfer. The liquidation de

February 7, 2000 506 2000–6 I.R.B.

respect to S2 effective on the day of the acquisition, see §1.1366–2(c)(1) for provisions relating to the carryover of losses and deductions with respect to a former shareholder of S2 that may be available to that shareholder as a shareholder of S1.

(d) Examples . The following examples illustrate the application of this section:

Example 1 . X, an S corporation, owns 100 percent of the stock of Y, a C corporation. On June 2, 2002, X makes a valid QSub election for Y, effective June 2, 2002. Assume that, under general principles of tax law, including the step transaction doctrine, X’s acquisition of the Y stock and the subsequent QSub election would not be treated as related. The liquidation described in paragraph (a)(2) of this section occurs at the close of the day on June 1, 2002, the day before the QSub election is effective, and the plan of liquidation is considered adopted on that date. Y’s taxable year and separate existence for Federal tax purposes end at the close of June 1, 2002. Example 2 . X, a C corporation, owns 100 percent of the stock of Y, another C corporation. On December 31, 2002, X makes an election under section 1362 to be treated as an S corporation and a valid QSub election for Y, both effective January 1, 2003. Assume that, under general principles of tax law, including the step transaction doctrine, X’s acquisition of the Y stock and the subsequent QSub election would not be treated as related. The liquidation described in paragraph (a)(2) of this section occurs at the close of December 31, 2002, the day before the QSub election is effective. The QSub election for Y is effective on the same day that X’s S election is effective, and the deemed liquidation is treated as occurring before the S election is effective, when X is still a C corporation. Y’s taxable year ends at the close of December 31, 2002. See §1.381(b)–1.

Example 3 . On June 1, 2002, X, an S corporation, acquires 100 percent of the stock of Y, an existing S corporation, for cash in a transaction meeting the requirements of a qualified stock purchase (QSP) under section 338. X immediately makes a QSub election for Y effective June 2, 2002, and also makes a joint election under section 338(h)(10) with the shareholder of Y. Under section 338(a) and §1.338(h)(10)–1T(d)(3), Y is treated as having sold all of its assets at the close of the acquisition date, June 1, 2002. Y is treated as a new corporation which purchased all of those assets as of the beginning of June 2, 2000, the day after the acquisition date. Section 338(a)(2). The QSub election is effective on June 2, 2002, and the liquidation under paragraph (a)(2) of this section occurs immediately after the deemed asset purchase by the new corporation.

Example 4 . X, an S corporation, owns 100 percent of Y, a corporation for which a QSub election is in effect. On May 12, 2002, a date on which the QSub election is in effect, X issues Y a $10,000 note under state law that matures in ten years with a market rate of interest. Y is not treated as a separate corporation, and X’s issuance of the note to Y on May 12, 2002, is disregarded for Federal tax purposes. Example 5 . X, an S corporation, owns 100 percent of the stock of Y, a C corporation. At a time

scribed in paragraph (a)(2) of this section is respected as an independent step separate from the stock acquisition, and the tax consequences of the liquidation are determined under sections 332 and 337. The contribution by A of the Y stock to X qualifies under section 351, and no gain or loss is recognized by A, X, or Y. Y is not treated as a C corporation for any period solely because of the transfer of its stock to X, an ineligible shareholder. Compare Example 3 of §1.1361–4(a)(2)(ii).

(b) Timing of the liquidation —(1) In general . Except as otherwise provided in paragraph (b)(3) or (4) of this section, the liquidation described in paragraph (a)(2) of this section occurs at the close of the day before the QSub election is effective. Thus, for example, if a C corporation elects to be treated as an S corporation and makes a QSub election (effective the same date as the S election) with respect to a subsidiary, the liquidation occurs immediately before the S election becomes effective, while the S electing parent is still a C corporation.

(2) Application to elections in tiered situations . When QSub elections for a tiered group of subsidiaries are effective on the same date, the S corporation may specify the order of the liquidations. If no order is specified, the liquidations that are deemed to occur as a result of the QSub elections will be treated as occurring first for the lowest tier entity and proceed successively upward until all of the liquidations under paragraph (a)(2) of this section have occurred. For example, S, an S corporation, owns 100 percent of C, the common parent of an affiliated group of corporations that includes X and Y. C owns all of the stock of X and X owns all of the stock of Y. S elects under §1.1361–3 to treat C, X and Y as QSubs effective on the same date. If no order is specified for the elections, the following liquidations are deemed to occur as a result of the elections, with each successive liquidation occuring on the same day immediately after the preceding liquidation: Y is treated as liquidating into X, then X is treated as liquidating into C, and finally C is treated as liquidating into S.

(3) Acquisitions . (i) In general . If an S corporation does not own 100 percent of the stock of the subsidiary on the day before the QSub election is effective, the liquidation described in paragraph (a)(2) of this section occurs immediately after the time at which the S corporation first owns 100 percent of the stock.

(ii) Special rules for acquired S corpo-

rations . Except as provided in paragraph (b)(4) of this section, if a corporation (Y) for which an election under section 1362(a) was in effect is acquired, and a QSub election is made effective on the day Y is acquired, Y is deemed to liquidate into the S corporation at the beginning of the day the termination of its S election is effective. As a result, if corporation X acquires Y, an S corporation, and makes an S election for itself and a QSub election for Y effective on the day of acquisition, Y liquidates into X at the beginning of the day when X’s S election is effective, and there is no period between the termination of Y’s S election and the deemed liquidation of Y during which Y is a C corporation. Y’s taxable year ends for all Federal income tax purposes at the close of the preceding day. Furthermore, if Y owns Z, a corporation for which a QSub election was in effect prior to the acquisition of Y by X, and X makes QSub elections for Y and Z, effective on the day of acquisition, the transfer of assets to Z and the deemed liquidation of Z are disregarded. See §§1.1361–4(a)(2) and 1.1361–5(b)(1)(i). (4) Coordination with section 338 election . An S corporation that makes a qualified stock purchase of a target may make an election under section 338 with respect to the acquisition if it meets the requirements for the election, and may make a QSub election with respect to the target. If an S corporation makes an election under section 338 with respect to a subsidiary acquired in a qualified stock purchase, a QSub election made with respect to that subsidiary is not effective before the day after the acquisition date (within the meaning of section 338(h)(2)). If the QSub election is effective on the day after the acquisition date, the liquidation under paragraph (a)(2) of this section occurs immediately after the deemed asset purchase by the new target corporation under section 338. If an S corporation makes an election under section 338 (without a section 338(h)(10) election) with respect to a target, the target must file a final or deemed sale return as a C corporation reflecting the deemed sale. See §1.338–10T(a).

(c) Carryover of disallowed losses and deductions . If an S corporation (S1) acquires the stock of another S corporation (S2), and S1 makes a QSub election with

2000–6 I.R.B. 507 February 7, 2000

when Y is indebted to X in an amount that exceeds the fair market value of Y’s assets, X makes a QSub election effective on the date it is filed with respect to Y. The liquidation described in paragraph (a)(2) of this section does not qualify under sections 332 and 337 and, thus, Y recognizes gain or loss on the assets distributed, subject to the limitations of section 267.

§1.1361–5 Termination of QSub election.

(a) In general —(1) Effective date . The termination of a QSub election is effective—

(i) On the effective date contained in the revocation statement if a QSub election is revoked under §1.1361–3(b);

(ii) At the close of the last day of the parent’s last taxable year as an S corporation if the parent’s S election terminates under §1.1362–2; or

(iii) At the close of the day on which an event (other than an event described in paragraph (a)(1)(ii) of this section) occurs that renders the subsidiary ineligible for QSub status under section 1361(b)(3)(B).

(2) Information to be provided upon termination of QSub election by failure to qualify as a QSub . If a QSub election terminates because an event renders the subsidiary ineligible for QSub status, the S corporation must attach to its return for the taxable year in which the termination occurs a notification that a QSub election has terminated, the date of the termination, and the names, addresses, and employer identification numbers of both the parent corporation and the QSub.

(3) QSub joins a consolidated group . If a QSub election terminates because the S corporation becomes a member of a consolidated group (and no election under section 338(g) is made) the principles of §1.1502–76(b)(1)(ii)(A)(2) (relating to a special rule for S corporations that join a consolidated group) apply to any QSub of the S corporation that also becomes a member of the consolidated group at the same time as the S corporation. See Ex- ample 4 of paragraph (a)(4) of this section.

(4) Examples . The following examples illustrate the application of this paragraph (a):

Example 1. Termination because parent’s S election terminates . X, an S corporation, owns 100 percent of Y. A QSub election is in effect with respect to Y for 2001. Effective on January 1, 2002, X revokes its S election. Because X is no longer an S corporation, Y no longer qualifies as a QSub at the close of December 31, 2001.

Example 2. Termination due to transfer of

QSub stock . X, an S corporation, owns 100 percent of Y. A QSub election is in effect with respect to Y. On December 10, 2002, X sells one share of Y stock to A, an individual. Because X no longer owns 100 percent of the stock of Y, Y no longer qualifies as a QSub. Accordingly, the QSub election made with respect to Y terminates at the close of December 10, 2002.

Example 3. No termination on stock transfer between QSub and parent . X, an S corporation, owns 100 percent of the stock of Y, and Y owns 100 percent of the stock of Z. QSub elections are in effect with respect to both Y and Z. Y transfers all of its Z stock to X. Because X is treated as owning the stock of Z both before and after the transfer of stock solely for purposes of determining whether the requirements of section 1361(b)(3)(B)(i) and §1.1361–2(a)(1) have been satisfied, the transfer of Z stock does not terminate Z’s QSub election. Because the stock of Z is disregarded for all other Federal tax purposes, no gain is recognized under section 311.

Example 4. Termination due to acquisition of S parent by a consolidated group . X, an S corporation, owns 100 percent of Y, a corporation for which a QSub election is in effect. Z, the common parent of a consolidated group of corporations, acquires 80 percent of the stock of X on June 1, 2002. Z does not make an election under section 338(g) with respect to the purchase of X stock. X’s S election terminates as of the close of the preceding day, May 31, 2002. Y’s QSub election also terminates at the close of May 31, 2002. Under §1.1502–76(b)(1)(ii)(A)(2) and paragraph (a)(3) of this section, X and Y become members of Z’s consolidated group of corporations as of the beginning of the day June 1, 2002.

Example 5. Termination due to acquisition of QSub by a consolidated group . The facts are the same as in Example 4, except that Z acquires 80 percent of the stock of Y (instead of X) on June 1, 2002. In this case, Y’s QSub election terminates as of the close of June 1, 2002, and, under §1.1502–76(b)(1)(ii)(A)(1), Y becomes a member of the consolidated group at that time.

(b) Effect of termination of QSub elec- tion —(1) Formation of new corporation (i) In general . If a QSub election terminates under paragraph (a) of this section, the former QSub is treated as a new corporation acquiring all of its assets (and assuming all of its liabilities) immediately before the termination from the S corporation parent in exchange for stock of the new corporation. The tax treatment of this transaction or of a larger transaction that includes this transaction will be determined under the Internal Revenue Code and general principles of tax law, including the step transaction doctrine. For purposes of determining the application of section 351 with respect to this transaction, instruments, obligations, or other arrangements that are not treated as stock of the QSub under §1.1361–2(b) are disregarded in determining control for purposes of section 368(c) even if they are eq

uity under general principles of tax law.

(ii) Termination for tiered QSubs . If QSub elections terminate for tiered QSubs on the same day, the formation of any higher tier subsidiary precedes the formation of its lower tier subsidiary. See Example 6 in paragraph (b)(3) of this section.

(2) Carryover of disallowed losses and deductions . If a QSub terminates because the S corporation distributes the QSub stock to some or all of the S corporation’s shareholders in a transaction to which section 368(a)(1)(D) applies by reason of section 355 (or so much of section 356 as relates to section 355), see §1.1366–2(c)(2) for provisions relating to the carryover of disallowed losses and deductions that may be available.

(3) Examples . The following examples illustrate the application of this paragraph (b):

Example 1 . X, an S corporation, owns 100 percent of the stock of Y, a corporation for which a QSub election is in effect. X sells 21 percent of the Y stock to Z, an unrelated corporation, for cash, thereby terminating the QSub election. Y is treated as a new corporation acquiring all of its assets (and assuming all of its liabilities) in exchange for Y stock immediately before the termination from the S corporation. The deemed exchange by X of assets for Y stock does not qualify under section 351 because X is not in control of Y within the meaning of section 368(c) immediately after the transfer as a result of the sale of stock to Z. Therefore, X must recognize gain, if any, on the assets transferred to Y in exchange for its stock. X’s losses, if any, on the assets transferred are subject to the limitations of section 267.

Example 2 . (i) X, an S corporation, owns 100 percent of the stock of Y, a corporation for which a QSub election is in effect. As part of a plan to sell a portion of Y, X causes Y to merge into T, a limited liability company wholly owned by X that is disregarded an as entity separate from its owner for Federal tax purposes. X then sells 21 percent of T to Z, an unrelated corporation, for cash. Following the sale, no entity classification election is made under §301.7701–3(c) of this chapter to treat the limited liability company as an association for Federal tax purposes.

(ii) The merger of Y into T causes a termination of Y’s QSub election. The new corporation (Newco) that is formed as a result of the termination is immediately merged into T, an entity that is disregarded for Federal tax purposes. Because, at the end of the series of transactions, the assets continue to be held by X for Federal tax purposes, under step transaction principles, the formation of Newco and the transfer of assets pursuant to the merger of Newco into T are disregarded. The sale of 21 percent of T is treated as a sale of a 21 percent undivided interest in each of T’s assets. Immediately thereafter, X and Z are treated as contributing their respective interests in those assets to a partnership in exchange for ownership inter

February 7, 2000 508 2000–6 I.R.B.

ests in the partnership.

(iii) Under section 1001, X recognizes gain or loss from the deemed sale of the 21 percent interest in each asset of the limited liability company to Z. Under section 721(a), no gain or loss is recognized by X and Z as a result of the deemed contribution of their respective interests in the assets to the partnership in exchange for ownership interests in the partnership.

Example 3 . Assume the same facts as in Example 1, except that, instead of purchasing Y stock, Z contributes to Y an operating asset in exchange for 21 percent of the Y stock. Y is treated as a new corporation acquiring all of its assets (and assuming all of its liabilities) in exchange for Y stock immediately before the termination. Because X and Z are cotransferors that control the transferee immediately after the transfer, the transaction qualifies under section 351.

Example 4 . X, an S corporation, owns 100 percent of the stock of Y, a corporation for which a QSub election is in effect. X distributes all of the Y stock pro rata to its shareholders, and the distribution terminates the QSub election. The transaction can qualify as a distribution to which sections 368(a)(1)(D) and 355 apply if the transaction otherwise satisfies the requirements of those sections.

Example 5 . X, an S corporation, owns 100 percent of the stock of Y, a corporation for which a QSub election is in effect. X subsequently revokes the QSub election. Y is treated as a new corporation acquiring all of its assets (and assuming all of its liabilities) immediately before the revocation from its S corporation parent in a deemed exchange for Y stock. On a subsequent date, X sells 21 percent of the stock of Y to Z, an unrelated corporation, for cash. Assume that under general principles of tax law including the step transaction doctrine, the sale is not taken into account in determining whether X is in control of Y immediately after the deemed exchange of assets for stock. The deemed exchange by X of assets for Y stock and the deemed assumption by Y of its liabilities qualify under section 351 because, for purposes of that section, X is in control of Y within the meaning of section 368(c) immediately after the transfer.

Example 6 . (i) X, an S corporation, owns 100 percent of the stock of Y, and Y owns 100 percent of the stock of Z. Y and Z are corporations for which QSub elections are in effect. X subsequently revokes the QSub elections and the effective date specified on each revocation statement is June 26, 2002, a date that is less than 12 months after the date on which the revocation statements are filed.

(ii) Immediately before the QSub elections terminate, Y is treated as a new corporation acquiring all of its assets (and assuming all of its liabilities) directly from X in exchange for the stock of Y. Z is treated as a new corporation acquiring all of its assets (and assuming all of its liabilities) directly from Y in exchange for the stock of Z.

Example 7 . (i) The facts are the same as in Ex- ample 6, except that, prior to June 26, 2002 (the effective date of the revocations), Y distributes the Z stock to X under state law.

(ii) Immediately before the QSub elections terminate, Y is treated as a new corporation acquiring all of its assets (and assuming all of its liabilities) directly from X in exchange for the stock of Y. Z is also treated as a new corporation acquiring all of its

assets (and assuming all of its liabilities) directly from X in exchange for the stock of Z.

Example 8. Merger of parent into QSub. X, an S corporation, owns 100 percent of the stock of Y, a corporation for which a QSub election is in effect. X merges into Y under state law, causing the QSub election for Y to terminate, and Y survives the merger. The formation of the new corporation, Y, and the merger of X into Y can qualify as a reorganization described in section 368(a)(1)(F) if the transaction otherwise satisfies the requirements of that section.

Example 9. Transfer of 100 percent of QSub . X, an S corporation, owns 100 percent of the stock of Y, a corporation for which a QSub election is in effect. Z, an unrelated C corporation, acquires 100 percent of the stock of Y. The deemed formation of Y by X (as a consequence of the termination of Y’s QSub election) is disregarded for Federal income tax purposes. The transaction is treated as a transfer of the assets of Y to Z, followed by Z’s transfer of these assets to the capital of Y in exchange for Y stock. Furthermore, if Z is an S corporation and makes a QSub election for Y effective as of the acquisition, Z’s transfer of the assets of Y in exchange for Y stock, followed by the immediate liquidation of Y as a consequence of the QSub election are disregarded for Federal income tax purposes.

(c) Election after QSub termination (1) In general . Absent the Commissioner’s consent, and except as provided in paragraph (c)(2) of this section, a corporation whose QSub election has terminated under paragraph (a) of this section (or a successor corporation as defined in paragraph (b) of this section) may not make an S election under section 1362 or have a QSub election under section 1361(b)(3)(B)(ii) made with respect to it for five taxable years (as described in section 1361(b)(3)(D)). The Commissioner may permit an S election by the corporation or a new QSub election with respect to the corporation before the five-year period expires. The corporation requesting consent to make the election has the burden of establishing that, under the relevant facts and circumstances, the Commissioner should consent to a new election.

(2) Exception . In the case of S and QSub elections effective after December 31, 1996, if a corporation’s QSub election terminates, the corporation may, without requesting the Commissioner’s consent, make an S election or have a QSub election made with respect to it before the expiration of the five-year period described in section 1361(b)(3)(D) and paragraph (c)(1) of this section, provided that—

(i) Immediately following the termination, the corporation (or its successor corporation) is otherwise eligible to make an S election or have a QSub election made for it; and

(ii) The relevant election is made ef

fective immediately following the termination of the QSub election.

(3) Examples . The following examples illustrate the application of this paragraph (c):

Example 1. Termination upon distribution of QSub stock to shareholders of parent . X, an S corporation, owns Y, a QSub. X distributes all of its Y stock to X’s shareholders. The distribution terminates the QSub election because Y no longer satisfies the requirements of a QSub. Assuming Y is otherwise eligible to be treated as an S corporation, Y’s shareholders may elect to treat Y as an S corporation effective on the date of the stock distribution without requesting the Commissioner’s consent.

Example 2. Sale of 100 percent of QSub stock . X, an S corporation, owns Y, a QSub. X sells 100 percent of the stock of Y to Z, an unrelated S corporation. Z may elect to treat Y as a QSub effective on the date of purchase without requesting the Commissioner’s consent.

§1.1361–6 Effective date.

Except as provided in §§1.1361–4(a)(3)(iii), 1.1361–4(a)(5)(i), and 1.1361–5(c)(2), the provisions of §§1.1361–2 through 1.1361–5 apply to taxable years beginning on or after January 20, 2000; however, taxpayers may elect to apply the regulations in whole, but not in part (aside from those sections with special dates of applicability), for taxable years beginning on or after January 1, 2000, provided all affected taxpayers apply the regulations in a consistent manner. To make this election, the corporation and all affected taxpayers must file a return or an amended return that is consistent with these rules for the taxable year for which the election is made. For purposes of this section, affected taxpayers means all taxpayers whose returns are affected by the election to apply the regulations.

Par. 5. Amend §1.1362–0 by adding an entry for §1.1362–8 to read as follows:

§1.1362–0 Table of contents.

§1.1362–8 Dividends received from affiliated subsidiaries.

(a) In general. (b) Determination of active or passive earnings and profits. (1) In general. (2) Lower tier subsidiaries. (3) De minimis exception. (4) Special rules for earnings and profits accumulated by a C corporation prior to 80 percent acquisition.

2000–6 I.R.B. 509 February 7, 2000

(5) Gross receipts safe harbor. (c) Allocating distributions to active or passive earnings and profits. (1) Distributions from current earnings and profits. (2) Distributions from accumulated earnings and profits. (3) Adjustments to active earnings and profits. (4) Special rules for consolidated groups. (d) Examples. (e) Effective date.

Par. 6. Section 1.1362–2 is amended by adding a sentence to the end of the paragraph (c)(5)(ii)(C) to read as follows:

§1.1362–2 Termination of election.

(c) * * * (5) * * * (ii) * * * (C) * * * See §1.1362–8 for special rules regarding the treatment of dividends received by an S corporation from a C corporation in which the S corporation holds stock meeting the requirements of section 1504(a)(2).

Par. 7. Section 1.1362–8 is added to read as follows:

§1.1362–8 Dividends received from affiliated subsidiaries.

(a) In general . For purposes of section 1362(d)(3), if an S corporation holds stock in a C corporation meeting the requirements of section 1504(a)(2), the term pas- sive investment income does not include dividends from the C corporation to the extent those dividends are attributable to the earnings and profits of the C corporation derived from the active conduct of a trade or business (active earnings and profits). For purposes of applying section 1362(d)(3), earnings and profits of a C corporation are active earnings and profits to the extent that the earnings and profits are derived from activities that would not produce passive investment income (as defined in section 1362(d)(3)) if the C corporation were an S corporation.

(b) Determination of active or passive earnings and profits —(1) In general . An S corporation may use any reasonable method to determine the amount of dividends that are not treated as passive investment income under section 1362(d)(3)(E). Paragraph (b)(5) of this section describes a

method of determining the amount of dividends that are not treated as passive investment income under section 1362(d)(3)(E) that is deemed to be reasonable under all circumstances.

(2) Lower tier subsidiaries . If a C corporation subsidiary (upper tier corporation) holds stock in another C corporation (lower tier subsidiary) meeting the requirements of section 1504(a)(2), the upper tier corporation’s gross receipts attributable to a dividend from the lower tier subsidiary are considered to be derived from the active conduct of a trade or business to the extent the lower tier subsidiary’s earnings and profits are attributable to the active conduct of a trade or business by the subsidiary under paragraph (b)(1), (3), (4), or (5) of this section. For purposes of this section, distributions by the lower tier subsidiary will be considered attributable to active earnings and profits according to the rule in paragraph (c) of this section. This paragraph (b)(2) does not apply to any member of a consolidated group (as defined in §1.1502–1(h)).

(3) De minimis exception . If less than 10 percent of a C corporation’s earnings and profits for a taxable year are derived from activities that would produce passive investment income if the C corporation were an S corporation, all earnings and profits produced by the corporation during that taxable year are considered active earnings and profits.

(4) Special rules for earnings and profits accumulated by a C corporation prior to 80 percent acquisition . A C corporation may treat all earnings and profits accumulated by the corporation in all taxable years ending before the S corporation held stock meeting the requirements of section 1504(a)(2) as active earnings and profits in the same proportion as the C corporation’s active earnings and profits for the three taxable years ending prior to the time when the S corporation acquired 80 percent of the C corporation bears to the C corporation’s total earnings and profits for those three taxable years.

(5) Gross receipts safe harbor . A corporation may treat its earnings and profits for a year as active earnings and profits in the same proportion as the corporation’s gross receipts (as defined in §1.13622(c)(4)) derived from activities that would not produce passive investment income (if the C corporation were an S corpora

tion), including those that do not produce passive investment income under paragraphs (b)(2) through (b)(4) of this section, bear to the corporation’s total gross receipts for the year in which the earnings and profits are produced.

(c) Allocating distributions to active or passive earnings and profits —(1) Distri- butions from current earnings and profits . Dividends distributed by a C corporation from current earnings and profits are attributable to active earnings and profits in the same proportion as current active earnings and profits bear to total current earnings and profits of the C corporation.

(2) Distributions from accumulated earnings and profits . Dividends distributed by a C corporation out of accumulated earnings and profits for a taxable year are attributable to active earnings and profits in the same proportion as accumulated active earnings and profits for that taxable year bear to total accumulated earnings and profits for that taxable year immediately prior to the distribution.

(3) Adjustments to active earnings and profits . For purposes of applying paragraph (c)(1) or (2) of this section to a distribution, the active earnings and profits of a corporation shall be reduced by the amount of any prior distribution properly treated as attributable to active earnings and profits from the same taxable year.

(4) Special rules for consolidated groups . For purposes of applying section 1362(d)(3) and this section to dividends received by an S corporation from the common parent of a consolidated group (as defined in §1.1502–1(h)), the following rules apply —

(i) The current earnings and profits, accumulated earnings and profits, and active earnings and profits of the common parent shall be determined under the principles of §1.1502–33 (relating to earnings and profits of any member of a consolidated group owning stock of another member); and

(ii) The gross receipts of the common parent shall be the sum of the gross receipts of each member of the consolidated group (including the common parent), adjusted to eliminate gross receipts from intercompany transactions (as defined in §1.1502–13(b)(1)(i)).

(d) Examples . The following examples illustrate the principles of this section:

February 7, 2000 510 2000–6 I.R.B.

Example 1 . (i) X, an S corporation, owns 85 percent of the one class of stock of Y. On December 31, 2002, Y declares a dividend of $100 ($85 to X), which is equal to Y’s current earnings and profits. In 2002, Y has total gross receipts of $1,000, $200 of which would be passive investment income if Y were an S corporation.

(ii) One-fifth ($200/$1,000) of Y’s gross receipts for 2002 is attributable to activities that would produce passive investment income. Accordingly, onefifth of the $100 of earnings and profits is passive, and $17 (1/5 of $85) of the dividend from Y to X is passive investment income.

Example 2 . (i) The facts are the same as in Exam- ple 1, except that Y owns 90 percent of the stock of Z. Y and Z do not join in the filing of a consolidated return. In 2002, Z has gross receipts of $15,000, $12,000 of which are derived from activities that would produce passive investment income. On December 31, 2002, Z declares a dividend of $1,000 ($900 to Y) from current earnings and profits.

(ii) Four-fifths ($12,000/15,000) of the dividend from Z to Y are attributable to passive earnings and profits. Accordingly, $720 (4/5 of $900) of the dividend from Z to Y is considered gross receipts from an activity that would produce passive investment income. The $900 dividend to Y gives Y a total of $1,900 ($1,000 + $900) in gross receipts, $920 ($200 + $720) of which is attributable to passive investment income-producing activities. Under these facts, $41 ($920/1,900 of $85) of Y’s distribution to X is passive investment income to X.

(e) Effective date . This section applies to dividends received in taxable years beginning on or after January 20, 2000; however, taxpayers may elect to apply the regulations in whole, but not in part, for taxable years beginning on or after January 1, 2000, provided all affected taxpayers apply the regulations in a consistent manner. To make this election, the corporation and all affected taxpayers must file a return or an amended return that is consistent with these rules for the taxable year for which the election is made. For purposes of this section, affected taxpayers means all taxpayers whose returns are affected by the election to apply the regulations.

§1.1368–0 [Amended]

Par. 8. Amend §1.1368–0 in the entry for §1.1368–2(d)(2) by revising “Reorganizations” to read “Liquidations and reor

ganizations”.

§1.1368–2 [Amended]

Par. 9. Amend §1.1368–2 in paragraph (d)(2) by revising “Reorganizations” to read “Liquidations and reorganizations” in the heading and by revising “section 381(a)(2)” to read “section 381(a)” in the first sentence.

Par. 10. Amend §1.1374–8 by adding one sentence to the end of paragraph (b) to read as follows:

§1.1374–8 Section 1374(d)(8) transactions.

(b) Separate determination of tax . * *

If an S corporation makes QSub elections under section 1361(b)(3) for a tiered group of subsidiaries effective on the same day, see §1.1361–4(b)(2).

PART 301—PROCEDURE AND ADMINISTRATION

Par. 11. The authority citation for part 301 continues to read in part as follows: Authority: 26 U.S.C. 7805 * * * Par. 12. Section 301.6109–1 is amended as follows:

Paragraph (i) is redesignated as paragraph (j) and the first sentence of newly designated paragraph (j)(1) is amended by removing the language “paragraph (i)” and adding “paragraph (j)” in its place.
A new paragraph (i) is added. The addition reads as follows:

§301.6109–1 Identifying numbers.

(i) Special rule for qualified subchapter S subsidiaries (QSubs) —(1) General rule . Any entity that has an employer identification number (EIN) will retain that EIN if a QSub election is made for the entity under §1.1361–3 or if a QSub

election that was in effect for the entity terminates under §1.1361–5.

(2) EIN while QSub election in effect . Except as otherwise provided in regulations or other published guidance, a QSub must use the parent S corporation’s EIN for Federal tax purposes.

(3) EIN when QSub election terminates . If an entity’s QSub election terminates, it may not use the EIN of the parent S corporation after the termination. If the entity had an EIN prior to becoming a QSub or obtained an EIN while it was a QSub in accordance with regulations or other published guidance, the entity must use that EIN. If the entity had no EIN, it must obtain an EIN upon termination of the QSub election.

(4) Effective date . The rules of this paragraph (i) apply on January 20, 2000.

Part 602—OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 13. The authority citation for part 602 continues to read as follows: Authority: 26 U.S.C. 7805. Par. 14. In §602.101, paragraph (b) is amended by adding entries for §§1.1361–3, 1.1361–5, and 1.1362–8 to the table in numerical order to read as follows: §602.101 OMB Control numbers.

(b) * * *

Robert E. Wenzel, Deputy Commissioner of Internal Revenue Service.

Approved January 14, 2000.

Jonathan Talisman, Acting Assistant Secretary of the

Treasury.

(Filed by the Office of the Federal Register on January 20, 2000, 1:19 p.m., and published in the issue of the Federal Register for January 25, 2000, 65 F.R. 3843)

CFR part or section where Current OMB identified and described control No.

1.1361–3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-1590 1.1361–5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-1590 * * * 1.1361–8 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-1590

2000–6 I.R.B. 511 February 7, 2000

cludes only remuneration for “employment.” Section 3121(b)(7)(F)(iv) provides that the services of an election worker are not employment for FICA purposes if the worker’s remuneration is less than $1,000. For calendar years beginning on or after January 1, 2000, the amount is indexed for inflation. The applicable amount for the year 2000 is $1,100. Because service performed by an election worker for calendar year 2000 for an amount less than $1,100 is excluded from employment for FICA purposes, that amount is not wages for FICA purposes unless covered under a § 218 agreement.

Similarly, section 3121(u)(2)(B)(ii)(V) provides that the services of an election worker are not employment for purposes of the Medicare tax portion of the FICA if the worker’s remuneration is less than $1,000 in a calendar year. For calendar years beginning on or after January 1, 2000, the amount is indexed for inflation. The applicable amount for the year 2000 is $1,100. For services performed before January 1, 1995, the § 3121(u)(2)(B)(ii)(V) exclusion was for remuneration of less than $100. Rev. Rul. 88–36, 1988–1 C.B. 343, A2, provides that an election worker is subject to Medicare tax unless the remuneration paid to the worker in a calendar year is less than $100.

Section 3401(a) provides that, for purposes of income tax withholding, the term “wages” means all remuneration (other than fees paid to a public official) for services performed by an employee for an employer. Section 31.3401(a)–2(b)(2) of the Employment Tax Regulations states that amounts paid to precinct workers for services performed at election booths are “in the nature of fees paid to public officials” and not subject to income tax withholding.

Sections 6041(a) and 6051(a) both impose a duty to file information reports of compensation paid to workers.

Section 6041(a) provides: All persons engaged in a trade or business and making payment in the course of such trade or business to another person, of rent, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, or other fixed or determinable gains, profits, and income ... of $600 or more in any taxable year ... shall render a true and accurate return to the Secretary, under such regulations and in such form and manner

Section 3121.—Definitions

At what level of compensations does FICA tax apply to election workers? See Rev. Rul. 2000–6 on this page.

Section 3401.—Receipts for Employees

26 CFR 31.3401

Does federal income tax withholding apply to compensation paid to election workers? See Rev. Rul. 2000–6 on this page.

Section 6041.—Information at Source

(Also §§ 3121, 3401, 6051)

26 CFR 1.6041–2: Return of information as to payments to employees. (Also § 1.6041–1)

Information reporting requirements applicable to election workers. The requirements for information reporting applicable to election workers whose compensation is not subject to FICA tax are found in Code section 6041(a). As a result, reporting is generally not required for election workers earning less than $600 annually. Rev. Rul. 88–36, 1988–1 C.B. 343, modified.

Rev. Rul. 2000–6

ISSUE

How do the information reporting requirements of §§ 6041(a) and 6051(a) of the Internal Revenue Code apply to election workers?

FACTS

Election workers are individuals who are generally employed to perform services for state and local governments (governments) at election booths in connection with national, state, or local elections. Governments typically pay election workers a set fee for each day of work. Election workers’ wages are includible in gross income as compensation for services. Section 61(a)(1). An individual employed as an election worker may also perform services for the government in another capacity.

A state and the Social Security Admin

istration may agree to extend social security coverage to services of employees of the state or its political subdivisions under § 218 of the Social Security Act (§ 218 agreement). A § 218 agreement may cover the services of election workers. If so, the § 218 agreement may specify the level of fees the election workers must receive to be entitled to coverage. Information about a state’s § 218 agreement can be obtained from the State Social Security Administrator.

Situation 1: Government A pays V $200 in a calendar year for services as an election worker. A does not employ V in any other capacity. The services of A’ s election workers are not covered by a § 218 agreement. V is not covered by a retirement plan maintained by A .

Situation 2: Government B pays W $200 in a calendar year for services as an election worker. B does not employ W in any other capacity. The services of B ’s election workers are covered by a § 218 agreement if their remuneration is $100 or more in a calendar year. W is not covered by a retirement plan maintained by B .

Situation 3: Government C pays X $1,100 in calendar year 2000 for services as an election worker. C does not employ X in any other capacity. The services of C ’s election workers are not covered by a § 218 agreement. X is not covered by a retirement plan maintained by C .

Situation 4: Government D pays Y $200 in a calendar year for services as an election worker. D also employed Y in another capacity, in which Y earned wages of $300 that are subject to income tax withholding. The services of D ’s election workers are not covered by a § 218 agreement. Y is not covered by a retirement plan maintained by D .

Situation 5: Government E pays Z $200 in a calendar year for services as an election worker. E also employed Z in another capacity, in which Z earned wages of $500 that are subject to income tax withholding. The services of E ’s election workers are not covered by a § 218 agreement. Z is not covered by a retirement plan maintained by E .

LAW

Taxes under the Federal Insurance Contribution Act (FICA) apply to “wages” as defined in § 3121(a). That section provides that the term wages in

February 7, 2000 512 2000–6 I.R.B.

and to such extent as may be prescribed by the Secretary, setting forth the amount of such gains, profits, and income, and the name and address of the recipient of such payment. Under § 1.6041–1(b)(1) of the Income Tax Regulations, the term “all persons engaged in a trade or business,” as used in § 6041(a), includes organizations the activities of which are not for the purpose of gain or profit.

The general rule stated in § 1.6041–1(a)(2) is that the required return is made on Forms 1096 and 1099, except that § 1.6041–1(a)(2)(ii) provides that compensation paid to an employee by an employer shall be reported on Forms W-3 and W-2 under the provisions of § 1.6041–2 (relating to return of information as to payments to employees).

Under § 1.6041–2(a)(1), payments of wages not subject to income tax withholding must be reported on Form W-2 if the total of those payments and the amount of the employee’s wages subject to income tax withholding, if any, is $600 or more in a calendar year. For example, if a payment of $700 was made to an employee and $400 thereof represents wages subject to withholding under section 3402 and the remaining $300 represents compensation not subject to withholding, such wages and compensation must both be reported on Form W-2. If the employee has no wages subject to income tax withholding, the employer is required to file Form W-2 for that employee if payments to that employee equal $600 or more in a calendar year.

Section 1.6041–2(a)(1) provides that, at the election of the employer, components of amounts required to be reported on Form W-2 pursuant to this subparagraph may be reported on more than one Form W-2. Thus the amounts paid to an individual for services as an election worker may be reported on a separate W2 from amounts paid to the individual for service in another capacity, even though the amounts are aggregated to determine whether reporting applies.

Section 6051(a) imposes a reporting requirement on the following two categories of payors of remuneration:

Every person required to deduct and withhold from an employee a tax under section 3101 [employee FICA tax] or 3402 [income tax withholding], ... or every employer engaged in a trade or

business who pays remuneration for services performed by an employee ... . Section 6051(a) does not require reporting of compensation that is not subject to withholding of FICA tax or income tax.

Section 6051(c) provides that the Secretary may prescribe by regulations the reporting of additional items. No regulations requiring employers to furnish additional information have been published.

ANALYSIS

Compensation of an election worker is not subject to income tax withholding. Sections 3401(a) and 31.3401(a)–2(b)(2). If an election worker’s compensation is less than $1,100 for calendar year 2000, it is generally not subject to FICA tax. Sections 3121(b)(7)(F)(iv) and 3121(u)(2)(B)(ii)(V). However, under a state’s § 218 agreement, an election worker’s compensation may be subject to both the old-age, survivors and disability insurance (OASDI) and the Medicare portions of the FICA tax at a level below $1,100 for calendar year 2000.

Section 6041(a) applies to payments of compensation that are not subject to withholding of FICA or income tax. If an election worker’s compensation is not subject to withholding of FICA tax, the § 6041(a) reporting requirement applies to payments that aggregate $600 or more in any taxable year. Under § 1.6041–2(a)(1), compensation subject to income tax withholding is taken into account in determining whether the $600 reporting requirement applies.

Section 6051(a) requires reporting of compensation subject to either FICA tax or income tax withholding. No reporting is required by §§ 6051(a) and 31.6051–1(a) and (b) for items of income that are not subject to withholding of FICA tax or income tax. If an election worker’s compensation is subject to withholding of FICA tax, reporting is required by § 6051(a), regardless of the amount of compensation.

HOLDINGS

The reporting requirements applicable to governments that employ election workers are as follows:

Situation 1: Neither FICA tax nor income tax withholding applies to the $200 paid to V . The reporting requirements of § 6041(a) apply. Because V earns fees

that are less than $600, Government A is not required to issue Form W-2 to V .

Situation 2: FICA tax, but not income tax withholding, applies to the $200 paid to W because the fees exceed the $100 threshold in the § 218 agreement. Government B must follow the reporting requirements of § 6051(a), reporting on Form W-2 the fees of $200 and the FICA tax withheld.

Situation 3: FICA tax, but not income tax withholding, applies to the $1,100 paid to X for calendar year 2000. Government C must follow the reporting requirements of §6051(a), reporting on Form W2 the fees of $1,100 and the FICA tax withheld.

Situation 4: Neither FICA tax nor income tax withholding applies to the $200 paid to Y for services as an election worker, but the $300 payment is subject to income tax withholding. Government D must follow the reporting requirements of § 6051(a), reporting on Form W-2 the $300 payment and the income tax withheld. Section 6041(a) does not require reporting of the $200 payment because the total of the two payments is less than $600 for the calendar year.

Situation 5: Neither FICA tax nor income tax withholding applies to the $200 paid to Z for services as an election worker, but the $500 payment is subject to income tax withholding. Government E must follow the reporting requirements of §§ 6041(a) and 6051(a), reporting on Form W-2 both the $200 and the $500 payments and the amount of income tax withheld.

EFFECT ON OTHER REVENUE RULING(S)

This ruling modifies Rev. Rul. 88–36, A2, to reflect the increase in the amount of remuneration applicable for purposes of the Medicare tax exclusion under § 3121(u)(2)(B)(ii)(V), currently $1,100 for calendar year 2000.

DRAFTING INFORMATION

The principal author of this revenue ruling is Elizabeth Edwards of the Office of Chief Counsel (Employee Benefits & Exempt Organizations). For further information regarding this revenue ruling, contact Elizabeth Edwards at (202) 622-6040 (not a toll-free call).

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Section 6051.—Receipts for Employees

26 CFR 31.6051–1

How do the information reporting requirements of § 6051(a) apply to election workers? See Rev. Rul. 2000–6, page 512.

Section 7520.—Valuation Tables

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of February 2000. See Rev. Rul. 2000–9, page 497.

Section 7872.—Treatment of Loans with Below-Market Interest Rates

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of February 2000. See Rev. Rul. 2000–9, page 497.

February 7, 2000 514 2000–6 I.R.B.