Part IV. Items of General Interest

pant is eligible to receive an immediate distribution and certain other conditions are satisfied. In addition, some regulatory exceptions to the application of section 411(d)(6)(B) to optional forms of benefit address plan amendments that are related to statutory changes. See Q&A-2(b) and Q&A-10 of §1.411(d)–4.

The IRS and Treasury recognize that the accumulation of a variety of payment choices in a plan may increase the cost and complexity of plan operations. For example, an employer that initially adopted a plan for which the plan document was prepared by a prototype sponsor may now be using a different prototype plan that offers a different array of distribution forms. The requirement to preserve virtually all preexisting optional forms for benefits accrued up to the date of change in the prototype plan may present significant practical problems in certain cases.

Similar issues arise where employers merge with or acquire other businesses. These employers often face issues of whether to maintain separate plans, terminate one or more of the plans, or merge the plans. If the employer chooses to merge the plans, the resulting plan may accumulate a wide variety of optional forms, some of which may differ in insignificant ways or may entail special administrative costs. Because the existing elective transfer rule of §1.411(d)–4, Q&A-3(b) applies only to situations in which a participant’s benefits have become distributable, its applicability is limited.

In recent years, it has become easier for individuals to replicate the various payment choices available from qualified plans through other means. The Unemployment Compensation Amendments of 1992, Public Law 102-318 (106 Stat. 290), substantially expanded participants’ ability to transfer distributions from qualified plans to individual retirement arrangements (IRAs) on a tax-deferred basis. Individuals who receive singlesum distributions from qualified plans frequently roll those distributions over directly to IRAs, under which distributions can be made in a wide variety of payment forms. There are also indications that the vast majority of participants in defined contribution plans who are given a choice

Notice of Proposed Rulemaking and Notice of Public Hearing

Special Rules Regarding Optional Forms of Benefit Under Qualified Retirement Plans

REG–109101–98

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

SUMMARY: This document contains proposed regulations that would permit qualified defined contribution plans to be amended to eliminate some alternative forms in which an account balance can be paid under certain circumstances, and would permit certain transfers between defined contribution plans that are not permitted under regulations now in effect. These proposed regulations affect qualified retirement plan sponsors, administrators, and participants. This document also provides notice of a public hearing on these proposed regulations.

DATES: Written comments must be received by June 27, 2000. Requests to speak and outlines of oral comments to be discussed at the public hearing scheduled for June 27, 2000, at 10 a.m., must be received by June 6, 2000.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG–109101–98), room 5226, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand delivered Monday through Friday between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG–109101–98), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue NW., Washington, DC. Alternatively, taxpayers may submit comments electronically via the Internet by selecting the “Tax Regs” option of the IRS Home Page, or by submitting comments directly to the IRS Internet site at: http://www.irs.gov/tax_regs/reglist.html. The public hearing will be held in room 6718, Internal Revenue Building, 1111 Constitution Avenue NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Linda S. F. Marshall, 202-622-6030; concerning submissions and the hearing, and/or to be placed on the building access list to attend the hearing, LaNita VanDyke, 202-6227190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

This document contains proposed amendments to 26 CFR part 1 under section 411(d)(6) of the Internal Revenue Code of 1986 (Code).

Section 411(d)(6) generally provides that a plan will not be treated as satisfying the requirements of section 411 if the accrued benefit of a participant is decreased by a plan amendment. Section 411(d)(6)(B), which was added by the Retirement Equity Act of 1984 (REA), Public Law 98-397 (98 Stat. 1426), provides that a plan amendment that eliminates an optional form of benefit is treated as reducing accrued benefits to the extent that the amendment applies to benefits accrued as of the later of the adoption date or the effective date of the amendment. However, section 411(d)(6)(B) authorizes the Secretary of the Treasury to provide exceptions to this requirement. This authority does not extend to a plan amendment that would have the effect of eliminating or reducing an early retirement benefit or a retirement-type subsidy.

Final regulations regarding section 411(d)(6)(B) were published in the Fed- eral Register on July 8, 1988. Those final regulations, and subsequent amendments to the regulations, define the optional forms of benefit that are protected under section 411(d)(6)(B) and provide for certain exceptions to the general rule of section 411(d)(6)(B). In general, existing regulatory exceptions to the application of section 411(d)(6)(B) to optional forms of benefit have been developed to address certain specific practical problems. For example, §1.411(d)–4, Q&A3(b) permits a transfer between plans of a participant’s entire nonforfeitable benefit to be made at the election of the participant, without a requirement that the transferee plan preserve all section 411(d)(6) protected benefits, but only if the partici

2000–16 I.R.B. 903 April 17, 2000

of distribution forms that includes a single-sum distribution elect the single-sum distribution.

The IRS and Treasury have been weighing these considerations as they apply to various circumstances and various benefit forms. As a result, the IRS and Treasury have been considering the appropriateness of exercising the regulatory authority under section 411(d)(6)(B) to provide additional exceptions under that provision, in order to allow greater flexibility for sponsors to modify alternative forms of payment and simplify plan provisions and plan administration.

Notice 98–29 (1998–1 C.B. 1163) requested public comment on several ways of providing regulatory relief from the requirements of section 411(d)(6)(B) for defined contribution plans. Most of the public comments received in response to Notice 98–29 indicate that, particularly for defined contribution plans, the section 411(d)(6)(B) requirement that a plan continue to offer all existing payment options often imposes significant administrative burdens that are disproportionate to any corresponding benefit to participants. Accordingly, after considering the comments received in response to Notice 98–29, the IRS and Treasury are issuing these proposed regulations, which would provide relief from the requirements of section 411(d)(6)(B) in a wide range of circumstances.

As anticipated in Notice 98–29, the primary focus of these regulations is on defined contribution plans, and the provisions of these regulations relating to elimination of alternative forms of payment are limited to defined contribution plans. Defined benefit plans have special characteristics, including benefit payment calculation specifications, early retirement benefits, and other retirement-type subsidies (for which section 411(d)(6)(B) does not authorize the issuance of regulatory relief). Features such as these are not characteristic of defined contribution plans and provide important protections to participants. While limited comments relating to defined benefit plans were received in response to Notice 98–29, the IRS and Treasury remain open to further comment in this area. As discussed below, the provisions of these proposed regulations relating to elimination of inkind distributions extend to both defined

contribution plans and defined benefit plans, and the provisions of these proposed regulations relating to transfers between plans apply to defined contribution plans and, to some extent, to defined benefit plans.

These proposed regulations would not affect other requirements of the Code. For example, a money purchase pension plan (or a plan otherwise described in section 401(a)(11)(B)) generally must satisfy certain requirements relating to qualified joint and survivor annuities and qualified preretirement survivor annuities. Similarly, these proposed regulations would not affect the requirements of section 401(a)(31) relating to direct rollovers.

Explanation of Provisions

A . Permitted Amendments to Alternative Forms of Payment Under a Defined Contribution Plan

The proposed regulations would simplify plan administration and allow greater flexibility by significantly expanding the permitted changes that may be made to alternative forms of payment under a defined contribution plan. Instead of requiring defined contribution plans to continue to maintain nearly all existing alternative forms of payment with only limited exceptions, these proposed regulations would permit defined contribution plans to be amended to eliminate nearly all existing forms of payment if certain specified forms of payment are available. Under the proposed regulations, a defined contribution plan would not violate the requirements of section 411(d)(6) merely because the plan was amended to eliminate or restrict the ability of a participant to receive payment of the participant’s accrued benefit under a particular optional form of benefit if, after the plan amendment became effective with respect to the participant, the distribution choices available to the participant included both payment of the accrued benefit in a single-sum distribution form and payment of the accrued benefit in an extended distribution form, each of which is otherwise identical to the eliminated or restricted optional form of benefit.

Under the proposed regulations, a distribution form is an otherwise identical distribution form with respect to an optional form of benefit that is eliminated or

restricted only if the distribution form is identical in all respects to the eliminated or restricted optional form of benefit except with respect to the timing of payments after commencement. For example, a single-sum distribution form is not an otherwise identical distribution form with respect to a specified installment form of benefit if the single-sum distribution form is not available for distribution on any date on which the installment form would have been available for commencement, is not available in the same medium of distribution as the installment form, does not apply to the benefit to which the installment form applied, imposes any condition of eligibility that did not apply to the installment form, or lacks any related election rights that were available with respect to the installment form. However, a distribution form does not fail to be identical just because it provides greater rights to the participant. Further, an otherwise identical distribution form need not retain rights or features of the optional form of benefit that is eliminated or restricted to the extent that those rights or features are not otherwise protected under section 411(d)(6). Moreover, in the case of an optional form of benefit that is in the form of an annuity and that provides for distribution of an annuity contract, a distribution form that is not in the form of an annuity would not fail to be an otherwise identical distribution form with respect to that optional form of benefit merely because the non-annuity distribution form does not provide for distribution of an annuity contract.

The requirement under the proposed regulations that an extended distribution form be retained would be satisfied if the plan provided either (1) a life annuity or (2) periodic payments over the participant’s life expectancy (or, at the election of the participant, over the joint life expectancy of the participant and the participant’s spouse). Thus, a defined contribution plan would not violate section 411(d)(6) merely because of a plan amendment that replaced an optional form of benefit payable under the plan with either of these two extended distribution forms, together with a single-sum distribution form, provided that the single-sum distribution form and the extended distribution form are each otherwise identical to the replaced optional

April 17, 2000 904 2000–16 I.R.B.

form of benefit. A plan providing for periodic payments over life expectancy could provide for the life expectancy to be fixed when payments begin or, alternatively, could provide for the life expectancy to be redetermined annually as described in section 401(a)(9)(D).

As noted above, the proposed regulations would not affect the survivor annuity requirements of sections 401(a)(11) and 417. Thus, for example, as required under sections 401(a)(11) and 417, any profit-sharing plan that provides for payment in the form of a life annuity (whether or not the life annuity was added to the plan in lieu of some other optional form) would also be required to offer payment in the form of a qualified joint and survivor annuity.

A third extended distribution form would generally be permitted under the proposed regulations for a plan amendment that did not eliminate any optional form of benefit that is an extended distribution form described above. For such an amendment, the requirement to provide an extended distribution form would be satisfied if the plan offered a distribution in the form of substantially equal periodic payments made (not less frequently than annually) over a period at least as long as the longest period over which the participant is entitled to receive a distribution under the plan before the plan amendment under any of the optional forms of benefit that are eliminated by the plan amendment. Thus, for example, a defined contribution plan that offers distributions in the form of a single-sum distribution, 5year installment payments, 10-year installment payments, 15-year installment payments, and 20-year installment payments could be amended to offer only a single-sum distribution and 20-year installment payments, each of which is otherwise identical to the formerly available 5-year, 10-year, and 15-year distribution forms.

The provisions of the proposed regulations permitting payment forms to be eliminated if the defined contribution plan retains a single-sum distribution form and an extended distribution form are similar to one of the proposals outlined in Notice 98–29. In response to Notice 98–29, commentators generally stated that implementing this relief would be very helpful for plan sponsors, but there was also sub

stantial comment urging further relief, so that a defined contribution plan with a single-sum distribution option would not also be required to continue to offer an extended distribution form. These commentators took the position that, in light of a participant’s ability to roll over distributions to IRAs, which may offer multiple payment forms, there is only a marginal advantage to the participant in requiring the retention of an option to receive extended payments from a qualified defined contribution plan.

Some of these comments described plans that have been preserving a variety of payment options because the regulations require it, even though certain of the options have not been selected by a single participant for years. Commentators asserted that ultimately, employee demand would tend to shape the array of payment options offered by plan sponsors, and that plan sponsors generally would feel more free to offer or “test market” various payment form alternatives to participants if the sponsors were not legally prohibited from ever removing any option, once offered, even when participants in the plan have evidenced little or no interest in the option. Commentators observed that participants would in all events continue to have the option to leave their account balance in the plan (if above the $5,000 cashout threshold) until they were ready to begin receiving distributions. It was argued that the vast majority of participants are not ready to begin drawing lifetime retirement benefits at the time their employment with a particular plan sponsor terminates, and that, accordingly, a participant’s rollover to a single IRA of the participant’s benefits from a series of employer-sponsored plans over the course of the participant’s working life is an effective and common means of achieving portability, consolidation, and preservation of retirement savings.

Commentators also asserted that the protections of section 411(d)(6)(B) may have adversely affected participants involved in corporate sale transactions. Specifically, some sellers and buyers that might otherwise have merged their plans, or transferred benefits under the seller’s plan to the buyer’s plan, instead have terminated the seller’s plan or made distributions in order to avoid being required to preserve all of the distribution forms in

the seller’s plan.

Although the comments received in response to Notice 98–29 made a strong case that only a single sum distribution should be required to be retained, these proposed regulations reflect the view that the advantages to participants from retaining an extended distribution form may be worth the plan administration costs of retaining this additional option. These advantages include the benefits that participants, especially less sophisticated participants, can derive from employer involvement, which is subject to the fiduciary standards, in selecting and monitoring investment options under the plan after retirement distributions have begun. The IRS and Treasury are open to further comments on whether or not an extended distribution form should be required to be preserved, including comments that identify circumstances in which it may be acceptable for a plan not to preserve an extended distribution form. In particular, comments are requested on whether the final regulations should provide any of the following further relief:

• Should an extended distribution form be required to be retained only for participants who have reached a specified age, such as age 55, age 62, or normal retirement age, at the time of the distribution?

• Should there be an exception from this requirement for small businesses (e.g., employers with fewer than 100 employees or fewer than 25 employees)?

• Should a plan be treated as satisfying the requirement that it retain an extended distribution form if the plan allows a participant to elect to receive distribution by transfer of his or her vested account to a defined benefit plan for distribution in an extended distribution form?

• Should a plan be treated as satisfying the requirement that it retain an extended distribution form if the plan offers installment payments over a fixed period, such as 20 years?

• Should there be an exception from the requirement that an extended distribution form be retained if a plan with an extended distribution form is merged into another plan that does not offer an extended distribution form (for example, if the plan with

2000–16 I.R.B. 905 April 17, 2000

out the extended distribution form has a larger number of participants) in connection with an asset or stock acquisition, merger, or similar transaction involving a change in employer of the employees of a trade or business?

• If extended distribution forms are permitted to be eliminated, should there be additional protections, such as requiring that the amendment not go into effect for a specified period (such as two, four, or five years) or that the amendment not apply to participants who have reached a specified age (such as age 55, age 62, or normal retirement age) at the time of the amendment, or both? Approaches such as these may be considered either independently of each other, as a series of coordinated alternatives, or in combination (such as permitting small businesses to limit the availability of extended distribution forms to participants who receive distributions after attaining a specified age, or such as permitting plan amendments that make extended distribution forms available only to participants who reach a specified age before a specified date, such as five years after the amendment). Commentators are requested to identify the burdens in plan administration that may be reduced by any of these approaches and the extent to which the approaches involve elimination of distribution alternatives that may be important to a participant.

B. Voluntary Direct Transfers Between Plans

The proposed regulations would make a number of changes in the existing regulations relating to elective transfers between qualified plans. Under certain circumstances, the existing regulations permit elimination of optional forms of benefit in connection with plan transfers with a participant’s consent. The proposed regulations would significantly liberalize the application of these elective transfer provisions.

The existing regulations do not permit an elective transfer from one qualified plan to another unless the participant’s benefit under the transferring plan is immediately distributable. This condition has precluded use of the elective transfer

provision in the existing regulations in connection with merger and acquisition transactions involving plans with a cash or deferred arrangement under section 401(k) in cases in which benefits under the cash or deferred arrangement are not distributable because section 401(k)(10) is not applicable. Many commentators have stated that permitting elective transfers from the former employer’s section 401(k) plan to the new employer’s section 401(k) plan under these circumstances would allow employers to permit employees to keep their old retirement benefits in a qualified plan together with their newly earned retirement benefits, particularly in cases where the new employer chooses not to maintain the former employer’s plan.

The proposed regulations would grant broad section 411(d)(6) relief for many types of elective transfers of a participant’s entire benefit, without regard to whether the participant’s benefit is immediately distributable. The elective transfer provision would be available for transfers made in connection with certain corporate transactions (such as a merger or acquisition), or in connection with the transfer of a participant to a different job (for example, to a different subsidiary or division of the employer) that is not covered by the transferor plan, even if the event is not one that allows a distribution. Insofar as the immediately distributable requirement of the existing regulations would be eliminated, the proposed regulations would permit an elective transfer even if the participant’s benefit is not fully vested, provided that the requirements of section 411(a)(10) are satisfied. The proposed regulations would not restrict the permissible types of elective transfers to transfers between plans of the same employer. Accordingly, elective transfers could be made to plans that are within the employer’s controlled group or to plans that are outside the employer’s controlled group.

The proposed regulations would provide section 411(d)(6) relief for elective transfers involving corporate transactions or employee job transfers generally where the defined contribution plans are of the same type (e.g., from a qualified cash or deferred arrangement

under section 401(k) to another qualified cash or deferred arrangement). The restrictions on the types of plans between which transfers would be permitted would ensure that amounts transferred to the receiving plan will be subject to similar legal restrictions with respect to in-service distributions. See Rev. Rul. 94–76 (1994–2 C.B. 46). In the case of transfers from plans that are subject to the survivor annuity requirements under sections 401(a)(11) and 417, those survivor annuity requirements would apply to the receiving plan with respect to the transferred amount in accordance with the transferee plan rules of section 401(a)(11)(B)(iii)(III).

The existing regulations relating to elective transfers were issued in 1988. Since then, section 401(a)(31) has been enacted. Under section 401(a)(31), any eligible rollover distribution may be directly rolled over to an IRA or to another eligible retirement plan. The section 411(d)(6) requirements do not apply to amounts that have been distributed, such as distributions that are directly rolled over to another plan under section 401(a)(31). Accordingly, the elective transfer rules of the existing regulations have largely been duplicated by the enactment of section 401(a)(31) because the same result generally is available through a direct rollover. The proposed regulations would eliminate this duplication by replacing the elective transfer rules of the existing regulations that apply to immediately distributable amounts, except for certain transfers of amounts that are not eligible rollover distributions (such as amounts attributable to after-tax employee contributions). Specifically, an elective transfer of an immediately distributable amount would be permitted to the extent the amount is not an eligible rollover distribution, if the participant’s entire nonforfeitable accrued benefit is transferred by means of a combination of a section 401(a)(31) transfer and the elective transfer. This rule would apply to transfers between defined benefit plans, as well as transfers between defined contribution plans. Comments are requested regarding whether there are other situations (where direct rollovers are unavailable) to which the elective transfer approach should apply.

April 17, 2000 906 2000–16 I.R.B.

C. Rules Regarding In-Kind Distributions

The proposed regulations clarify and modify the rules regarding the application of the protections of section 411(d)(6)(B) to a right to receive benefit distributions in kind with respect to defined contribution plans and defined benefit plans. Provisions for distribution in kind are sometimes found in plans invested in annuity contracts or in marketable mutual funds. The right to a particular form of investment is not a protected optional form of benefit. However, the investments made by a plan generally are subject to fiduciary requirements, including the prudence requirement of section 404(a)(1)(B) of the Employee Retirement Income Security Act of 1974, Public Law 93-406 (88 Stat. 829). The existing regulations state that the right to a medium of distribution, such as cash or in-kind payments, is an optional form of benefit to which section 411(d)(6)(B) applies. Under the proposed regulations, if a defined benefit plan includes an optional form of benefit under which benefits are distributed in the medium of an annuity contract, that optional form of benefit could be modified by substituting cash for the annuity contract. Thus, a defined benefit plan that provides for distribution of an annuity contract could be amended to substitute cash payments from the plan that are identical in all respects protected by section 411(d)(6) to the payments available from the annuity contract except with respect to the source of the payments. Comments are requested regarding whether any additional section 411(d)(6)(B) relief for non-cash distributions is appropriate for defined benefit plans.

The proposed regulations would permit a defined contribution plan to be amended to replace the ability to receive a distribution in the form of marketable securities (other than employer securities) with the ability to receive a distribution in the form of cash. The right to distributions from a defined contribution plan in the form of cash, employer securities or other property that is not marketable securities would generally be protected. However, the proposed regulations would also permit a defined contribution plan that gives a participant the

right to an in-kind distribution (including employer securities and property that is not marketable securities) to be amended to limit the types of property in which distributions could be made to the participant to specific types of property in which the participant’s account is invested at the time of the amendment (and with respect to which the participant had the right to receive an in-kind distribution before the plan amendment). In addition, the proposed regulations would permit a defined contribution plan giving a participant the right to a distribution in a type of property to be amended to specify that the participant is permitted to receive a distribution in that type of property only to the extent that the plan assets held in the participant’s account at the time of the distribution include that type of property. These provisions of the proposed regulations would not permit a plan to be amended in a way that would affect protected features of optional forms of benefit other than the medium of distribution. Thus, for example, a plan could not be amended to eliminate a participant’s right to payments over a period of years, regardless of the plan’s current investments, except as permitted under other provisions of the current or proposed regulations (such as the provisions described above relating to permitted plan amendments affecting alternative forms of payment under defined contribution plans).

Comments are requested on whether section 411(d)(6) protection for in-kind distributions of employer securities and property that is not marketable securities from defined contribution plans should be preserved or eliminated. Commentators are requested to address the extent to which these may be important rights for participants. For example, in a defined contribution plan that does not give participants the right to payment in kind, it is possible that a distribution made in cash for a particular asset may be in an amount that is less than the value that the participant assigns to the asset. Commentators are further requested to address the potential administrative burden if, as proposed, plans are prohibited from eliminating these media of distribution. Comments are also requested on whether section 411(d)(6)(B) protection should be retained for any form of in-kind distri

bution from a defined contribution plan other than employer securities and property that is not marketable securities.

Proposed Effective Date

The proposed regulations are proposed to be effective upon publication of final regulations in the Federal Register and cannot be relied upon before finalization.

Special Analyses

It has been determined that this notice of proposed rulemaking 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 these regulations, 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 Code, these proposed regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any written comments (preferably a signed original and eight (8) copies) that are submitted timely to the IRS. In addition to the other requests for comments set forth in this document, the IRS and Treasury also request comments on the clarity of the proposed rule and how it may be made easier to understand. All comments will be available for public inspection and copying.

A public hearing has been scheduled for June 27, 2000, at 10 a.m., in room 6718, Internal Revenue Building, 1111 Constitution Avenue NW., Washington, DC. Due to building security procedures, visitors must enter at the 10 ^th

street entrance, located between Constitution and Pennsylvania Avenues, NW. In addition, all visitors must present photo identification to enter the building. Because of access restrictions, visitors will not be admitted beyond the immediate entrance area more than 15 minutes

2000–16 I.R.B. 907 April 17, 2000

before the hearing starts. For information about having your name placed on the building access list to attend the hearing, see the “FOR FURTHER INFORMATION CONTACT” section of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons who wish to present oral comments at the hearing must submit written comments by June 6, 2000, and submit an outline of the topics to be discussed and the time to be devoted to each topic (signed original and eight (8) copies) by June 6, 2000.

A period of 10 minutes will be allotted to each person for making comments.

An agenda showing the scheduling of the speakers will be prepared after the deadline for receiving outlines has passed. Copies of the agenda will be available free of charge at the hearing.

Drafting Information

The principal author of these regulations is Linda S. F. Marshall of the Office of the Associate Chief Counsel (Employee Benefits and Exempt Organizations). However, other personnel from the IRS and Treasury participated in their development.

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Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

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

Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.411(d)–4 is amended as follows:

1. In Q&A-1, paragraph (b)(1), the last sentence is amended by removing the language “§1.401(a)(4)–4(d)” and adding “§1.401(a)(4)–4(e)(1)” in its place.

2. Q&A-2 is amended by: a. Revising paragraph (b)(2)(iii). b. Adding paragraph (e).

3. Q&A-3 is amended by: a. Revising paragraph (a)(3). b. Adding paragraph (a)(4). c. Revising paragraphs (b), (c), and (d).

d. Adding paragraph (e). The additions and revisions read as follows:

§1.411(d)–4 Section 411(d)(6) protected benefits.

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A-2: * * * (b) * * * (2) * * * (iii) In-kind distributions –(A) Distrib- utions of annuity contracts payable under defined benefit plans. If a defined benefit plan includes an optional form of benefit under which benefits are distributed in the medium of an annuity contract, that optional form of benefit may be modified by substituting cash for the annuity contract.

(B) In-kind distributions payable under defined contribution plans in the form of marketable securities other than employer securities . If a defined contribution plan includes an optional form of benefit under which benefits are distributed in the form of marketable securities, other than securities of the employer, that optional form of benefit may be modified by substituting cash for the marketable securities. For purposes of this paragraph (b)(2)(iii), the term marketable se- curities means marketable securities as defined in section 731(c)(2), and the term securities of the employer means securities of the employer as defined in section 402(e)(4)(E)(ii). (C) Amendments to defined contribu- tion plans to specify medium of distribu- tion . If a defined contribution plan includes an optional form of benefit under which benefits are distributable to a participant in a medium other than cash, the plan may be amended to limit the types of property in which distributions may be made to the participant to the types of property specified in the amendment. For this purpose, the types of property specified in the amendment must include all types of property (other than types of property for which the plan may be amended to substitute cash under paragraph (b)(2)(iii)(B) of this Q&A-2) that are held in the participant’s account on the effective date of the amendment and in which the participant would be able to receive a distribution immediately before the effective date of the amendment. In addition, a plan amendment may provide that the participant’s right to receive a distribution in the form of specified types of property is limited to the property held in the participant’s account at the time of

distribution that consists of property of those specified types.

(D) In-kind distributions after plan termination . If a plan includes an optional form of benefit under which benefits are distributed in specified property, that optional form of benefit may be modified for distributions after plan termination by substituting cash for the specified property to the extent that, on plan termination, an employee has the opportunity to receive the optional form of benefit in the form of the specified property. This exception is not available, however, if the employer that maintains the terminating plan also maintains another plan that provides an optional form of benefit under which benefits are distributed in the specified property.

(E) Examples . The following examples illustrate the application of this paragraph (b)(2)(iii):

Example 1 . (i) An employer maintains a profitsharing plan under which participants may direct the investment of their accounts. One investment option available to participants is a fund invested in common stock of the employer. The plan provides that the participant has the right to a distribution in the form of cash upon termination of employment. In addition, the plan provides that, to the extent a participant’s account is invested in the employer stock fund, the participant may receive an in-kind distribution of employer stock upon termination of employment. On September 1, 2000, the plan is amended, effective on January 1, 2001, to remove the fund invested in employer common stock as an investment option under the plan and to provide for the stock held in the fund to be sold. The amendment permits participants to elect how the sale proceeds are to be reallocated among the remaining investment options, and provides for amounts not so reallocated as of January 1, 2001, to be allocated to a specified investment option.

(ii) The plan does not fail to satisfy section 411(d)(6) solely on account of the plan amendment relating to the elimination of the employer stock investment option, which is not a section 411(d)(6) protected benefit. See paragraph (d)(7) of Q&A-1 of this section. Moreover, because the plan did not provide for distributions of employer securities except to the extent participants’accounts were invested in the employer stock fund, the plan is not required operationally to offer distributions of employer securities following the amendment. In addition, the plan would not fail to satisfy section 411(d)(6) on account of a further plan amendment, effective after the plan has ceased to provide for an employer stock fund investment option, to eliminate the right to a distribution in the form of employer stock. See paragraph (b)(2)(iii)(C) of this Q&A-2.

Example 2 . (i) An employer maintains a profitsharing plan under which a participant, upon termination of employment, may elect to receive benefits in a single-sum distribution either in cash or in kind. The plan’s investments are limited to a fund invested in employer stock, a fund invested in XYZ

April 17, 2000 908 2000–16 I.R.B.

portion of the benefit than the installment form, has fewer or less stringent conditions of eligibility than the installment form, or has election rights that the installment form lacked. In addition, an otherwise identical distribution form need not retain rights or features of the optional form of benefit that is eliminated or restricted to the extent that those rights or features are not otherwise protected under section 411(d)(6). Moreover, in the case of an optional form of benefit that is in the form of an annuity and that provides for distribution of an annuity contract, a distribution form that is not in the form of an annuity does not fail to be an otherwise identical distribution form with respect to that optional form of benefit merely because the nonannuity distribution form does not provide for distribution of an annuity contract.

(3) Extended distribution form –(i) In general . For purposes of this paragraph (e), a distribution form is an extended distribution form if it is—

(A) An annuity payable for the life of the participant;

(B) Substantially equal periodic payments made (not less frequently than annually), at the election of the participant, over either the life expectancy of the participant or the joint life expectancy of the participant and the participant’s spouse (with or without redetermination of those life expectancies, as described in section 401(a)(9)(D)); or (C) For a plan amendment that does not eliminate any optional form of benefit that is an extended distribution form described in paragraph (e)(3)(i)(A) or (B) of this Q&A-2, substantially equal periodic payments made (not less frequently than annually) over a period at least as long as the longest period over which the participant is entitled to receive a distribution under the plan before the plan amendment under any of the optional forms of benefit that are eliminated by the plan amendment.

(ii) Substantially equal periodic pay- ments . For purposes of this paragraph (e)(3), the rules of section 402(c)(4)(A)(ii) and §1.402(c)–2, Q&A5, apply in determining whether payments are substantially equal periodic payments (but without regard to the 10year minimum period for payments and

mutual funds (which are marketable securities), and a fund invested in shares of PQR limited partnership (which are not marketable securities).

(ii) The following alternative plan amendments would not cause the plan to fail to satisfy section 411(d)(6): (A) A plan amendment that limits non-cash distributions to a participant on termination of employment to a distribution of employer stock and shares of PQR limited partnership. See paragraph (b)(2)(iii)(B) of this Q&A-2.

(B) A plan amendment that limits non-cash distributions to a participant on termination of employment to a distribution of employer stock and shares of PQR limited partnership, and that also lists the participants that hold employer stock in their accounts as of the effective date of the amendment and provides that only those participants have the right to distributions in the form of employer stock, and lists the participants that hold shares of PQR limited partnership in their accounts as of the effective date of the amendment and provides that only those participants have the right to distributions in the form of shares of PQR limited partnership. See paragraphs (b)(2)(iii)(B) and (C) of this Q&A-2.

(C) A plan amendment that limits non-cash distributions to a participant on termination of employment to a distribution of employer stock and shares of PQR limited partnership to the extent that the participant’s account is invested in those assets at the time of the distribution. See paragraphs (b)(2)(iii)(B) and (C) of this Q&A-2.

(D) A plan amendment that limits non-cash distributions to a participant on termination of employment to a distribution of employer stock and shares of PQR limited partnership, and that lists the participants that hold employer stock in their accounts as of the effective date of the amendment and provides that only those participants have the right to distributions in the form of employer stock, and lists the participants that hold shares of PQR limited partnership in their accounts as of the effective date of the amendment and provides that only those participants have the right to distributions in the form of shares of PQR limited partnership, and further provides that the distribution of that stock or those shares is available only to the extent that the participants’ accounts are invested in those assets at the time of the distribution. See paragraphs (b)(2)(iii)(B) and (C) of this Q&A-2.

Example 3 . (i) An employer maintains a stock bonus plan under which a participant, upon termination of employment, may elect to receive benefits in a single-sum distribution in employer stock. This is the only plan maintained by the employer under which distributions in employer stock are available. The employer decides to terminate the stock bonus plan.

(ii) If the plan makes available a single-sum distribution in employer stock on plan termination, the plan will not fail to satisfy section 411(d)(6) solely because the optional form of benefit providing a single-sum distribution in employer stock on termination of employment is modified to provide that such distribution is available only in cash. See paragraph (b)(2)(iii)(D) of this Q&A-2.

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(e) Permitted plan amendments affect- ing alternative forms of payment under

defined contribution plans —(1) General rule . A defined contribution plan does not violate the requirements of section 411(d)(6) merely because the plan is amended to eliminate or restrict the ability of a participant to receive payment of accrued benefits under a particular optional form of benefit if, after the plan amendment is effective with respect to the participant, the alternative forms of payment available to the participant include payment in both a single-sum distribution form and an extended distribution form described in paragraph (e)(3) of this Q&A-2, each of which is an otherwise identical distribution form with respect to the optional form of benefit that is being eliminated or restricted.

(2) Otherwise identical distribution form . For purposes of this paragraph (e), a distribution form is an otherwise identical distribution form with respect to an optional form of benefit that is eliminated or restricted pursuant to paragraph (e)(1) of this Q&A-2 only if the distribution form is identical in all respects to the eliminated or restricted optional form of benefit (or would be identical except that it provides greater rights to the participant) except with respect to the timing of payments after commencement. For example, a single-sum distribution form is not an otherwise identical distribution form with respect to a specified installment form of benefit if the single-sum distribution form is not available for distribution on the date on which the installment form would have been available for commencement, is not available in the same medium of distribution as the installment form, does not apply to the benefit (or any portion of the benefit) to which the installment form applied, imposes any condition of eligibility that did not apply to the installment form, or lacks any related election rights that were available with respect to the installment form. However, the single-sum distribution form would not fail to be an otherwise identical distribution form with respect to the installment form merely because the single-sum distribution form is available for distribution on a date on which the installment form would not have been available for commencement, is available in media of distribution that the installment form was not, applies (if the participant so chooses) to a larger

2000–16 I.R.B. 909 April 17, 2000

without regard to §1.402(c)–2, Q&A5(b), regarding certain periodic payments that decrease upon a participant’s attainment of eligibility for social security benefits).

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

Example 1 . (i) P is a participant in Plan M, a qualified profit-sharing plan that is invested in mutual funds. The distribution forms available to P under Plan M include a distribution of P’s vested account balance under Plan M in the form of distribution of various annuity contract forms (including a single life annuity and a joint and survivor annuity). The annuity payments under the annuity contract forms begin as of the first day of the month following P’s termination of employment (or as of the first day of any subsequent month, subject to the requirements of section 401(a)(9)). P has not previously elected payment of benefits in the form of a life annuity, and Plan M is not a direct or indirect transferee of any plan that is a defined benefit plan or a defined contribution plan that is subject to section 412. Plan M provides that distributions on the death of a participant are made in accordance with section 401(a)(11)(B)(iii)(I). Plan M is amended so that, after the amendment is effective, P is no longer entitled to any distribution in the form of the distribution of an annuity contract. However, after the amendment is effective, P is entitled to receive a single-sum cash distribution of P’s vested account balance under Plan M payable as of the first day of the month following P’s termination of employment (or as of the first day of any subsequent month, except as required by section 401(a)(9)). In addition, P is entitled to receive P’s vested account balance under Plan M payable in substantially equal monthly payments made, at P’s election, over either P’s life expectancy or the joint life expectancies of P and P’s spouse, beginning as of the first day of the month following P’s termination of employment (or as of the first day of any subsequent month, except as required by section 401(a)(9)). (ii) Plan M does not violate the requirements of section 411(d)(6) (or section 401(a)(11)) merely because the plan amendment has eliminated P’s option to receive a distribution in any of the various annuity contract forms previously available.

Example 2 . (i) P is a participant in Plan M, a qualified profit-sharing plan to which section 401(a)(11)(A) does not apply. Upon termination of employment, P is entitled to receive cash distributions from Plan M, payable as of the first day of the month following P’s termination of employment (or as of the first day of any subsequent month, subject to the requirements of section 401(a)(9)), in the

form of a single-sum distribution, or in substantially equal monthly installment payments over either 5, 10, 15, or 20 years. Plan M is amended so that, after the amendment is effective, P is no longer entitled to receive a distribution in the form of substantially equal monthly installment payments over 5, 10, or 15 years. However, after the amendment is effective, P continues to be entitled to receive cash distributions from Plan M, payable as of the first day of the month following P’s termination of employment (or as of the first day of any subsequent month, except as required by section 401(a)(9)), in the form of a single-sum distribution or in substantially equal monthly installment payments over 20 years.

(ii) Plan M does not violate the requirements of section 411(d)(6) merely because the plan amendment has eliminated P’s option to receive a distribution in the form of substantially equal monthly installment payments over 5, 10, or 15 years.

(5) Effective date . This paragraph (e) applies to plan amendments that are adopted and made effective after the date of publication of final regulations in the Federal Register .

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A-3. (a) * * *

(3) Waiver prohibition . In general, except as provided in paragraph (b) of this Q&A-3, a participant may not elect to waive section 411(d)(6) protected benefits. Thus, for example, the elimination of the defined benefit feature of a participant’s benefit under a defined benefit plan by reason of a transfer of such benefits to a defined contribution plan pursuant to a participant election, at a time when the benefit is not distributable to the participant, violates section 411(d)(6).

(4) Direct rollovers . A direct rollover described in Q&A-3 of §1.401(a)(31)–1 that is paid to a qualified plan is not a transfer of assets and liabilities that must satisfy the requirements of section 414(l), and is not a transfer of benefits for purposes of applying the requirements under section 411(d)(6) and paragraph (a)(1) of this Q&A-3. Therefore, for example, if such a direct rollover is made to another qualified plan, the receiving plan is not required to provide, with respect to amounts paid to it in a direct rollover, the same optional forms of benefit that were provided under the plan that made the direct rollover. See §1.401(a)(31)–1, Q&A-14.

(b) Elective transfers of benefits be- tween defined contribution plans –(1) Gen-

eral rule . A transfer of a participant’s entire benefit between qualified defined contribution plans (other than a direct transfer described in section 401(a)(31)) that results in the elimination or reduction of section 411(d)(6) protected benefits does not violate section 411(d)(6) if the following requirements are met:

(i) Voluntary election . The plan from which the benefits are transferred must provide that the transfer is conditioned upon a voluntary, fully-informed election by the participant to transfer the participant’s entire benefit to the other qualified defined contribution plan. As an alternative to the transfer, the participant must be offered the opportunity to retain the participant’s section 411(d)(6) protected benefits under the plan (or, if the plan is terminating, to receive any optional form of benefit for which the participant is eligible under the plan as required by section 411(d)(6)).

(ii) Types of plans to which transfers may be made . To the extent the benefits are transferred from a money purchase pension plan, the transferee plan must be a money purchase pension plan. To the extent the benefits being transferred are part of a qualified cash or deferred arrangement under section 401(k), the benefits must be transferred to a qualified cash or deferred arrangement under section 401(k). To the extent the benefits being transferred are part of an employee stock ownership plan as defined in section 4975(e)(7), the benefits must be transferred to another employee stock ownership plan. Benefits transferred from a profit-sharing plan other than from a qualified cash or deferred arrangement, or from a stock bonus plan other than an employee stock ownership plan, may be transferred to any type of defined contribution plan.

(iii) Circumstances under which trans- fers may be made . The transfer must be made in connection with an asset or stock acquisition, merger, or other similar transaction involving a change in employer of the employees of a trade or business (i.e., an acquisition or disposition within the meaning of §1.410(b)–2(f)) or in connection with the participant’s transfer of employment to a different job for which service does not result in additional allocations under the transferor plan.

April 17, 2000 910 2000–16 I.R.B.

(2) Applicable qualification require- ments . A transfer described in this paragraph (b) is a transfer of assets or liabilities within the meaning of section 414(l)(1) that must meet the requirements of section 414(l) and all other applicable qualification requirements. Thus, for example, if the survivor annuity requirements of sections 401(a)(11) and 417 apply to the plan from which the benefits are transferred, as described in this paragraph (b), but do not otherwise apply to the receiving plan, the requirements of sections 401(a)(11) and 417 must be met with respect to the transferred benefits under the receiving plan. In addition, the vesting provisions under the receiving plan must satisfy the requirements of section 401(a)(10) with respect to the amounts transferred.

(c) Elective transfers of certain dis- tributable benefits between defined bene- fit plans or between defined contribution plans –(1) In general . A transfer of a participant’s benefits that are distributable between qualified defined benefit plans, or between defined contribution plans (other than the portion of such a transfer that is a direct transfer described in section 401(a)(31)), that results in the elimination or reduction of section 411(d)(6) protected benefits does not violate section 411(d)(6) if–

(i) The voluntary election requirement of paragraph (b)(1)(i) of this Q&A-3 is met; and

(ii) The amount of the benefit transferred, together with the amount of a contemporaneous section 401(a)(31) transfer to the transferee plan, equals the entire nonforfeitable accrued benefit under the plan of the participant whose benefit is being transferred, calculated to be at least the greater of the single-sum distribution provided for under the plan for which the participant is eligible (if any) or the present value of the participant’s accrued benefit payable at normal retirement age (calculated by using interest and mortality assumptions that satisfy the requirements of section 417(e) and subject to the limitations imposed by section 415).

rules of section 411(a)(7), the early termination requirements of section 411(d)(2), and the survivor annuity requirements of sections 401(a)(11) and 417. However, the transfer is not treated as a distribution for purposes of the minimum distribution requirements of section 401(a)(9). (3) Distributable benefits . For purposes of this paragraph (c), a participant’s benefits are distributable on a particular date if, on that date, the participant is eligible, under the terms of the plan from which the benefits are transferred, to receive an immediate distribution of these benefits from that plan under provisions of the plan not inconsistent with section 401(a).

(d) Status of elective transfer as op- tional form of benefit . A right to a transfer of benefits pursuant to the elective transfer rules of paragraph (b) or (c) of this Q&A-3 is an optional form of benefit under section 411(d)(6). The availability of such optional form is subject to the nondiscrimination requirements of section 401(a)(4). However, a plan will not be treated as failing to satisfy §1.401(a)(4)–4 merely because it restricts the transfer option to benefits that exceed the dollar limits on mandatory distributions that can be made without the consent of the participant under section 411(a)(11).

(e) Effective date . This Q&A-3 is applicable for transfers made after the date of publication of final regulations in the Federal Register .

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(Filed by the Office of the Federal Register on March 28, 2000, 8:45 a.m., and published in the issue of the Federal Register for March 29, 2000, 65 F.R. 16546)

Notice of Proposed Rulemaking and Notice of Public Hearing

Coordination of Sections 755 and 1060 Relating to Allocation of Basis Adjustments Among Partnership Assets

REG–107872–99

Robert E. Wenzel, Deputy Commissioner

of Internal Revenue.

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

SUMMARY: This document contains proposed regulations relating to the allocation of basis adjustments among partnership assets under section 755. The proposed regulations are necessary to implement section 1060(d), which applies the residual method to certain partnership transactions. This document also provides notice of a public hearing on these proposed regulations.

DATES: Written comments must be received by July 4, 2000. Outlines of topics to be discussed at the public hearing scheduled for July 12, 2000, must be received by June 21, 2000.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG–107872–99), room 5226, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand delivered Monday through Friday between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG–107872–99), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW., Washington, DC. Alternatively, taxpayers may submit comments electronically via the internet by selecting the “Tax Regs” option on the IRS Home Page, or by submitting comments directly to the IRS internet site at http://www.irs.ustreas.gov/tax_regs/reglist. html. The public hearing will be held in room 2716, Internal Revenue Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Matthew Lay or Craig Gerson, (202) 6223050; concerning submissions, the hearing, and/or to be placed on the building access list to attend the hearing, LaNita VanDyke, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

As part of the Tax Reform Act of 1986, Congress enacted section 1060, which generally requires the use of the residual method in order to allocate the purchase price of “applicable asset ac

(2) Treatment of transfer . The transfer of benefits pursuant to this paragraph (c) generally is treated as a distribution for purposes of section 401(a). For example, the transfer is subject to the cash-out

2000–16 I.R.B. 911 April 17, 2000

quisitions” among individual assets purchased. An applicable asset acquisition is defined as any transfer of assets that constitute a trade or business where the transferee’s basis is determined wholly by reference to the consideration paid for the assets. Both direct and indirect transfers of a business were intended to be covered by the provision, including “the sale of a partnership interest in which the basis of the purchasing partner’s proportionate share of the partnership’s assets is adjusted to reflect the purchase price.” See section 1060(c) and S. Rep. No. 99–313, 1986–3 C.B. Vol. 3 at 254–255. In July of 1988, the IRS and the Treasury Department issued temporary and proposed regulations, which, among other things, provided guidance concerning the application of section 1060 and coordinated the application of sections 755 and 1060. TD 8215 (1988–2 C.B. 305). In 1988, shortly after the IRS and the Treasury Department issued its temporary and proposed regulations, Congress enacted section 1060(d), which expressly addresses the extent to which section 1060 should apply to transactions involving partnerships. As amended in 1993, section 1060(d)(1) applies the section 1060 residual method in the case of a distribution of partnership property or a transfer of an interest in a partnership, but only in determining the value of section 197 intangibles for purposes of applying section 755. Section 1060(d)(2) provides that if section 755 applies, such distribution or transfer (as the case may be) shall be treated as an applicable asset acquisition for purposes of section 1060(b) (which imposes certain reporting requirements for applicable asset acquisitions).

Section 755 governs the allocation of certain adjustments to the basis of partnership property among partnership assets. Section 1.755–2T applies the residual method to transfers and distributions which trigger basis adjustments under section 743(b) (involving certain transfers of partnership interests) or section 732(d) (involving certain distributions within two years of a partnership interest transfer) if the assets of the partnership constitute a trade or business for purposes of section 1060(c). Section 1.755–2T(c) contains a cross reference to

the reporting requirements applicable to such transfers and distributions.

Explanation of Provisions

1. Application of Proposed Regulations

The temporary regulations under section 755 apply only if the assets of the partnership comprise a trade or business within the meaning of section 1060(c), and the basis adjustments are made under section 743(b) or section 732(d). They do not apply the residual method in valuing partnership property for the purpose of allocating basis adjustments under section 734(b). However, the temporary regulations were issued prior to the enactment of section 1060(d)(1), which expressly refers to basis adjustments triggered by partnership distributions, and does not reference a trade or business requirement.

The IRS and the Treasury Department anticipate that the regulations under §1.755–2, when finalized, will apply to all transfers of partnership interests and partnership distributions to which section 755 applies, and not just to transfers and distributions relating to partnerships conducting a trade or business. This approach is consistent with the language of section 1060(d) and is supported by language contained in the legislative history. See H.R. Rep. No. 100–795, at 70 n.34 (1988) (the IRS is not precluded from applying the residual method under other provisions of the Code).

Proposed §1.755–2(d) contains a cross reference to the reporting requirements applicable to such transfers and distributions.

2. Basis Adjustments Under Section 743(b) or 732(d)

In the case of a basis adjustment under section 743(b) or section 732(d), the proposed regulations determine the fair market value of partnership assets in two steps. In most situations, it first is necessary to determine partnership gross value. Second, partnership gross value must be allocated among partnership property.

(a) Partnership gross value. In general, partnership gross value equals the amount that, if assigned to all partnership property, would result in a liquidating

distribution to the partner equal to the transferee’s basis in the transferred partnership interest immediately following the relevant transfer (reduced by the amount, if any, of such basis that is attributable to partnership liabilities). Here, the amount paid for the partnership interest provides the frame of reference for valuing the entire partnership.

In the case of basis adjustments which are triggered by an exchange of a partnership interest in which the transferee’s basis in the interest is determined in whole or in part by reference to the transferor’s basis in the interest (transferred basis exchange), the transferee’s basis does not necessarily have any connection to the value of partnership assets. Accordingly, a transferred basis exchange provides no frame of reference for valuing partnership assets. Furthermore, if the valuation rules which apply to other transfers were applied to transferred basis exchanges, then partners could use these exchanges to shift basis from capital gain assets to ordinary income assets, or vice versa. The proposed regulations do not provide a rule addressing transferred basis exchanges. Comments are requested as to how the residual method should apply if basis adjustments under section 743(b) are triggered by transferred basis exchanges, or if basis adjustments under section 732(d) relate to prior transferred basis exchanges.

(b) Allocating partnership gross value among partnership property. Once determined, partnership gross value is allocated among five classes of property, as follows: first among cash and general deposit accounts (including savings and checking accounts) other than certificates of deposit held in banks, savings and loan associations, and other depository institutions (referred to hereafter as cash); then among partnership assets other than cash, capital assets, section 1231(b) property, and section 197 intangibles (referred to hereafter as ordinary income property); then among capital assets and section 1231(b) property other than section 197 intangibles; then among section 197 intangibles other than goodwill and going concern value; and finally to goodwill and going concern value (referred to hereafter as goodwill).

In determining the values to be assigned to assets in the third, fourth, and

April 17, 2000 912 2000–16 I.R.B.

fifth classes, properties or potential gain within these classes that are treated as unrealized receivables under the flush language in section 751(c) are not counted as assets in the second class. To provide otherwise would be inconsistent with the residual method, because the residual method is justified, at least in part, by the fact that goodwill is not readily subject to valuation. Where goodwill is subject to amortization under section 197, the portion of the intangible that is subject to recapture under section 1245 will be treated as an unrealized receivable under the flush language of section 751(c). To assign value to this portion of the asset in the second class would require a determination that the goodwill has a value equal to at least the amount of the recapture. If these assets are not readily subject to valuation, this determination presumably could not be made. Accordingly, in allocating value among the five classes under the residual method, it is appropriate to include properties or potential gain treated as unrealized receivables under the flush language of section 751(c) within the overall class to which the underlying property belongs rather than treating the section 751(c) portion of such property as a separate asset included in the second class.

Although properties or potential gain treated as unrealized receivables under the flush language of section 751(c) are not included in the second class of assets under these proposed regulations for purposes of allocating value, they are treated as separate assets that are ordinary income property for purposes of allocating basis adjustments among such assets under §1.755–1.

With respect to allocating value within the asset classes, in general, if the value assigned to a class is less than the sum of the fair market values of the assets in that class (determined without regard to the residual method), then the assigned value must be allocated among the individual assets in proportion to their fair market values. Although, as discussed above, it is not appropriate to treat properties or potential gain treated as unrealized receivables under the flush language of section 751(c) as separate ordinary income assets, it is appropriate to allocate value within each class by giving priority to the portions of the assets that will be

taxed at higher rates as ordinary income. Such treatment better equates the basis adjustments of the transferee with the higher taxed income recognized by the transferor, thereby avoiding duplicative recognition of ordinary income on subsequent transfers with respect to the same asset. Accordingly, once values have been assigned generally to the third, fourth, and fifth classes of assets, such values will be assigned within each of these classes first to properties or potential gain treated as unrealized receivables under the flush language in section 751(c), if any, in proportion to the income that would be recognized if the underlying assets were sold for their fair market values (determined without regard to the residual method), but only to the extent of the income attributable to the unrealized receivables. Any remaining value in each class will be allocated among the remaining portions of the assets in that class in proportion to the fair market values of such portions (determined without regard to the residual method).

In general, the value assigned to an asset (other than goodwill) cannot exceed the fair market value (determined without regard to the residual method) of that asset on the date of the relevant transfer. Therefore, if partnership gross value exceeds the aggregate value of the partnership’s individual assets, the excess must be allocated entirely to the value of goodwill. However, an exception is provided if partnership gross value exceeds the aggregate value of the partnership’s individual assets, and goodwill could not under any circumstances attach to the assets. Under this exception, the excess partnership gross value must be allocated among all partnership assets other than cash in proportion to their fair market values (determined without regard to the residual method).

(c) Special situations. In general, partnership gross value may be determined without reference to the value of individual partnership assets. In calculating partnership gross value, it is only necessary to determine the relevant partner’s share of book value in partnership assets and how much book gain or loss must be recognized by the partnership on the disposition of all such assets to cause the partner to receive the appropriate liqui

dating distribution. The manner in which the book gain or loss is allocated among the partnership’s assets generally will not affect the amount of the liquidating distribution to the partner.

In certain circumstances, however, such as where book income or loss with respect to particular partnership properties is allocated differently among partners, partnership gross value may vary depending on the value of particular partnership assets. In these situations, it is not possible to first determine the total value of the partnership (i.e., partnership gross value) and then apply the residual method to allocate that value to the partnership’s individual assets. Instead, it is necessary first to determine the fair market value of the partnership’s individual assets (determined taking into account all relevant facts and circumstances), and then to assign such value among the asset tiers described in the residual method such that the combined value of all partnership assets would cause the appropriate distribution to the relevant partner. The proposed regulations include a rule to address these special situations. In addition, under this rule, if the value determined for assets in the first four asset classes is not sufficient to cause the appropriate liquidating distribution, then, so long as goodwill could attach to the assets of the partnership, the value of goodwill is presumed to be an amount that, if assigned to such property, would cause the appropriate liquidating distribution.

3. Basis Adjustments Under Section 734(b)

The proposed regulations do not provide a rule for valuing partnership assets in the case of distributions that result in a basis adjustment under section 734(b). The IRS and the Treasury Department have considered several alternative approaches, described below. Two of these approaches utilize a method similar to the one provided for basis adjustments under sections 743(b) and 732(d); that is, first determine partnership gross value and then allocate such amount among the partnership property applying the residual method. The third approach does not rely on the concept of partnership gross value. The IRS and the Treasury Department request comments as to which, if

2000–16 I.R.B. 913 April 17, 2000

any, of these approaches should be utilized in applying the residual method in the context of basis adjustments under section 734(b). In addition, comments are requested concerning whether the second or third approach should be adopted in the context of basis adjustments under sections 743(b) and 732(d) involving transferred basis transactions.

Under the first approach, in the case of a distribution which results in a basis adjustment under section 734(b) and which causes the distributee partner’s interest in the partnership to decrease, partnership gross value would be deemed to equal the amount that, if assigned to all partnership property, would result in a liquidating distribution to the partner (attributable to the reduction in interest) equal to the value of the consideration received by the distributee partner in the distribution. Under this approach, the amount distributed in exchange for the relinquished interest would provide the frame of reference for valuing the entire partnership. The reduction in a partner’s interest could be measured as the difference between the partner’s interest in the partnership immediately before the distribution and the partner’s interest in the partnership immediately after the distribution. However, the IRS and the Treasury Department recognize that measuring the reduction in a partner’s interest in the partnership in connection with a distribution can be difficult in some situations (for example, situations in which partners do not share profits or other items in proportion to their relative capital account balances). Moreover, in the case of a distribution that results in a basis adjustment under section 734(b) and does not reduce the distributee partner’s interest in the partnership (such as in a pro rata distribution of cash), the transaction provides no frame of reference to value the partnership.

A second approach would be to determine partnership gross value as the value of the entire partnership as a going concern, and to apply the residual method by reference to that overall value. This method has the disadvantage of divorcing the valuation of partnership property from the transaction that gives rise to the adjustment. However, there would be no need to measure the reduction in the distributee partner’s interest or even to have

a reduction in the distributee partner’s interest to apply this method. The method would work equally well for distributions where the partner’s interest in the partnership is reduced and for distributions where it is not.

Under a third possible approach, the concept of partnership gross value would be disregarded, and, instead, value would be allocated to goodwill for section 755 purposes only if the amount of a positive basis adjustment under section 734(b) exceeds the appreciation in all assets of the character required to be adjusted which are not goodwill. This approach avoids the problems relating to the measurement or presence of a reduction in the distributee partner’s interest and has the added benefit of avoiding a valuation of the partnership’s overall operations. In contrast with the second approach, however, the value that is assigned to goodwill under this approach would not necessarily bear any relation to the actual value of goodwill in the hands of the partnership. In addition, this rule arguably would be inconsistent with the rule in §1.755–1(c), which requires that positive basis adjustments must be allocated to undistributed property of like character to the distributed property (or capital gain property in the case of adjustments attributable to gain recognized by the distributee partner) first in proportion to unrealized appreciation with respect to such property and then in proportion to fair market value. Under the third approach, a basis adjustment under section 734(b) to the class of assets composed of capital assets and property described in section 1231(b) could not exceed the unrealized appreciation with respect to any such partnership property other than goodwill. Accordingly, a section 734(b) basis adjustment never would be made in proportion to the fair market value of the property in the class of capital assets and property described in section 1231(b).

4. Effect on §1.755–1

Section 1.755–1(b)(3)(ii)(B) of the Income Tax Regulations published on December 15, 1999 (64 FR 69903) contains a rule allocating discounts among capital assets following the transfer of a partnership interest that results in a basis adjustment under section 743(b). Because pro

posed §1.755–2 takes discounts and premiums into account when assigning values to partnership property for purposes of section 755 in such cases, the rule in §1.755–1(b)(3)(ii)(B) would become unnecessary.

5. Possible Expansion of Regulations

With respect to transfers of partnership interests, the IRS and the Treasury Department are considering applying the rules contained in these proposed regulations not just for valuing partnership assets for purposes of applying section 755, but also to determine the value of assets for purposes of applying section 1(h)(6)(B) (collectibles gain or loss) with respect to partnerships, section 1(h)(7) (section 1250 capital gain), and section 751(a) (ordinary income treatment upon sale or exchange of an interest in a partnership). Applying the rules in these proposed regulations in connection with these provisions is consistent with the legislative history to section 1060(d) and would provide greater uniformity with respect to the amount and character of income recognized upon the transfer of a partnership interest and the basis adjustments to partnership assets to which the different income character is attributable. However, this application of the rules could cause an increase in complexity, particularly if a section 754 election is not in effect for a year in which the transfer of a partnership interest occurs (so that application of the residual method otherwise would not be required). The IRS and the Treasury Department request comments on whether partnerships should value partnership assets using the residual method for purposes of sections 1(h)(6)(B), 1(h)(7), and 751(a).

Proposed Effective Date

The regulations are proposed to be effective for any basis adjustment resulting from any distribution of partnership property or transfer of a partnership interest that occurs on or after the date final regulations are published in the Federal Register.

Special Analyses

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Ex

April 17, 2000 914 2000–16 I.R.B.

ecutive 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, and because the regulations do 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, this notice of proposed rulemaking will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small businesses.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any written comments (a signed original and eight (8) copies) that are timely submitted to the IRS. The IRS and the Treasury Department request comments on the clarity of the proposed rule and how it may be made easier to understand. All comments will be available for public inspection and copying.

A public hearing has been scheduled for July 12, 2000, beginning at 10 a.m., in room 2716 of the Internal Revenue Building. Due to building security procedures, visitors must enter at the 10th Street entrance, located between Constitution and Pennsylvania Avenues, NW. In addition, all visitors must present photo identification to enter the building. Because of access restrictions, visitors will not be admitted beyond the immediate entrance area more than 15 minutes before the hearing starts. For information about having your name placed on the building access list to attend the hearing, see the “FOR FURTHER INFORMATION CONTACT” section of the preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons that wish to present oral comments at the hearing must submit written comments and an outline of the topics to be discussed and the time to be devoted to each topic (signed original and eight (8) copies) by June 21, 2000.

A period of 10 minutes will be allotted to each person for making comments.

An agenda showing the scheduling of the speakers will be prepared after the

deadline for receiving outlines has passed. Copies of the agenda will be available free of charge at the hearing.

Drafting Information

The principal author of these proposed regulations is Matthew Lay of the Office of the Assistant Chief Counsel (Passthroughs and Special Industries). However, personnel from other offices of the IRS and the Treasury Department participated in their development.

• ---

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1—INCOME TAXES

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

Authority: 26 U.S.C. 7805 *** Section 1.755–2 also issued under 26 U.S.C. 755 and 26 U.S.C. 1060. ***

Par. 2. Section 1.755–2 is added to read as follows: §1.755–2 Coordination of sections 755 and 1060 .

(a) Coordination with section 1060 (1) In general . If there is a basis adjustment to which this section applies, the partnership must determine the fair market value of each item of partnership property under the residual method, as described in paragraph (b) of this section, and the rules of §1.755–1 must be applied using the values so determined.

(2) Application of this section . This section applies to any basis adjustment made under section 743(b) (relating to certain transfers of interests in a partnership) or section 732(d) or section 734(b) (relating to certain partnership distributions).

(b) Residual method —(1) In general —(i) Five classes . (A) Except as provided in paragraph (b)(3) of this section, partnership gross value (as defined in paragraph (c) of this section) is allocated among five asset classes in the following order—

( 1 ) Among cash and general deposit accounts (including savings and checking accounts) other than certificates of

deposit held in banks, savings and loan associations, and other depository institutions (referred to hereafter as cash);

( 2 ) Among partnership assets other than cash, capital assets, section 1231(b) property, and section 197 intangibles (referred to hereafter as ordinary income property);

( 3 ) Among capital assets and section 1231(b) property other than section 197 intangibles;

( 4 ) Among section 197 intangibles other than goodwill and going concern value; and

( 5 ) To goodwill and going concern value (referred to hereafter as goodwill).

(B) In determining the values to be assigned to each class, properties or potential gain treated as unrealized receivables under the flush language in section 751(c) are not counted as assets in the second class. For example, any portion of goodwill that would result in ordinary income under section 1245 if the goodwill were sold would be included in the residual class for goodwill.

(ii) Impaired classes . If the value assigned to a class is less than the sum of the fair market values (determined under paragraph (b)(2)(i) of this section) of the assets in that class, then the assigned value generally must be allocated among the individual assets in proportion to such fair market values. However, in the third, fourth, and fifth classes, values must be assigned first to properties or potential gain treated as unrealized receivables under the flush language in section 751(c), if any, in proportion to the income that would be recognized if the underlying assets were sold for their fair market values (determined under paragraph (b)(2)(i) of this section), but only to the extent of the income attributable to the unrealized receivables. Any remaining value in each class will be allocated among the remaining portions of the assets in that class in proportion to the fair market values of such portions (determined under paragraph (b)(2)(i) of this section).

(2) Special rules. For purposes of this section:

(i) Except as otherwise provided in this section, the fair market value of each item of partnership property (other than goodwill) shall be determined on the basis of all the facts and circumstances, taking into account section 7701(g).

2000–16 I.R.B. 915 April 17, 2000

(ii) If goodwill could not under any circumstances attach to the assets of a partnership, then the value of goodwill is zero. This might occur, for example, if a partnership’s only asset is a vacant parcel of real estate that does not produce current income.

(iii) (A) The value assigned to an asset (other than goodwill) shall not exceed the fair market value (determined under paragraph (b)(2)(i)) of that asset on the date of the relevant transfer, unless—

( 1 ) Partnership gross value (as defined in paragraph (c) of this section) exceeds the aggregate value of the partnership’s individual assets; and

( 2 ) Goodwill could not under any circumstances attach to the assets.

(B) If both of these conditions are satisfied, the excess must be allocated among all partnership assets other than cash in proportion to such fair market values.

(3) Special situations . In certain circumstances, such as where book income or loss with respect to particular partnership properties is allocated differently among partners, partnership gross value may vary depending on the value of particular partnership assets. In these special situations, the fair market value of each item of partnership property (other than goodwill) first shall be determined on the basis of all the facts and circumstances, taking into account section 7701(g). Such value then shall be assigned within the first four asset classes under the residual method described in paragraph (b)(1) of this section in a manner that is consistent with the ordering rule used in paragraph (b)(1) of this section (together with the special rules in paragraph (b)(2) of this section) so that the amount of the liquidating distribution described in paragraph (c)(1) of this section would equal the transferee’s basis in the transferred partnership interest. If the value so determined for the assets in the first four asset classes is not sufficient to cause the appropriate liquidating distribution, then, so long as goodwill may attach to the assets of the partnership, the fair market value of goodwill shall be presumed to equal an amount that if assigned to goodwill would cause the appropriate liquidating distribution.

(c) Partnership gross value —(1) Basis adjustments under section 743(b) and

section 732(d) —(i) In general . In the case of a basis adjustment under section 743(b) or 732(d), partnership gross value generally is equal to the amount that, if assigned to all partnership property, would result in a liquidating distribution to the partner equal to the transferee’s basis in the transferred partnership interest immediately following the relevant transfer (reduced by the amount, if any, of such basis that is attributable to partnership liabilities) pursuant to the hypothetical transaction (as defined in paragraph (c)(3) of this section). Solely for the purpose of determining partnership gross value under the preceding sentence, where a partnership interest is transferred as a result of the death of a partner, the transferee’s basis in its partnership interest is determined without regard to section 1014(c), and is deemed to be adjusted for that portion of the interest, if any, which is attributable to items representing income in respect of a decedent under section 691.

(ii) Transferred basis transactions .

[Reserved]

(2) Basis adjustments under section 734(b) . [Reserved] (3) Hypothetical transaction . For purposes of this paragraph (c), the hypothetical transaction means the disposition by the partnership of all partnership property in a fully taxable transaction for cash, followed by the payment of all partnership liabilities (within the meaning of section 752 and the regulations thereunder), and the distribution of all remaining proceeds to the partners.

(d) Required statements . See §1.743–1(k)(2) for provisions requiring the transferee of a partnership interest to provide information to the partnership relating to the transfer of an interest in the partnership. See §1.743–1(k)(1) for a provision requiring the partnership to attach a statement to the partnership return showing the computation of a basis adjustment under section 743(b) and the partnership properties to which the adjustment is allocated under section 755. See §1.732–1(d)(3) for a provision requiring a transferee partner to attach a statement to its return showing the computation of a basis adjustment under section 732(d) and the partnership properties to which the adjustment is allocated under section 755. See §1.732–1(d)(5)

for a provision requiring the partnership to provide information to a transferee partner reporting a basis adjustment under section 732(d).

(e) Examples . The provisions of this section are illustrated by the following examples, which assume that the partnerships have an election in effect under section 754 at the time of the transfer. Except as provided, no partnership asset (other than inventory) is property described in section 751(a). The examples are as follows:

Example 1 . (i) A is the sole general partner in ABC, a limited partnership. ABC has goodwill and three other assets with fair market values (determined under paragraph (b)(2)(i) of this section) as follows: inventory worth $1,000,000, a building (a capital asset) worth $2,000,000, and section 197 intangibles (other than goodwill) worth $800,000. ABC has one liability of $1,000,000, for which A bears the entire risk of loss under section 752 and the regulations thereunder. Each partner has a onethird interest in partnership capital and profits. D purchases A’s partnership interest for $1,000,000.

(ii) D’s basis in the transferred partnership interest (reduced by the amount of such basis that is attributable to partnership liabilities) is $1,000,000 ($2,000,000 - $1,000,000). Under paragraph (c) of this section, partnership gross value is $4,000,000 (the amount that, if assigned to all partnership property, would result in a liquidating distribution to D equal to $1,000,000).

(iii) Under paragraph (b) of this section, partnership gross value is allocated first to the inventory ($1,000,000), then to the building ($2,000,000), and third to section 197 intangibles $800,000. The partnership must allocate the remainder of partnership gross value, $200,000, to goodwill ($4,000,000 - $3,800,000). D’s section 743(b) adjustment must be allocated under §1.7551 using these fair market value calculations for the partnership’s assets.

Example 2 . (i) D is the sole general partner in DEF, a limited partnership. DEF has goodwill and three other assets with fair market values (determined under paragraph (b)(2)(i) of this section) as follows: inventory worth $1,000,000, a building (a capital asset) worth $2,000,000, and equipment (section 1231(b) property) worth $750,000. DEF has one liability of $1,000,000, for which D bears the entire risk of loss under section 752 and the regulations thereunder. Each partner has a onethird interest in partnership capital and profits. If the equipment were sold for $750,000, $250,000 would be depreciation recapture treated as an unrealized receivable under the flush language in section 751(c). G purchases E’s limited partnership interest for $750,000.

(ii) Under paragraph (c) of this section, partnership gross value is $3,250,000 (the amount that, if assigned to all partnership property, would result in a liquidating distribution to G equal to $750,000).

(iii) Under paragraph (b) of this section, partnership gross value is allocated first to inventory ($1,000,000), and then to the class containing capital assets and section 1231(b) property

April 17, 2000 916 2000–16 I.R.B.

($2,250,000). Within that class, value must be assigned first to the $250,000 ordinary gain portion of the equipment (properties or potential gain treated as unrealized receivables under the flush language in section 751(c)). The remaining value in the class ($2,250,000 minus $250,000, which is $2,000,000) must be allocated among the remaining portions of the assets in that class in proportion to the fair market values of such portions (determined under paragraph (b)(2)(i) of this section). The remaining portion of the building is $2,000,000. The remaining portion of the equipment is $500,000 ($750,000, its fair market value, minus $250,000, the section 751(c) portion). Thus, the remaining portion of the building will be allocated $1,600,000 ($2,000,000 multiplied by $2,000,000/$2,500,000) and the remaining portion of the equipment will be allocated $400,000 ($2,000,000 multiplied by $500,000/$2,500,000). Nothing is allocated to goodwill. G’s section 743(b) adjustment must be allocated under §1.755–1 using these fair market value calculations for the partnership’s assets.

Example 3 . (i) G and H are partners in partnership GH. GH has goodwill and three other assets with fair market values (determined under paragraph (b)(2)(i) of this section) as follows: inventory worth $1,000,000 and two buildings (capital assets), each worth $500,000. GH has no liabilities. The GH partnership agreement provides that the partners will allocate all income, gain, loss, and deductions equally, except with respect to depreciation, loss, and gain from the buildings. With respect to the buildings, depreciation and loss are allocated two-thirds to G and one-third to H. Gain from the disposition of the buildings is charged back two-thirds to G and one-third to H to the extent of accrued depreciation, and then is allocated equally between G and H. G transfers one-half of its interest in GH to I for $450,000. At the time of the transfer, the book value of the inventory is $900,000, the book value of each building is $300,000, and $150,000 of book depreciation has accrued with respect to each building. The capital account attributable to the partnership interest purchased by I from G is equal to $350,000. H’s capital account is equal to $800,000, and the capital account attributable to G’s retained partnership interest is equal to $350,000.

(ii) Because gain with respect to the inventory and buildings are shared in different ratios as between H, and G and I, a partnership gross value cannot be determined without assuming values for the individual assets of the partnership. Accordingly, the rule for special situations in paragraph (b)(3) of this section must be used to compute the value of the partnership’s assets.

(iii) Applying paragraph (b)(2)(i) of this section, the fair market value of the inventory is $1,000,000 and the fair market value of each building is $500,000. These values would result in a liquidating distribution to I under paragraph (c)(1) of this section equal to $500,000, determined as follows. The book gain from the sale of the inventory would equal $100,000 ($1,000,000 - $900,000) and the book gain from the sale of each building would equal $200,000 ($500,000 - $300,000). Book gain from the inventory equal to $25,000 ($100,000 x 1/4) and book gain from each building equal to $62,500 (($150,000 x 1/3) + ($50,000 x 1/4))

would be allocated to I. The sum of this book gain ($25,000 + $62,500 + $62,500 = $150,000) and I’s capital account inherited from G ($350,000) would equal $500,000.

(iv) Because I’s basis in the transferred partnership interest is only $450,000, under paragraph (b)(2)(ii) of this section, the value with respect to the buildings must be reduced in proportion to the fair market values of such assets to an amount that would cause a liquidating distribution to I equal to $450,000. This calculation is accomplished as follows. In order for I to receive a liquidating distribution of $450,000, the book gain attributable to the buildings that is allocated to I must equal $75,000 ($350,000 inherited capital account + $25,000 book gain from inventory + $75,000 book gain from buildings). Each building has the same book value and fair market value, and the allocations with respect to each building are the same as between G, H, and I. Accordingly, I’s share of book gain should be allocated equally between the two buildings, $37,500 to each. In order for I to be allocated $37,500 of book gain with respect to each building, the total amount of book gain with respect to each building would have to be $112,500 ($112,500 x 1/3 = $37,500). Adding this book gain to the current book value of each building results in a value for each building of $412,500 ($300,000 + $112,500). Nothing is allocated to goodwill. I’s section 743(b) adjustment must be allocated under §1.755–1 using these fair market value calculations for the partnership’s assets.

Example 4 . The facts are the same as Example 3, except that I purchases one-half of G’s partnership interest for $550,000. Because the fair market value of the partnership’s assets (as determined under paragraph (b)(2)(i) of this section) in the first four asset classes under the residual method is not sufficient to cause a liquidating distribution to I equal to its basis in the purchased interest (i.e., $550,000), the additional value necessary to cause such a distribution must be allocated to goodwill. Accordingly, under paragraph (b)(3) of this section, the value of the partnership’s assets is as follows: inventory $1,000,000, each building $500,000, and goodwill $200,000. I’s section 743(b) adjustment must be allocated under §1.7551 using these fair market value calculations for the partnership’s assets.

(f) Effective date . This section applies to any basis adjustment resulting from any distribution of partnership property or transfer of a partnership interest that occurs on or after the date final regulations are published in the Federal Register .

§1.755–2T [Removed]

Par. 3. Section 1.755–2T is removed.

Robert E. Wenzel, Deputy Commissioner

of Internal Revenue.

(Filed by the Office of the Federal Register on April 4, 2000, 8:45 a.m., and published in the issue of the Federal Register for April 5, 2000, 65 F.R. 17829)

Notice of Proposed Rulemaking and Notice of Public Hearing

Lifetime Charitable Lead Trusts

REG–100291–00

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

SUMMARY: These proposed regulations relate to the definitions of a guaranteed annuity interest and a unitrust interest for purposes of the income, gift, and estate tax charitable deductions. The proposed regulations will affect taxpayers who make transfers to charitable lead trusts. The purpose of these proposed regulations is to restrict the permissible terms for charitable lead trusts in order to eliminate the potential for abuse. This document also provides notice of a public hearing.

DATES: Written and electronic comments must be received by June 19, 2000. Outlines of topics to be discussed at the public hearing scheduled for June 29, 2000, must be received by June 8, 2000.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG–100291–00), room 5226, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. Submissions may also be hand delivered Monday through Friday between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG–100291–00), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW., Washington, DC. Alternatively, taxpayers may submit comments electronically via the Internet by selecting the “Tax Regs” option on the IRS Home Page, or by submitting comments directly to the IRS Internet site at http://www.irs.gov/tax_regs/regslist.html. The public hearing will be held in room 4718, Internal Revenue Service Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, Scott S. Landes, (202) 622-3090; concerning submissions of comments, the hearing, and/or to be placed on the building access list to attend the hearing, Guy

2000–16 I.R.B. 917 April 17, 2000

R. Traynor, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

In general, if interests in the same property are transferred for both charitable and noncharitable purposes, the charitable interest will qualify for the charitable deduction for federal income, gift, and estate tax purposes only if the interest is in one of certain prescribed forms. If the charitable interest is not a remainder interest, sections 170, 2522, and 2055 of the Internal Revenue Code (Code) require that the charitable interest be in the form of either a guaranteed annuity interest or a fixed percentage of the annual fair market value of the property (unitrust interest). In addition, an income tax charitable deduction is available only if the grantor is treated as the owner of the entire trust under subpart E, part I of subchapter J of the Code.

The requirement that a nonremainder interest passing to charity be in the form of a guaranteed annuity interest or a unitrust interest was added to the Code by the Tax Reform Act of 1969. That Act also added the requirement that a remainder interest passing to charity must generally be in the form of a charitable remainder unitrust or annuity trust or a pooled income fund. The statutory provisions for charitable remainder trusts and pooled income funds specifically state the permissible terms for these entities. Section 664(d)(1)(A) and (d)(2)(A) provide that the permissible term for a charitable remainder trust is a period of years (not to exceed 20 years) or the life or lives of individuals who are living at the creation of the trust. Similarly, section 642(c)(5)(A) provides that the permissible term for the noncharitable income interest in a pooled income fund is the life of one or more beneficiaries living at the time of the transfer.

Unlike the statutory provisions for charitable remainder trusts and pooled income funds, neither the statute nor the legislative history sets forth the permissible term for which a charitable guaranteed annuity interest or a unitrust interest must be paid. Rather, the permissible term for these interests is set forth in the regulations as either a specified term of years, or

the life or lives of an individual or individuals, each of whom must be living at the date of the transfer and can be ascertained at such date.

The IRS and the Treasury Department are aware of situations in which taxpayers attempt to take advantage of the regulations by using an unrelated individual’s measuring life, as the term of a charitable lead trust, to artificially inflate the charitable deduction. Taxpayers select as a measuring life an individual who is seriously ill but not “terminally ill” within the meaning of the section 7520 regulations. Because the individual is not “terminally ill” as defined in the regulations, the charitable interest is valued based on the actuarial tables. These tables take into account the life expectancies of all individuals of the same age as the individual who is the measuring life, even though such individual has been carefully chosen because he or she likely will not live to an average life expectancy. When the seriously ill individual dies prematurely, the amount the charity actually receives will be significantly less than the amount on which the gift or estate tax charitable deduction was based. Conversely, the amount of the actual transfer to the remainder beneficiaries will be significantly greater than the amount subject to gift or estate tax.

These charitable lead trusts are being marketed in a package which includes the name of a seriously ill individual and access to the individual’s medical records. A token payment is made to the ill individual who is serving as a measuring life. Sometimes the individual is led to believe that a charitable organization interested in the individual’s particular illness will receive some benefit from the transaction. In the words of one author, “[t]his technique (which is not strictly speaking wealth transfer planning for the terminally ill, but rather wealth transfer planning using the terminally ill) falls somewhere between ghoulish and grotesque.” Marketing schemes that exploit the misfortunes of some for the benefit of others are contrary to public policy.

The IRS and the Treasury Department believe that this scheme is abusive and frustrates the Congressional purpose in limiting the charitable deduction to specific types of split-interest transfers. Congress enacted the provisions regard

ing guaranteed annuity interests, unitrust interests, charitable remainder trusts, and pooled income funds in order to ensure that the amount the taxpayer claims as a charitable deduction reasonably correlates to the amount ultimately passing to the charitable organization. H.R. Rep. No. 413 (Part 1), 91 ^st Cong., 1 ^st Sess. 61 (1969); S. Rep. No. 552, 91 ^st Cong., 1 ^st

Sess. 93 (1969). In this scheme, taxpayers choose a measuring life that ensures the amount passing to charity will be substantially less than the allowable charitable deduction. This kind of adverse selection of an unrelated measuring life to artificially inflate the charitable deduction is contrary to Congressional intent.

EXPLANATION OF PROVISIONS

Under the proposed regulations, the permissible term for guaranteed annuity interests and unitrust interests is either a specified term of years, or the life of certain individuals living at the date of the transfer. Only one or more of the following individuals may be used as measuring lives: the donor, the donor’s spouse, and a lineal ancestor of all the remainder beneficiaries. However, this limitation regarding permissible measuring lives does not apply in the case of a charitable guaranteed annuity interest or unitrust interest payable under a charitable remainder trust described in section 664. An interest payable for a specified term of years can qualify as a guaranteed annuity or unitrust interest even if the governing instrument contains a “savings clause” intended to ensure compliance with a rule against perpetuities. The savings clause must utilize a period for vesting of 21 years after the deaths of measuring lives who are selected to maximize, rather than limit, the term of the trust. For example, a guaranteed annuity or unitrust interest that will terminate on the earlier of 30 years or 21 years after the death of the last survivor of the descendants of any grandparent of the donor living on the date of the creation of the interest will be treated as payable for a specified term of years.

The proposed regulations will allow the use of an individual’s measuring life when appropriate for estate planning purposes. Thus, the regulations permit the donor, the donor’s spouse, or an individual who is an ancestor of the remainder

April 17, 2000 918 2000–16 I.R.B.

beneficiaries to be used as the measuring life. A transfer using the donor or the donor’s spouse as the measuring life is a substitute for a testamentary disposition to the remainder beneficiaries. In other situations, the donor may desire to benefit an individual’s heirs only after the death of the individual currently providing their support. For example, a donor may establish a charitable lead trust for the life of the donor’s sibling with the sibling’s children named as the remainder beneficiaries. A measuring life unrelated to the remainder beneficiaries is not appropriate for estate planning purposes and therefore is not permitted under the proposed regulations.

The proposed regulations apply to transfers to inter vivos charitable lead trusts made on or after April 4, 2000. In addition, the proposed regulations apply to transfers made pursuant to wills or revocable trusts where the decedent dies on or after April 4, 2000. Two exceptions from the application of the proposed regulations are provided in the case of transfers pursuant to a will or revocable trust executed on or before April 4, 2000. One exception is for a decedent who dies on or before the date that is 6 months after the date these regulations are published as final regulations without having republished the will (or amended the trust) by codicil or otherwise. The other exception is for a decedent who was on April 4, 2000, under a mental disability to change the disposition of the decedent’s property, and either does not regain competence to dispose of such property before the date of death, or dies prior to the later of: 90 days after the date on which the decedent first regains competence, or 6 months after the date these regulations are published as final regulations without having republished the will (or amended the trust) by codicil or otherwise.

The IRS will not disallow the charitable deduction where the charitable interest is payable for the life of an individual, other than one permitted under the proposed regulations, if the interest is reformed into a lead interest payable for a specified term of years. The term of years must be determined by taking the factor for valuing the annuity or unitrust interest for the named individual’s measuring life and identifying the term of years (rounded up to the next whole year) that corre

sponds to the equivalent term of years factor for an annuity or unitrust interest. For example, in the case of an annuity interest payable for the life of an individual age 40 at the time of the transfer, assuming an interest rate of 7.4% under section 7520, the annuity factor from column 1 of Table S(7.4), contained in IRS Publication 1457, Book Aleph, for the life of an individual age 40 is 12.0587 (Publication 1457 is available from the Superintendent of Documents, U.S. Government Printing Office, Washington, DC 20402). Based on Table B(7.4), contained in Publication 1457, Book Aleph, the factor 12.0587 corresponds to a term of years between 31 and 32 years. Accordingly, the annuity interest must be reformed into an interest payable for a term of 32 years. In the case of inter vivos transfers, a judicial reformation must be commenced prior to the later of: (1) the date that is 6 months after the date these regulations are published as final regulations; or (2) October 15th of the year following the year in which the transfer is made. In the case of testamentary transfers, a judicial reformation must be commenced prior to the later of: (1) the date that is 6 months after the date these regulations are published as final regulations; or (2) the date prescribed by section 2055(e)(3)(C)(iii). Any judicial reformation must be completed within a reasonable time after it is commenced. A nonjudicial reformation is permitted if effective under state law, provided it is completed by the date on which a judicial reformation must be commenced.

An alternative to reformation may be available for any transfer made on or after April 4, 2000 and on or before the date that is 60 days after the date these regulations are published as final regulations. If a court, in a proceeding that is commenced on or before 6 months after these regulations are published as final regulations, declares the transfer null and void ab initio, the Service will treat such transfer in a manner similar to that described in section 2055(e)(3)(J).

Special Analyses

It has been determined that this notice of proposed rulemaking 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 these proposed regulations, and because these proposed regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Code, the proposed regulations will be submitted to the Small Business Administration for comment on their impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any written (a signed original and eight (8) copies) or electronic comments that are submitted timely (in the manner described in the ADDRESSES portion of this preamble) to the IRS. The IRS and the Treasury Department request comments on the clarity of the proposed regulations and how they may be made easier to understand. All comments will be available for public inspection and copying.

A public hearing has been scheduled for June 29, 2000, at 10 a.m., room 4718, Internal Revenue Building, 1111 Constitution Avenue, NW., Washington, DC. Due to building security procedures, visitors must enter at the 10 ^th Street entrance, located between Constitution and Pennsylvania Avenues, NW. In addition, all visitors must present photo identification to enter the building. Because of access restrictions, visitors will not be admitted beyond the immediate entrance area more than 15 minutes before the hearing starts. For information about having your name placed on the building access list to attend the hearing, see the “FOR FURTHER INFORMATION CONTACT” section of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who wish to present oral comments at the hearing must submit comments by June 19, 2000, and submit an outline of the topics to be discussed and the time to be devoted to each topic (signed original and eight (8) copies) by June 8, 2000.

A period of 10 minutes will be allotted to each person for making comments. An agenda showing the scheduling of the speakers will be prepared after the dead

2000–16 I.R.B. 919 April 17, 2000

line for receiving outlines has passed. Copies of the agenda will be available free of charge at the hearing.

Drafting Information

The principal author of these proposed regulations is Scott S. Landes, Office of the Chief Counsel, IRS. Other personnel from the IRS and the Treasury Department participated in their development.

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Proposed Amendments to the Regulations

Accordingly, 26 CFR parts 1, 20, and 25 are proposed to be amended as follows:

PART 1 — INCOME TAXES

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

Authority: 26 U.S.C. 7805 * * * Section 1.170A–6 also issued under 26 U.S.C. 170(f)(4); 26 U.S.C. 642(c)(5). *

• Par. 2. Section 1.170A–6 is amended as follows:

1. Paragraph (c)(2)(i)(A) is amended as follows:

a. In the first sentence, the comma is removed.

b. In the second sentence, the language “of years” is added after the word “term”, the language “an individual or individuals” is removed, and “certain individuals” is added in its place.

c. The third sentence is removed, and four new sentences are added in its place.

d. In the sentence beginning “For example, the amount”, the language “of years” is added after the word “term”, the language “an individual” is removed, and “the donor” is added in its place.

2. Paragraph (c)(2)(ii)(A) is amended as follows:

a. In the fifth sentence, the language “of years” is added after the word “term”, “an individual or individuals” is removed, and ”certain individuals” is added in its place.

b. The last sentence is removed, and four new sentences are added in its place.

3. Paragraph (e) is amended by adding four sentences to the end of the paragraph.

4. The authority citation at the end of the section is removed.

The additions read as follows: §1.170A–6 Charitable contributions in trust.

• ---

(c) * * * (2) * * *

(i) * * * (A) * * * Only one or more of the following individuals may be used as measuring lives: the donor, the donor’s spouse, and a lineal ancestor of all the remainder beneficiaries. However, this limitation regarding permissible measuring lives does not apply in the case of a charitable guaranteed annuity interest payable under a charitable remainder trust described in section 664. An interest payable for a specified term of years can qualify as a guaranteed annuity interest even if the governing instrument contains a savings clause intended to ensure compliance with a rule against perpetuities. The savings clause must utilize a period for vesting of 21 years after the deaths of measuring lives who are selected to maximize, rather than limit, the term of the trust. * * *

• ---

(ii) * * * (A) * * * Only one or more of the following individuals may be used as measuring lives: the donor, the donor’s spouse, and a lineal ancestor of all the remainder beneficiaries. However, this limitation regarding permissible measuring lives does not apply in the case of a charitable unitrust interest payable under a charitable remainder trust described in section 664. An interest payable for a specified term of years can qualify as a unitrust interest even if the governing instrument contains a savings clause intended to ensure compliance with a rule against perpetuities. The savings clause must utilize a period for vesting of 21 years after the deaths of measuring lives who are selected to maximize, rather than limit, the term of the trust.

• ---

(e) Effective date . * * * In addition, the rule in paragraphs (c)(2)(i)(A) and (ii)(A) of this section that guaranteed annuity interests and unitrust interests, respectively, may be payable for a specified term of years or for the life or lives of only certain individuals, applies to transfers made on or after April 4, 2000. If a transfer is made to a trust on or after April

4, 2000 that uses an individual other than one permitted in paragraphs (c)(2)(i)(A) and (ii)(A) of this section, the trust may be reformed to satisfy this rule. As an alternative to reformation, rescission may be available for a transfer made on or before the date that is 60 days after the date these regulations are published as final regulations. See § 25.2522(c)–3(e) of this chapter for the requirements concerning reformation or possible rescission of these interests.

PART 20—ESTATE TAX; ESTATES OF DECEDENTS DYING AFTER AUGUST 16, 1954

Par. 3. The authority citation for part 20 continues to read in part as follows: Authority: 26 U.S.C. 7805 * * * Par. 4. Section 20.2055–2 is amended as follows:

1. Paragraph (e)(2)(vi) (a) is amended as follows:

a. In the third sentence, the language “of years” is added after the word “term”, the language “an individual or individuals” is removed, and ”certain individuals” is added in its place.

3. Paragraph (e)(3) is amended as follows:

a. The period at the end of paragraph (e)(3)(ii) (c) is removed, a comma is added and the word “and” is added after the comma.

b. A new paragraph (e)(3)(iii) is added. The additions read as follows: § 20.2055–2 Transfers not exclusively for charitable purposes.

• ---

(e) * * * (2) * * *

b. The fourth sentence is removed, and four new sentences are added in its place.

c. In the sentence beginning “For example, the amount”, the language “of years” is added after the word “term”, the language “an individual” is removed, and “the decedent’s spouse” is added in its place.

2. Paragraph (e)(2)(vii) (a) is amended as follows:

a. In the sixth sentence, the language “of years” is added after the word “term”, the language “of an individual or individuals” is removed, and “of certain individuals” is added in its place.

b. The last sentence is removed, and four new sentences are added in its place.

April 17, 2000 920 2000–16 I.R.B.

(vi) * * * (a) - * * Only one or more of the following individuals may be used as measuring lives: the donor, the donor’s spouse, and a lineal ancestor of all the remainder beneficiaries. However, this limitation regarding permissible measuring lives does not apply in the case of a charitable guaranteed annuity interest payable under a charitable remainder trust described in section 664. An interest payable for a specified term of years can qualify as a guaranteed annuity interest even if the governing instrument contains a savings clause intended to ensure compliance with a rule against perpetuities. The savings clause must utilize a period for vesting of 21 years after the deaths of measuring lives who are selected to maximize, rather than limit, the term of the trust. * * *

• ---

(vii) * * * (a) - * * Only one or more of the following individuals may be used as measuring lives: the donor, the donor’s spouse, and a lineal ancestor of all the remainder beneficiaries. However, this limitation regarding permissible measuring lives does not apply in the case of a charitable unitrust interest payable under a charitable remainder trust described in section 664. An interest payable for a specified term of years can qualify as a unitrust interest even if the governing instrument contains a savings clause intended to ensure compliance with a rule against perpetuities. The savings clause must utilize a period for vesting of 21 years after the deaths of measuring lives who are selected to maximize, rather than limit, the term of the trust.

• ---

(3) * * * (iii) The rule in paragraphs (e)(2)(vi) (a) and (vii) (a) of this section that guaranteed annuity interests or unitrust interests, respectively, may be payable for a specified term of years or for the life or lives of only certain individuals, is generally effective in the case of transfers pursuant to wills and revocable trusts where the decedent dies on or after April 4, 2000. Two exceptions from the application of the rule in paragraphs (e)(2)(vi) (a) and (vii) (a) of this section are provided in the case of transfers pursuant to a will or revocable trust executed on or before April 4, 2000. One exception is for a decedent who dies on or before the

date that is 6 months after the date these regulations are published as final regulations without having republished the will (or amended the trust) by codicil or otherwise. The other exception is for a decedent who was on April 4, 2000, under a mental disability to change the disposition of the decedent’s property, and either does not regain competence to dispose of such property before the date of death, or dies prior to the later of: 90 days after the date on which the decedent first regains competence, or 6 months after the date these regulations are published as final regulations without having republished the will (or amended the trust) by codicil or otherwise. If a guaranteed annuity interest or unitrust interest created pursuant to a will or revocable trust where the decedent dies on or after April 4, 2000, uses an individual other than one permitted in paragraphs (e)(2)(vi)(a) and (vii) (a) of this section, and the interest does not qualify for this transitional relief, the interest may be reformed into a lead interest payable for a specified term of years. The term of years is determined by taking the factor for valuing the annuity or unitrust interest for the named individual measuring life and identifying the term of years (rounded up to the next whole year) that corresponds to the equivalent term of years factor for an annuity or unitrust interest. For example, in the case of an annuity interest payable for the life of an individual age 40 at the time of the transfer, assuming an interest rate of 7.4% under section 7520, the annuity factor from column 1 of Table S(7.4), contained in IRS Publication 1457, Book Aleph, for the life of an individual age 40 is 12.0587 (Publication 1457 is available from the Superintendent of Documents, U.S. Government Printing Office, Washington, DC 20402). Based on Table B(7.4), contained in Publication 1457, Book Aleph, the factor 12.0587 corresponds to a term of years between 31 and 32 years. Accordingly, the annuity interest must be reformed into an interest payable for a term of 32 years. A judicial reformation must be commenced prior to the later of the date that is 6 months after the date these regulations are published as final regulations, or the date prescribed by section 2055(e)(3)(C)(iii). Any judicial reformation must be completed within a reasonable time after it is commenced. A non-judicial reformation is permitted if

effective under state law, provided it is completed by the date on which a judicial reformation must be commenced. In the alternative, if a court, in a proceeding that is commenced on or before 6 months after these regulations are published as final regulations, declares any transfer made pursuant to a will or revocable trust where the decedent dies on or after April 4, 2000, and on or before the date that is 60 days after the date these regulations are published as final regulations, null and void ab initio, the Internal Revenue Service will treat such transfers in a manner similar to that described in section 2055(e)(3)(J).

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PART 25 — GIFT TAX; GIFTS MADE AFTER DECEMBER 31, 1954

Par. 5. The authority citation for part 25 continues to read in part as follows: Authority: 26 U.S.C. 7805 * * * Par. 6. Section 25.2522(c)–3 is amended as follows:

1. Paragraph (c)(2)(vi) (a) is amended as follows:

a. In the third sentence, the language “of years” is added after the word “term”, the language “a named individual or individuals” is removed, and “certain individuals” is added in its place.

b. The fourth sentence is removed, and four new sentences are added in its place.

c. In the sentence beginning “For example, the amount”, the language “of years” is added after the word “term”, the language “an individual” is removed, and “the donor” is added in its place.

2. Paragraph (c)(2)(vii) (a) is amended as follows:

a. In the sixth sentence, the language ”of years” is added after the word “term”, the language “an individual or individuals” is removed, and “certain individuals” is added in its place.

b. The last sentence is removed, and four new sentences are added in its place. 3. Paragraph (e) is amended by adding nine new sentences to the end of the paragraph.

The additions read as follows: § 25.2522(c)–3 Transfers not exclusively for charitable, etc., purposes in the case of gifts made after July 31, 1969.

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(c) * * * (2) * * *

2000–16 I.R.B. 921 April 17, 2000

(vi) * * * (a) - * * Only one or more of the following individuals may be used as measuring lives: the donor, the donor’s spouse, and a lineal ancestor of all the remainder beneficiaries. However, this limitation regarding permissible measuring lives does not apply in the case of a charitable guaranteed annuity interest payable under a charitable remainder trust described in section 664. An interest payable for a specified term of years can qualify as a guaranteed annuity interest even if the governing instrument contains a savings clause intended to ensure compliance with a rule against perpetuities. The savings clause must utilize a period for vesting of 21 years after the deaths of measuring lives who are selected to maximize, rather than limit, the term of the trust. * * *

• ---

(vii) * * * (a) - * * Only one or more of the following individuals may be used as measuring lives: the donor, the donor’s spouse, and a lineal ancestor of all the remainder beneficiaries. However, this limitation regarding permissible measuring lives does not apply in the case of a charitable unitrust interest payable under a charitable remainder trust described in section 664. An interest payable for a specified term of years can qualify as a unitrust interest even if the governing instrument contains a savings clause intended to ensure compliance with a rule against perpetuities. The savings clause must utilize a period for vesting of 21 years after the deaths of measuring lives who are selected to maximize, rather than limit, the term of the trust.

• ---

(e) Effective date . * * * In addition, the rule in paragraphs (c)(2)(vi) (a) and (vii) (a) of this section that guaranteed annuity interests or unitrust interests, respectively, may be payable for a specified term of years or for the life or lives of only certain individuals, applies to transfers made on or after April 4, 2000. If a transfer is made on or after April 4, 2000, that uses an individual other than one permitted in paragraphs (c)(2)(vi) (a) and (vii) (a) of this section, the interest may be reformed into a lead interest payable for a specified term of years. The term of years is determined by taking the factor for valuing the annuity or unitrust interest for the named individual measuring life and identifying the term of

years (rounded up to the next whole year) that corresponds to the equivalent term of years factor for an annuity or unitrust interest. For example, in the case of an annuity interest payable for the life of an individual age 40 at the time of the transfer, assuming an interest rate of 7.4% under section 7520, the annuity factor from column 1 of Table S(7.4), contained in IRS Publication 1457, Book Aleph, for the life of an individual age 40 is 12.0587 (Publication 1457 is available from the Superintendent of Documents, U.S. Government Printing Office, Washington, DC 20402). Based on Table B(7.4), contained in Publication 1457, Book Aleph, the factor 12.0587 corresponds to a term of years between 31 and 32 years. Accordingly, the annuity interest must be reformed into an interest payable for a term of 32 years. A judicial reformation must be commenced prior to the later of the date that is 6 months after the date these regulations are published as final regulations, or October 15th of the year following the year in which the transfer is made and must be completed within a reasonable time after it is commenced. A nonjudicial reformation is permitted if effective under state law, provided it is completed by the date on which a judicial reformation must be commenced. In the alternative, if a court, in a proceeding that is commenced on or before 6 months after these regulations are published as final regulations, declares any transfer, made on or after April 4, 2000, and on or before the date that is 60 days after the date these regulations are published as final regulations, null and void ab initio, the Internal Revenue Service will treat such transfers in a manner similar to that described in section 2055(e)(3)(J).

Charles O. Rossotti, Commissioner of Internal Revenue.

(Filed by the Office of the Federal Register on April 4, 2000, 8:45 a.m., and published in the issue of the Federal Register for April 5, 2000, 65 F.R. 17835)

Advance Pricing Agreements, Issued Pursuant to Pub. L. 106- 170, Section 521(b)

Announcement 2000–35

This Announcement is issued pursuant to Section 521(b) of Pub. L. 106-170, the Ticket to Work and Work Incentives Improvement Act of 1999, requiring that the

Secretary of the Treasury annually report to the public concerning Advance Pricing Agreements (“APAs”) and the APA Program. As this is the first report issued under Section 521(b), it includes information about APAs and the APA Program with respect to calendar years 1991 through 1999. Section 521(b)(4) . This document does not provide general guidance regarding the application of the arm’s length standard; rather, it reports on the structure and activities of the APA Program.

Karl L. Kellar, Acting Director, Advance Pricing Agreement Program.

ANNUAL REPORT CONCERNING

ADVANCE PRICING

AGREEMENTS

INTRODUCTION

For convenient reference, the subject matter of this report will be organized on the basis of Section 521(b)(2) of Pub. L. 106-170, with each required item or subject reported and captioned by reference to the corresponding statutory provision. First, however, the report provides a general introductory discussion concerning the history, practice, and general approach of the APA Program. This introductory discussion is adapted in part from material contained in Publication 3216, Report on the Application and Administration of Section 482 (April 21, 1999).

Background

The Advance Pricing Agreement Program is designed to resolve actual or potential transfer pricing disputes in a principled, cooperative manner, as an alternative to the traditional adversarial process. Under the adversarial model, the data gathering, development, and interpretation of a transfer pricing issue is a complex, time-consuming process that often results in an administrative appeal, litigation, or competent authority proceedings under the mutual agreement procedures of our bilateral income tax treaties. A significant transfer pricing issue can typically take eight or more years to resolve. Accordingly, by the time the issue is resolved, the facts in dispute

April 17, 2000 922 2000–16 I.R.B.

are typically many years old, and considerable uncertainty concerning the proper transfer pricing of current transactions under current conditions can remain.

During the 1980s and prior to the creation of the APA Program, the government as well as taxpayers with transfer pricing issues began to explore some sort of an advance pricing agreement mechanism. A 1985 study by a U.S. professional group on how to improve the large case program recommended advance rulings in the transfer pricing area. In 1986, an agenda topic at a meeting of U.S. and foreign tax officials on how to reduce controversies discussed an advance resolution process for transfer pricing. In 1989, several taxpayers and groups approached the IRS to consider alternative approaches to transfer pricing compliance, viewing the existing means of dealing with transfer pricing issues as being too adversarial as well as unproductive.

The IRS considered new techniques whereby all parties could share the responsibility for enhancing compliance in the transfer pricing area. Derived from the “Compliance 2000” initiatives, this concept of shared responsibility is also consistent with the current mission statement of the IRS to work with taxpayers “to help them understand and meet their tax responsibilities.” In April of 1989, the IRS announced at a meeting with the Tax Executives Institute that it was considering an advance ruling procedure for transfer pricing issues. The IRS entered into pilot projects with several taxpayers to negotiate and execute what were initially called Advance Determination Rulings but later became known as Advance Pricing Agreements (APAs). In June of 1990, a draft IRS Revenue Procedure for Advance Determination Rulings was publicly disseminated and the first APA was concluded in January of 1991. With the publication of Rev. Proc. 91–22 (1991–1 C.B. 526), in March of 1991, the IRS formally initiated the APA Program, and by the end of that year, 15 new negotiations had started.

Since then, the APA Program’s caseload has steadily grown. The staff has also grown, though not at the same rate as the workload. As of December 31, 1999, the APA Program’s staffing included slots for a Director, two Branch Chiefs, four Economists, fourteen Team Leaders, and

three clerical support staff. As of December 31, 1999, 231 APAs had been concluded, with another 187 pending. These APAs involve a wide variety of industries. The cross-border transactions involved are also varied, including, for example, manufacturing, sale, and distribution of goods, provision of financial services, and licensing of intellectual property.

The APA Program has also become more “institutionalized” over the years. In 1996, the Service issued internal procedures for processing APA cases. Chief Counsel Directives Manual (“CCDM”), ¶¶ (42)(10)10 – (42)(10)(16)0 (November 15, 1996). Also in 1996, Rev. Proc. 96–53, 1996–2 C.B. 375, was released, updating Rev. Proc. 91–22 in light of the Service’s additional experience with administering the APA Program. Together, these releases clarified APA procedures and the respective roles of the various IRS functions involved in the APA process. Rev. Proc. 96–53, in particular, also provides taxpayers a road map of how to apply for an APA and what to expect in the processing of the case.

The APA Program has had a consistent goal of making APAs more practical and affordable, and available to more taxpayers. To this end, in 1997, the IRS instituted an Early Referral program by which, in appropriate cases, District examination teams suggest that taxpayers pursue APAs before substantial time is spent examining transfer pricing issues. To date, however, only three APA requests have been filed pursuant to this procedure. Similarly, in 1998, the IRS published more streamlined procedures for APAs involving Small Business Taxpayers, and also expanded the availability of the lowest APA user fee, in an effort to attract smaller taxpayers who may lack the resources to do the sophisticated studies normally included in APA requests (Notice 98–65, 1998–52 I.R.B. 10). By the end of calendar year 1999, the IRS had concluded 9 small business APAs under these streamlined procedures.

As the United States has become more comfortable with the APA process so has the world. Today, APAs are receiving increased acceptance by many of our treaty partners, including Australia, Mexico, the United Kingdom, Japan, and Canada. In fact, of the 231 closed APAs, 118 involve our treaty partners through the bilateral

process (the bilateral process is discussed below). In 1999, the Organization for Economic Cooperation and Development (“OECD”) issued as an annex to its Transfer Pricing Guidelines, guidelines for bilateral APAs. OECD , Guidelines for Conducting Advance Pricing Arrange- ments Under the Mutual Agreement Pro- cedure (“MAP APAs”) (October 1999). These new OECD guidelines should lead to an even broader acceptance of the APA process by the international community, and it is to be hoped that they will expedite the processing of bilateral APAs by providing for more standardized bilateral APA procedures among OECD members.

The APA Process

The APA process is designed to enable taxpayers and the IRS to agree on the proper treatment of transfer pricing, including cost-sharing arrangements. An APA is a legally enforceable agreement. It need not cover all of a taxpayer’s pricing arrangements and instead may be restricted to specified years, specified affiliates, and specified intercompany transactions. APAs are either “unilateral” or “bilateral.” A unilateral APA is an agreement between only the taxpayer and the IRS on an appropriate transfer pricing methodology (“TPM”) for the transactions at issue. A bilateral APA combines an agreement between the taxpayer and the IRS on a particular TPM with an agreement between the U.S. and foreign taxing authority that the TPM is correct, under authority of the mutual agreement process usually contained in Article 25 of our income tax treaties. 118 of the APAs completed as of the end of 1999 have been bilateral or multilateral, 112 unilateral, and one has involved a U.S. possession. The TPM adopted in both unilateral and bilateral APAs may also be “rolled back” to resolve similar issues for past years under examination.

In practice, an APA is always the result of a voluntary decision by a taxpayer to seek an APA. Before making any commitments or filing the formal application, Taxpayers may through a prefiling conference approach the Service to discuss the Service’s preliminary views of their potential APA request, including whether an APA would be appropriate under the facts, what types of information would be necessary to support the request, and

2000–16 I.R.B. 923 April 17, 2000

whether the taxpayer’s proposed TPM would be acceptable. Most taxpayers that come into the APA Program choose to participate in such a prefiling conference. A taxpayer may attend the prefiling conference on an anonymous basis if it wishes. Once the taxpayer decides to apply for an APA, it must prepare and file a submission consistent with the requirements of section 5 of Rev. Proc. 96–53 (1996–2 C.B. 375), accompanied by the appropriate user fee as determined under section 5.14 of Rev. Proc. 96–53.

A multidisciplinary APA Team evaluates the Taxpayer’s submission. The APA process focuses on identifying an appropriate TPM, not a desired tax result. The ultimate goal of the APA process is to arrive at an agreement on three basic points: (i) the description of the intercompany transactions to which the APA applies; (ii) the TPM to be applied to those transactions; and (iii) the arm’s length range of results that is expected after applying the agreed-upon TPM to the covered transactions. In effect, the IRS APA team conducts “due diligence” to verify the facts and to determine whether the proposed TPM constitutes the “best method” under the Regulations. Typically, one or more meetings between the taxpayer’s representatives and the IRS APA team take place. At these meetings, the parties discuss the issues related to the case and attempt to arrive at an agreement concerning the appropriate facts, TPM, and results. In a bilateral case, the APA team will then formulate a negotiating position for use by the United States Competent Authority in negotiations with the relevant foreign government under the mutual agreement article of the applicable treaty. Once a mutual agreement under the treaty is reached, the APA team and the taxpayer will finalize an APA consistent with the terms of the agreement. In unilateral cases, the team will negotiate the terms of the APA with the taxpayer. Both the ne

gotiating position and the APA itself are subject to review and approval by the Associate Chief Counsel (International).

The Arm’s-Length Standard

Section 482 of the Internal Revenue Code permits the IRS to allocate items of income, deductions, credits, or allowances between controlled groups or organizations, “to prevent evasion of taxes, or clearly to reflect the income” of any controlled taxpayer, and, in the case of transfers of intangible property, to allocate income with respect to the transfer in a manner that is “commensurate with the income attributable to the intangible.”

In determining whether an allocation under Section 482 is necessary clearly to reflect a controlled taxpayer’s income, the IRS employs the “arm’s length” standard, a principle which is defined in the attendant Treasury regulations. A controlled transaction meets the arm’s length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances. Under current Treasury regulations, the IRS is willing to consider many different approaches to establish the taxpayer’s appropriate intercompany transfer pricing methodology or cost sharing practices, provided these approaches satisfy the arm’s length principle.

The APA Program evaluates each APA case in terms of developing an arm’slength transfer pricing methodology that is consistent with the Regulations. Because transfer pricing cases typically involve complex facts and difficult issues, there is room for disagreement between reasonable people, acting in good faith, about both the “best method” and the proper application thereof. Therefore, in evaluating and processing an APA case, APA Program Team Leaders are willing to consider taxpayer positions, to engage

in negotiations, and to work to reach a mutually acceptable understanding of the appropriate application of the arm’s length standard to the taxpayer’s facts, in a manner that is consistent with the Regulations.

The arm’s length approach is also applied for bilateral and multilateral APAs. In 1995, the Organization for Economic Cooperation and Development (“OECD”) published transfer pricing guidelines that adopted the arm’s length standard, consistent with our Section 482 Regulations. Similarly, the OECD Model Tax Convention provides:

where conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly. Comparable language outlining the arm’s length principle is included – generally in Article 9 – in most income tax treaties to which the United States is a party. Thus, in cases where competent authority negotiations aimed at relieving double taxation under the mutual agreement provisions of our treaties are undertaken, the goal is a mutual agreement consistent with the OECD arm’s length standard.

APA OFFICE: STRUCTURE, COMPOSITION, AND OPERATION

(Section 521(b)(2)(A))

Table 1 provides the structure and staffing of the APA Program office as of December 31, 1999:

April 17, 2000 924 2000–16 I.R.B.

TABLE 1 APA PROGRAM STRUCTURE AS OF 12/31/99

Director’s Office 1 Director (vacant) 1 Secretary to the Director

Branch 1 Branch 2 1 Branch Chief 1 Branch Chief 1 Secretary 1 Secretary 7 Team Leaders 7 Team Leaders 2 Economists 2 Economists

part of the Office of the Assistant Commissioner (International). In addition, in some cases, depending on the circumstances, Field Specialists and personnel from IRS Appeals function participate as members of the APA Team.

MODELADVANCE PRICING

AGREEMENT (Section 521(b)(2)(B))

A copy of the model advance pricing agreement currently in use is attached as Appendix A.

APA PROGRAM STATISTICS

(Sections 521(b)(2)(C) and (E))

The statistical information required under Sections 521(b)(2)(C) and (E) is contained in Tables 2 through 6 below:

Discussion

Within the IRS, the APA Program is located in the Office of the Associate Chief Counsel (International) (“ACC(I)”), which is part of the Office of Chief Counsel. However, the APA process demands a variety of skills and draws on expertise from other offices within the IRS. The IRS APA team typically includes:

• a “team leader” from the APA Office, who is responsible for leading the IRS team, negotiating with the taxpayer and its representatives, coordinating with the other IRS functions that have a stake in the APA, formulating the U.S. negotiating position in the case of a bilateral APA, and ultimately drafting the APA

• when certain novel or complex issues are presented, an attorney from one of ACC(I)’s technical branches with expertise in such issues

• the revenue agent responsible for the taxpayer’s examination with respect to transfer pricing issues, and often that agent’s manager and/or the case manager (the manager with overall responsibility for the taxpayer in question)

• an economist from the APA Program or one assigned to assist the examination group

• an attorney from the District Counsel office that provides legal advice to the examination group

• in bilateral cases, an analyst from the Tax Treaty Division, which is

TABLE 2 APA PROGRAM STATISTICS – APPLICATIONS AND EXECUTED APAs

1 Applications filed during years 1991 through 1995 are reflected on a September 30 fiscal year-end basis. The number of APA applications filed from 10-1-95 to 12-31-95 were 23, and are included in the total of 58. Applications filed for years 1996 through 1999 are reflected on a calendar year-end basis. 2 One bilateral APA executed during the 1994 year was inadvertently omitted in prior reports issued by the APA Program. 3 One unilateral APA was amended during this year but was not counted as an executed APA. Whether an amendment or supplement to an APA is counted as a separate APA depends on the extent and nature of the change. 4 One bilateral APA revision to a renewal and one supplemental were closed this year but were not counted as executed APAs. See note 3 above.

2000–16 I.R.B. 925 April 17, 2000

5 One APA was canceled during 1998 due to taxpayer changing its way of doing business.

April 17, 2000 926 2000–16 I.R.B.

TABLE 5 APA PROGRAM STATISTICS – PENDING REQUESTS

6 This and other tables following will not necessarily total to 231, the number of APAs issued; for example, in this table the number of APAs covering the listed industries totals more than 231 because many APAs cover more than one industry.

2000–16 I.R.B. 927 April 17, 2000

RELATIONSHIPS BETWEEN RELATED ORGANIZATIONS,

TRADES, OR BUSINESSES

(Section 521(b)(2)(D)(i))

The natures of the relationships between the related organizations, trades, or businesses covered by existing APAs are set forth in Table 7 below:

TABLE 7 NATURE OF RELATIONSHIPS BETWEEN RELATED ENTITIES

April 17, 2000 928 2000–16 I.R.B.

There are a variety of ways in which this issue has been treated in APAs. In the vast majority of cases no adjustment has been incorporated into the APA agreement. This may be because the comparables experience similar currency exposure, the tested party is assumed not to bear any of the currency risk, the currency fluctuations have not been material, or the taxpayer is able to pass through substantially all of its currency risk to end users. In certain APAs a critical assumption has been inserted that requires the parties to renegotiate the agreement in the event that exchange rate fluctuations exceed certain parameters.

Two types of currency adjustments have been employed in APAs. Both have been employed in conjunction with the comparable profits method (“CPM”). The first type of adjustment specifies that, for a given percentage change in the exchange rate, the tested party’s gross margin will be adjusted by a percentage that is less than the percentage change in the exchange rate. The second type of adjustment has provided a band of exchange rate movements for which no adjustment would be made. For exchange rate movements outside of the no adjustment band, the operating margin of the tested party is adjusted based upon the extent of the exchange rate fluctuation. Both of these approaches have generally called for positive or negative adjustments depending on whether a currency appreciates or depreciates against the dollar.

BUSINESS FUNCTIONS

PERFORMED AND RISKS ASSUMED, INCLUDING

CURRENCY RISK

(Sections 521(b)(2)(D)(ii) and (xii)) The vast majority of APAs have covered transactions that involve numerous business functions and risks. For instance, with respect to functions, companies that manufacture products have typically conducted research and development, engaged in product design and engineering, manufactured the product, marketed and distributed the product, and performed support functions such as legal, finance, and human resources services. Regarding risks, companies have been subject to market risks, R&D risks, financial risks, credit and collection risks, product liability risks, and general business risks. In the APA evaluation process a significant amount of time and effort is devoted to understanding how the functions and risks are allocated amongst the controlled group of companies that are party to the covered transactions.

In their APA proposals taxpayers are required to provide a functional analysis. The functional analysis identifies the economic activities performed, the assets employed, the economic costs incurred, and the risks assumed by each of the controlled parties. The importance of the functional analysis derives from the fact that economic theory posits that there is a positive relationship between risk and expected return and that different functions provide different value and have different opportunity costs associated with them. It is important that the functional analysis go beyond simply categorizing the tested party as, say, a distributor. It should provide more specific information since, in the example of distributors, not all distributors undertake similar functions and risks.

Thus, the functional analysis has been critical in determining the TPM (including the selection of comparables). Although functional comparability has been

an essential factor in evaluating the reliability of the TPM (including the selection of comparables), the APA evaluation process has also involved consideration of economic conditions such as the economic condition of the particular industry.

In evaluating the functional analysis, the APA program has considered contractual terms between the controlled parties and the consistency of the conduct of the parties with respect to the allocation of risk. Per the Section 482 regulations, the APA program also has given consideration to the ability of controlled parties to fund losses that might be expected to occur as the result of the assumption of a risk. Another relevant factor considered in evaluating the functional analysis is the extent to which each controlled party exercises managerial or operational control over the business activities that directly influence the amount of income or loss realized. The Section 482 Regulations posit that parties at arm’s length will ordinarily bear a greater share of those risks over which they have relatively more control.

In some cases it has been necessary to employ special adjustments that quantify differences in functions, risks, and markets between the tested party or transactions and comparables. The question of whether and how to adjust for currency risk exposure has been an area of particular interest in APAs. Although there are several types of currency risk (e.g., transactional, translation, and economic), economic currency risk has been the area of greatest discussion. Economic currency risk represents the risk that companies incur when their input costs are denominated in a currency that is different than that of their competitors. For example, if a foreign multinational manufactures product in its home country for distribution into the United States then the company’s competitive position is eroded (strengthened) if the home country’s currency appreciates (depreciates) relative to the U.S. dollar, assuming that the firm’s competitors face U.S. dollar based costs.

RELATED ORGANIZATIONS, TRADES, OR BUSINESSES WHOSE PRICES OR RESULTS ARE TESTED

TODETERMINE COMPLIANCE

WITH APA TPMs

(Section 521(b)(2)(D)(iii)) The related organizations, trades, or businesses whose prices or results are tested to determine compliance with TPMs prescribed in existing APAs are set forth in Table 9 below:

2000–16 I.R.B. 929 April 17, 2000

TABLE 9 RELATED ORGANIZATIONS, TRADES OR BUSINESSES WHOSE PRICES OR

RESULTS ARE TESTED

April 17, 2000 930 2000–16 I.R.B.

TABLE 11 TPMs USED FOR SERVICES

TABLE 12 TPMs USED FOR FINANCIAL PRODUCTS

2000–16 I.R.B. 931 April 17, 2000

TABLE 13 TPMs USED FOR CONTRIBUTIONS TO COST SHARING ARRANGEMENTS

tween unrelated parties provide the most objective basis for determining an arm’s length price. Reg. § 1.482–1(c)(2). In such cases, reliability is a function of the degree of comparability between the controlled transactions or taxpayers and the uncontrolled comparable transactions or parties, and the quality of the data and assumptions used in the analysis. Reg. § 1.482–1(c)(2). Factors affecting comparability include the industry involved, the functions performed, the risks assumed, contractual terms, the relevant market and market level, and other considerations. Reg. § 1.482–1(d)(3). See also the discussion of comparables below.

These principles are central to the evaluation of an APA case by the APA Team. Typically, the Team will determine the relevant facts of the case; once the facts are determined, the Team will focus on determining the appropriate TPM by identifying comparable uncontrolled data, determining the degree of comparability of such data, making such adjustments (either to the taxpayer’s or tested party’s data or to the comparables) as are necessary to make the data more comparable (and thus more reliable), and determining which TPM would be most reliable, and thus the best method, in light of the available data.

DISCUSSION

In general, the TPMs set out in Tables 10-14 above track the methods specified in the Regulations. Reg. § 1.482–3(a) provides the following methods to determine income with respect to a transfer of tangible property: the comparable uncontrolled price (“CUP”) method (Reg. § 1.482–3(b)); the resale price method (Reg. § 1.482–3(c)); the cost plus method (Reg. § 1.482–3(d)); the comparable profits method (“CPM”) (Reg. § 1.482–5); and the profit split method (Reg. § 1.482–6). Reg. § 1.482–4 provides the following methods to determine income with respect to a transfer of intangible property: the comparable uncontrolled transaction (“CUT”) method (Reg. § 1.482–4(c)); CPM; and profit split. In addition, with respect to both tangibles and intangibles, methods not specified in these sections may be used if they provide a more reliable result; such methods are referred to as “unspecified methods.” In addition to these methods, the Regulations provide for pricing methods applicable to transactions other than the transfer of tangible or intangible property. Reg. § 1.482–2(a) provides rules concerning the proper treatment of loans or advances between controlled taxpayers. Reg. § 1.482–2(b) deals with provision of ser

vices, providing that services ordinarily should bear an arm’s length charge, and that in certain circumstances an arm’s length charge may be deemed to be the cost of providing the services. Finally, Reg. § 1.482–7 provides rules for qualified cost-sharing arrangements under which the parties agree to share the costs of development of intangibles in proportion to their shares of reasonably anticipated benefits from their use of the intangibles assigned to them under the agreement. APAs dealing with such cost sharing agreements deal with both the method of allocating costs among the parties, and the determination of the amount of the “buy-in” payment due in the case of preexisting intangibles transferred as a result of entering into the cost sharing agreement.

Under the Regulations, there is no strict hierarchy of methods, nor is one method exclusively applicable to a given type of transaction, while a different method would be exclusively applicable to a different type of transaction. Instead, the Regulations prescribe a more flexible “best method” approach. The best method is the method that provides the most reliable measure of an arm’s length result. Reg. § 1.482–1(c)(1). Usually, data based on results of transactions be

April 17, 2000 932 2000–16 I.R.B.

This in essence is the function performed by the APA Team. The Team must evaluate each case through an application of the principles of the Regulations. APA cases often tend to be more difficult than a typical transfer pricing case; if the case were easy to resolve, there would be less need to resort to the APA process. Given this fact, and the nature of transfer pricing law and analysis, the APA Team must focus on the particular facts of the case and must have a clear, detailed understanding of the taxpayer’s business. The Team then evaluates the taxpayer’s functions and risks, the industry involved, market conditions, contractual terms, availability of data, and all the other factors that are relevant under the Regulations. Analysis of the interplay of the facts and transfer pricing principles present in the case, coupled with careful consideration of the taxpayer’s views, allows the Team to reach a reasoned, casespecific application of the arm’s length principle under Section 482.

Such analysis of real-life cases has proven a valuable way for the Service to learn more about taxpayers’ businesses, and their concerns and difficulties in attempting voluntarily to comply with their tax obligations. This can enable the Service to provide better and more timely guidance. At the same time, in the interim, taxpayers can achieve certainty concerning their prospective filing obligations through participation in the APA process. A good example of such synergy between the APA Program and issuance of general guidance is provided by the proposed “global dealing” regulations (63 Fed. Reg. 11177 [REG–208299–90] (March 6, 1998)). The Service’s early experience with “global dealing” APAs was described in Notice 94–40, 1994–1 C.B. 351. This Notice described the methodologies that had been used for a particular type of global dealing cases. In these cases, a global financial institution or affiliated group of companies would continuously trade securities and other financial products on a twenty-four hour basis, with responsibility for the “book” of positions passing from location to location in accordance with the passing of normal business hours in a given location. Existing rules created uncertainty regarding the appropriate treatment of such fact patterns. APAs bridged the gap until more

general guidance could be issued.

Review of Table 10 reveals that the great majority of APA TPMs applicable to the transfer of tangible or intangible property are specified methods under the Regulations. The CUP method has been used when it has been possible under the facts of the cases submitted to identify uncontrolled transactions with the required degree of comparability between products, contractual terms, and economic conditions. See Reg. § 1.482–3(b)(2)(ii). In many cases data concerning external CUPs was difficult to obtain; unrelated taxpayers dealing in the comparable product would ordinarily also deal in other items as well, and it is sometimes difficult to separate the pricing of the relevant transactions from the other results, based on publicly reported available data. Thus, in the APA Program’s experience, there has been a tendency to utilize internal CUPs. In addition, in two cases, where the covered product involved a commodity, publicly available market data provided a comparable price that could be referred to for purposes of establishing a CUP.

For similar reasons, APAs applying the CUT method have tended to rely on internal transactions between the taxpayer and unrelated parties; i.e., it has often been difficult to identify an external CUT. For example, in a case dealing with a royalty for a nonroutine intangible such as a trademark, it can be difficult to identify an unrelated party royalty arrangement that is sufficiently comparable, due to the unique nature of the nonroutine intangibles. To avoid these difficulties, some cases have utilized a “step royalty” arrangement to determine the proper transfer price for use of a unique intangible. For example, taxpayers have argued that an intangible was very valuable and therefore a high royalty rate was appropriate. Because there were no exact or closely similar comparables, it was difficult to demonstrate objectively whether the taxpayer was correct. A sliding scale, or step royalty, in conjunction with a CPM analysis, has been used to resolve such cases. The premise of such APAs was that, if the intangible truly had great value, the taxpayer would earn higher than normal return from its activities utilizing the intangible. Conversely, as the value of the intangible decreased, the tax

payer’s pre-royalty results would be in the routine arm’s-length range. Therefore, the royalty rate adopted in these APAs increases as the licensee’s profitability increases.

Based on the facts and circumstances of the cases evaluated by the APA Program, ten APAs to date have utilized a strict transactional resale price method. Similar considerations concerning comparability and data availability apply to this method.

A transactional cost plus method has been applied in ten cases as well. This method has proved easier to apply than the other transactional methods because the taxpayer’s costs are identifiable and it is likely to be easier to identify functionally comparable transactions for purposes of determining an appropriate arm’s length markup than it is to identify closely similar products in the case of a CUP. See Reg. § 1.482–3(d)(3)(ii). In other words, for example, a manufacturer might perform similar functions and assume similar risks even though the product manufactured is not identical or nearly identical to the taxpayer’s product.

The CPM is frequently applied in APAs. This is because reliable public data on comparable business activities of independent companies can be more readily available than potential CUP data, and comparability of resources employed, functions, risks, and other relevant considerations is more likely to exist than comparability of product. The CPM also tends to be less sensitive than other methods to differences in accounting practices between the tested party and comparable companies, e.g. classification of expenses as cost of goods sold or operating expenses. Reg. §§ 1.482–3(c)(3)(iii)(B), 1.482–3(d)(3)(iii)(B). In addition, the degree of functional comparability required to obtain a reliable result under the CPM is generally less than required under the resale price or cost plus methods, because differences in functions performed often are reflected in operating expenses, and thus taxpayers performing different functions may have very different gross profit margins but earn similar levels of operating profit. Reg. § 1.482–5(c)(2).

As can be seen from Table 10, a variety of profit level indicators (“PLIs”) has been used in connection with application of the CPM. The rationale for choosing

2000–16 I.R.B. 933 April 17, 2000

these APAs have tended to use a multi-factor formula to represent the contribution of various functions to world-wide profits. Residual profit splits, as provided in Prop. Reg. § 1.482–8(e)(6), have been applied in two cases where routine functions, such as back office functions, were readily valued. The residual profits were allocated on the basis of a case-specific multi-factor formula similar to that discussed in Notice 94–40. In two cases, where all the intangibles were held in one jurisdiction and the other jurisdictions provided routine marketing functions, a market-based transactional commission was used as the most reliable measure of an arm’s length return for those routine services. In one case the APA Team determined that the taxpayer’s internal profit allocation method provided an arm’s length result. In this case, reliability was enhanced because this internal method was used in determining arm’s length payments such as compensation and bonuses. Prop. Reg. 1.482–8(e)(5)(iii). A separate group of financial products cases involves U.S. or foreign branches of a single taxpayer corporation that operate autonomously with respect to the covered transactions, for example the purchase and sale to customers of a financial product such as foreign currency. Pursuant to the business profits articles of the relevant income tax treaties, several APAs determined the appropriate amount of profits attributable to each branch from such activity by reference to the branches’ internal accounting methods. The branch results took into account all trades, including interbranch and/or interdesk trades. In order for this method to provide a reliable result, however, it was necessary to ensure that all such controlled trades be priced on the same market basis as uncontrolled trades. To test whether this was so, the branch’s controlled trades were matched with that branch’s comparable uncontrolled trades made at times close to the controlled trades. A statistical test would then be performed to detect pricing bias, by which the controlled trades might as a whole be priced higher or lower than the uncontrolled trades. See the discussion under “Nature of Ranges and Adjustment Mechanisms” below.

In APA cases involving a cost sharing arrangement (“CSA”) under Reg. §

which PLI to use in a given case turns on all the factors contained in the Regulations, including availability and reliability of information, and the nature of the activities of the tested party. For example, return on assets or return on capital employed (“ROCE”) may be most reliable in cases where the level of operating assets has a high correlation to profitability, that is, where the operating assets play a greater role in generating profits – for example, a manufacturer’s operating assets such as property, plant, and equipment could have more impact on profitability than a distributor’s operating assets, since often the primary value added by a distributor is based on services it provides, which are often less dependent on level of operating assets. Reg. § 1.482–5(b)(4)(i). The reliability of ROCE has also been dependent on the structure of the taxpayer’s assets and their similarity to those of the comparables, since different asset categories can have different rates of return.

Other PLIs applied by APAs in conjunction with the CPM are various financial ratios. These include operating margin (“OM”), Berry ratio, markup on costs, and gross margin. OM is defined as the ratio of operating profit to sales. The Berry ratio ⁷ is defined as the ratio of gross profit to operating expenses. A Berry ratio has in some cases been used when services provided (for example, a lowrisk distributor providing marketing and distribution services) are the main source of value added by the tested party, and the expenses incurred for providing those services are classified as operating expenses rather than costs of goods sold. In such cases a Berry ratio is essentially a markup on operating expenses. OM has been used when functions of the tested party are not as closely matched with the available comparables. Markup on costs (normally total costs) has been used when the taxpayer’s sales are a controlled transaction, because it relies on an uncontrolled cost figure rather than on the controlled sales figure. This method has also been used where it is common industry practice to set prices by reference to costs, for example, for contract manufacturers. Occasionally, certain costs have not been

7 Named after Professor Charles Berry, who used the Berry ratio when serving as an expert witness in E.I. DuPont de Nemours & Co. v. United States, 608 F.2d 445 (Ct.Cl. 1979).

marked up, such as product-specific taxes reimbursed by the purchaser. In general, gross margin has not been favored as a PLI because the categorization of expenses as operating expenses or cost of goods sold may be subject to manipulation, resulting in understatement of taxable income even where gross margins are within an arm’s length range.

The relative utility of each PLI is the subject of much discussion and analysis in each case and depends heavily on the facts and circumstances of the particular case. The APA Team’s analysis will often consider several different PLIs; if the results tend to converge, that may provide additional assurance that the result is reliable. If there is a broad divergence between the different PLIs, the Team may derive insight into important functional or structural differences between the tested party and the comparables. For example, such divergence may lead to a discovery that the taxpayer’s indicated asset values are not reliable or comparable, such as in the case of a largely depreciated but still valuable asset base.

Profit split methods are used most often when both sides of the controlled transactions own valuable nonroutine intangibles. If all such intangibles were owned by only one side, the other side would usually be the simpler party and therefore, its functional contribution would be more easily valued. Where both sides possess nonroutine intangibles for which there are no good comparables, however, a profit split method can be the most reliable method of establishing an arm’s length price. APAs have used both comparable profit splits and residual profit splits, as described in the Regulations. In addition, APAs have used as an unspecified method other types of profit splits; for example, an allocation of profits based on a weighted allocation formula with operating assets and certain operating expenses as factors, allocations based on the relative value of contributions of the parties, or allocations based on compensation and activities similar to the Notice 94–40 (1994–1 C.B. 351), profit split utilized in some financial products cases.

Profit splits have also been used in a number of financial products APAs where the primary income-producing functions are performed in more than one jurisdiction. As described in Notice 94–40, supra,

April 17, 2000 934 2000–16 I.R.B.

1.482–7, the APA Teams have worked with the taxpayers to ensure that the arrangement in question meet the requirements of Reg. § 1.482–7(b). In particular, the Team must determine that the method of determining each participant’s share of costs is consistent with the reasonably anticipated benefits that participant is likely to realize from exploitation of the intangible that is the subject matter of the CSA. In cases where the CSA involves transfer of existing technology, the Team must also determine the appropriate “buy-in” under Reg. § 1.482–7(g)(2). Table 13 shows the methods of allocating cost sharing payments adopted in existing APAs, and Table 14 shows the methods of determining the buy-in. These methods have been adopted on a case by case basis, depending on the taxpayer’s facts and circumstances.

APAs that have dealt with provision of services have applied Reg. § 1.482–2(b)(3) to determine an arm’s length charge for such services; in general, services have been charged out at cost when they were not an integral part of the business activity of either the party rendering the services or the recipient of the services. In cases where the services were integral, or where it was otherwise determined that parties dealing at arm’s length would not have charged out the cost of services, the tendency has been to use a cost-plus method to determine an arm’s length fee. In six cases, other methods of determining an arm’s length fee have been determined to be the best method, as seen in Table 11.

CRITICALASSUMPTIONS

(Section 521(b)(2)(D)(v))

APAs include critical assumptions upon which their respective TPMs depend. Critical assumptions are objective business and economic criteria that form the basis of a taxpayer’s proposed TPM. A critical assumption is any fact (whether or not within the control of the taxpayer) related to the taxpayer, a third party, an industry, or business and economic conditions, the continued existence of which is material to the taxpayer’s proposed TPM. Critical assumptions might include, for example, a particular mode of conducting business operations, a particular corporate or business structure or a range of expected business volume. Rev. Proc. 96

53, § 5.07. Failure to meet a critical assumption may render an APA inappropriate or unworkable.

A critical assumption may change (and/or fail to materialize) due to uncontrollable changes in economic circumstances, such as a fundamental and dramatic change in the economic conditions of a particular industry. This type of critical assumption may be defined in terms of a significant variance from budgeted sales volume. In addition, a critical assumption may change (and/or fail to materialize) due to a taxpayer’s actions that are initiated for good faith business reasons, such as a change in business strategy, mode of conducting operations, or the cessation or transfer of a business segment or entity covered by the APA.

Effects of Critical Assumptions

If a critical assumption has not been met, the APA may be revised by agreement of the parties. If such agreement cannot be achieved, the APA may be canceled. If a critical assumption has not been met, it requires taxpayer’s notice to and discussion with the Service, and possible Competent Authority activity. Rev. Proc. 96–53, § 11.07. Failure of a critical assumption may also provide an automatic adjustment in the TPM results.

Critical assumption provisions are crucial to the APA because a TPM is premised on certain assumptions that apply to a particular taxpayer, its industry, and the dynamics of the economy. Critical assumptions provide flexibility in an APA by recognizing the reality of change in business cycles and economic circumstances and their effects on varying arm’s length returns. Whether critical assumptions change (and/or fail to materialize) is subject to the examination process.

General Critical Assumption

Included in the model APA is the following critical assumption:

The business activities, functions performed, risks assumed, assets employed, and financial [and tax] accounting methods and categories [and estimates] of Taxpayer shall remain materially the same as described in Taxpayer’s request for this APA.

Taxpayer-Specific Critical Assumptions

The APAs concluded as of December

31, 1999, include approximately 160 different critical assumptions in addition to the model APA critical assumption noted above. Many of these critical assumptions appear in more than one APA. Most of the critical assumptions reflect specific terms and factors of each taxpayer in an elaboration of the general model APA critical assumption. The critical assumptions can be subdivided into the following categories:

(i) operational, (ii) legal, (iii) tax, (iv) financial, (v) accounting, or (vi) economic. These various categories of critical assumptions are discussed below.

Operational Critical Assumptions

Over 100 of the critical assumptions fall into the operational category. It is not surprising that this is the largest category of critical assumptions. APAs by their nature are factually intensive and reflect the specific operations of each taxpayer and its related parties. In agreeing to a TPM in an APA, the APA Team is basing its position on the facts presented and thus implicitly upon the assumption that those operational facts will remain the same. In addition to the general critical assumption to that effect, many APAs include specific critical assumptions relating to important factual underpinnings of the decision to adopt the TPM.

Over twenty of these operational critical assumptions involve costs or expenses, such as how the taxpayer defines, computes, allocates and apportions costs and expenses. Also included are critical assumptions concerning limits on the amount and manner by which expenses and costs can vary. An example of this type of critical assumption is that a U.S. subsidiary’s deductions for restructuring fees shall not exceed a stated maximum dollar amount.

Six operational critical assumptions involve sales. These concern limits on sales mixes, maximum sales amounts, projections of sales and permissible sales trends and variations. An example of this type of critical assumption is that the combined sales of covered products for each APA year must be within 20% of the previous year.

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Three operational critical assumption involve new products. They either include or exclude new products from coverage of the APA. They also control how a new product will be treated. An example of this type of critical assumption is that certain new products will not be covered.

Five operational critical assumptions involve permissible variations in items other than sales or expenses. These include how new or disposed of affiliates are treated, to what extent inventories can fluctuate, or to what extent covered purchases can be imported finished products. An example of this type of critical assumption is that the share of covered products that are imported finished goods can vary by X% from the historical baseline share percentage of imported finished goods.

The largest number (over 60) of operational critical assumptions involve limits on change. These critical assumptions state in a specific way that the following items remain substantially the same: customers, products, risks, functions, business methods, assets, pricing policies, absence of catastrophic events, business structure, presence and effect of a cost sharing agreement, functional currency, operating assets, presence or absence of intangible assets, intangible asset ownership, parties to the agreement, licensee agreements, specific personnel, location of specific personnel, presence or absence of commissions, and royalty amounts and percentages. An example of this type of critical assumption is that the location of a particular key executive may not change.

Other operational critical assumptions involve annual review of functions, dates of transfer of property, and maintenance of records. An example of this type of critical assumption is that the gross profit from certain transactions will be recorded in a regularly compiled database.

Legal Critical Assumptions

Fourteen critical assumptions involve legal issues. They include whether a competent authority agreement is conditioned, canceled or has an effect on rollback years (prior years not covered by the APA). An example is that the competent authorities’ mutual agreement, which is conditioned on the system profit remaining above a specified minimum level, will

remain in effect ( i.e., that such condition will continue to be satisfied).

Other critical assumptions of this nature involve liquidations, dissolutions, customs law changes, major regulatory changes, new import or export barriers, and maintenance of a distributor agreement in a specific form. An example of this type of critical assumption is that customs duties on imported covered products shall not increase or decrease by some stated parameter.

Others involve which controlled entity has title to inventory and production equipment, or which controlled entity is required to maintain guarantees, warranties, or product liability. An example of this type of critical assumption is that a parent corporation must maintain existing guarantees for all liabilities of its subsidiary, including its debt and product liability guarantees.

Tax Critical Assumptions

Eleven critical assumptions involve tax issues. These issues include estimated tax liability, period of limitation on assessment, tax effect of specified expenses, sourcing of income, Subpart F income, permanent establishment, foreign tax credit limitation, increasing coverage to other controlled foreign corporations, the ability to change a specified tax election, ability to file for a refund, and a condition of subsequently entering into a closing agreement for roll back years. An example of this type of critical assumption is that the period of limitation on assessments shall be kept open for all APA years until such period expires for the last APA year under U.S. tax law.

Financial Critical Assumptions

Eighteen types of critical assumption are financial in nature. These involve limitations on system loss, intangible profit projections, buy-in payments, lack of currency risk, and valid business reason for debt. Also included in this category are a number of requirements for maintaining various financial ratios such as profit splits, Berry ratios, operating profit margins, and gross profit margins, within prescribed ranges or within limits. An example of this type of critical assumption is that the TPM may not yield a gross margin outside A% to B% for a controlled subsidiary, nor may the combined

operating margins be outside C% to D% for the parent and the subsidiary, unless due to valid business reasons or attributable to economic conditions beyond the parent’s control.

Accounting Critical Assumptions

Seven critical assumptions involve accounting methods or practices. These include assumptions regarding the use of generally accepted accounting principles, favorable certified opinions, mark to market accounting, consistency of accounting computations for all related parties, methods of accounting for foreign currency gains and losses, and unchanged methods for both financial and tax accounting. An example of this type of critical assumption is that manufacturing costs must be computed in the same manner by U.S. and foreign members of an affiliated group.

Economic Critical Assumptions

Eight critical assumptions involve economic and financial conditions. These include assumptions regarding interest rates and changes in interest rates. They also include assumptions that there will not be significant changes in market conditions, technology, product liability, product design, process design, and market share. An example of this type of critical assumption is that there shall not be an unexpected economic development that materially affects a company’s market share or market price of a covered product.

and (vii)) At the core of most APAs are comparables. The APA program works closely with taxpayers to find the best and most reliable comparables for each covered transaction. In some cases, CUPs or CUTs can be identified, with the attendant product- or intangible-specific analysis of comparability and reliability. In other cases, comparable business activities of independent companies are utilized in applying the CPM or residual profit split

SOURCES OF COMPARABLES,

COMPARABLE SELECTION CRITERIA, AND NATURE OF

ADJUSTMENTS TO COMPARABLES AND TESTED

PARTIES (Sections 521(b)(2)(D)(v), (vi)

April 17, 2000 936 2000–16 I.R.B.

methods. In the APA Program’s experience, CUPs and CUTs have been most often derived from internal transactions of the taxpayer. But other cases have utilized third party CUPs or CUTs from external transactions.

For profit-based methods where comparable business activities or functions of independent companies are sought, the APA Program typically has applied a three-part process. First, a pool of potential comparables has been identified through broad searches. From this pool, companies having transactions that are clearly not comparable to those of the

tested party have been eliminated through the use of quantitative and qualitative analyses, i.e ., quantitative screens and business descriptions. Then, based on a review of available descriptive and financial data, a set of comparable companies or transactions has been finalized. The comparability of the finalized set has then been enhanced through the application of adjustments. These steps of identifying potential comparables, selecting comparables from the pool, and adjusting the comparables, are discussed in turn below.

Searching for Comparables

Comparables used in APAs can be U.S. or foreign companies. This depends, of course, on the relevant market, the type of transaction being evaluated and the results of the functional and risk analyses. In general, comparables have been located by searching a variety of databases which provide data on U.S. publiclytraded companies and on a combination of public and private non-U.S. companies. Table 15 summarizes some of the common databases that have been used for existing APAs.

TABLE 15 COMPARABLES DATABASES USED IN APA ANALYSES

• Many vendors now package their data with more than one type of access software. This table shows the major databases without regard to the “front-end” software used to access them. In addition, it does not show other vendors who package existing databases together in products.

Although comparables were most often identified from the databases cited above, in some cases comparables were found from other sources. Chief among this group are comparables derived internally from taxpayer transactions with third parties. In just over 10 percent of all APAs, there were transactions that were evaluated with reference to internal comparable uncontrolled transactions. Also used in a few cases was information available from trade publications in specific industries, and comparables derived from taxpayer information on competitors.

Selecting Comparables

Initial pools of potential comparables have been generally derived from the databases shown in Table 15 using a combination of industry and keyword identi

fiers. Then, the pool has been refined using a variety of selection criteria specific to the transaction or entity being tested and the transfer pricing method being used.

The databases listed above in Table 15 allow for searches by industrial classification (generally, U.S. Standard Industrial Classification (“SIC”)), by keywords, or by both. These searches can yield a number of companies whose business activities may or may not be even remotely comparable to those of the entity being tested. Therefore, so called “comparables” based solely on SIC or keyword searches are almost never used in APAs.

Rather, pools of initially identified companies are examined closely. This examination consists of a combination of quantitative screens and qualitative evaluations. The application of multiple quan

titative screens to select comparables, without also analyzing descriptive information about the companies, has not generally been acceptable APA practice. Rather, companies have been accepted or rejected as comparables based on a combination of screens, business descriptions, and other information found in a company’s Annual Report to shareholders and filings with the U.S. Securities and Exchange Commission (“SEC”). ⁸

In virtually all cases, business activities are required to meet certain basic comparability criteria to be considered comparables. Functions, risks, economic condi

8 While the framework is the same for searches for U.S. and non-U.S. comparables, there is generally less descriptive information publicly available for non-U.S. companies. Therefore, selection criteria can be more general for non-U.S. searches.

2000–16 I.R.B. 937 April 17, 2000

tions, and the property (product or intangible) and services associated with the transaction must be comparable. Determining comparability can be difficult – the goal has been to use comparability criteria restrictive enough to eliminate companies that are not comparable, but yet not so restrictive as to have no comparables remaining. The APA Program normally has begun with relatively strict comparability criteria and then has relaxed them slightly if necessary to derive a pool of comparables.

The APA Program has applied a combination of criteria to determine comparability of economic conditions. Specifically, it frequently has combined “same industry” criterion with criteria focusing on the level of market served, the maturity of the company (minimum or maximum number of years of operation) and/or the geographic market served (minimum or maximum percentage of sales in a geographic area and/or percentage of government sales.)

In addition, the APA Program has generally required the potential comparables to have complete financial data available for a specified period of time. Sometimes this has been three years, but it can be more or less, depending on the circumstances of the controlled transaction. Using a shorter period might result in the inclusion of companies in different stages of economic development or use of atypical years of a company subject to cyclical fluctuations in business conditions.

Beyond these criteria and screens which are most often applied, many covered transactions have been tested with comparables that have been chosen using additional criteria and/or screens. These include sales level criteria and tests for financial distress and product comparability.

These common selection criteria and screens have been used to increase the overall comparability of a group of companies and as a basis for further research. The sales level screen, for example, has been used to remove companies that, due to their size, might face fundamentally different economic conditions from those of the entity or transaction being tested.

In addition, many APA analyses have incorporated some form of selection criteria related to removing companies experiencing “financial distress” due to con

cerns that companies in financial distress often have experienced unusual circumstances that would render them not comparable to the entity being tested. These criteria include: operating losses in a given number of years, an unfavorable auditor’s opinion, or bankruptcy.

As the transfer pricing regulations state in Reg. § 1.482–1(d)(3)((v), the importance of product comparability depends on the transfer pricing method being used. In using methods that rely on the identification of comparable independent companies, the APA Program has generally required less product comparability than when using methods that rely on comparable uncontrolled prices and licensing transactions. Nonetheless, product comparability, as determined from publicly available corporate information, has been used as a selection criterion when possible.

An additional important class of selection criteria is that which relates to the development and ownership of intangible property. In many cases in which the entity being tested is a manufacturer, several criteria have been used to ensure, for example, that if the controlled entity does not own significant manufacturing intangibles or conduct research and development (“R&D”), neither will the comparables. These selection criteria have included determining the importance of patents in a company or screening for R&D expenditures as a percentage of sales or costs. Another criterion used in some cases has been a comparison of the book and market values of a company; this can be another indicator of intangible value. Again, quantitative screens related to identifying comparables with significant intangible property generally have been used in conjunction with an understanding of the comparable derived from publicly available business information.

Selection criteria relating to asset comparability and operating expense comparability have also been used at times. A screen of property, plant, and equipment (“PP&E”) as a percentage of sales or assets, combined with a reading of a company’s SEC filings, has been used to help ensure that distributors (generally lower PP&E) were not compared with manufacturers (generally higher PP&E), regardless of their SIC classification. Similarly, a test involving the ratio of operating expenses to sales or total costs has helped to

determine whether a company undertakes a significant marketing and distribution function. This has been used in circumstances when complete descriptive information about a company’s functions was not available.

Adjusting Comparables

After the comparables have been selected, the regulations require that “[i]f there are material differences between the controlled and uncontrolled transactions, adjustments must be made if the effect of such differences on prices or profits can be ascertained with sufficient accuracy to improve the reliability of the results.” Reg. § 1.482–1(d)(2). In almost all cases involving income-statement-based profit level indicators (“PLIs”), certain “asset intensity” or “balance sheet” adjustments for factors that have generally agreedupon effects on profits have been carried out. In addition, in specific cases, additional adjustments have been performed to improve reliability.

The most common asset intensity adjustments used in APAs include adjustments for differences in accounts receivable, inventories, and accounts payable. In practice, when data has been available, most APAs have included these adjustments, regardless of whether or not their effect is material. Further, while there is no single standard adjustment mechanism, the different methodologies used have tended to achieve similar results.

The APA Program has required that data must be compared on a first-in firstout (“FIFO”) accounting basis. Although financial statements may be prepared on a last-in first-out (“LIFO”) basis, crosscompany comparisons are less meaningful when one or more companies use LIFO inventory accounting methods. This adjustment directly affects costs of goods sold and inventories, and therefore affects both profitability measures and inventory adjustments.

The APA Program has required adjustments for receivables, inventory, and payables based on the principle that holding assets such as receivables and inventory is a cost to the entity holding them and a benefit to customers and/or suppliers (those on either side of a transaction with the entity holding the assets). Such adjustments are based on the assumption that the cost of holding these assets is

April 17, 2000 938 2000–16 I.R.B.

ferences in other balance sheet items, operating expenses, R&D, or currency risk. ¹¹ In rare or singular cases, there also have been adjustments for start-up costs, cost of capital variations, non-routine intangibles, sales shocks, manufacturing functions, and product liability. These adjustments have been evaluated on a case by case basis and made only when doing so improved the reliability of the results. Finally, accounting adjustments, such as reclassifying items from cost of goods sold to operating expenses, for example, have also been made when warranted to increase reliability. Often, data has not been available for both the controlled and uncontrolled transactions in sufficient detail to allow for these types of adjustments.

NATURE OF RANGES AND ADJUSTMENT MECHANISMS (Sections 521(b)(2)(D)(viii) and (ix))

The types of ranges used in existing APAs are set forth in Table 16 below:

equal to their carrying cost. Conversely, the holding of accounts payable is considered to be a benefit to the entity holding them, in that they are a source of funds. This benefit has generally been assumed to be equal to the cost of funds.

To compare the profits of two entities with different relative levels of receivables, inventory, or payables, the APA Program has estimated the carrying costs of each item and adjusted profits accordingly. Although somewhat different formulas have been used in specific APA cases, Appendix B presents one set of formulas used in many APAs. ⁹ Underlying these formulas are the notions that (1) balance sheet items should be expressed as mid-year averages, (2) formulas should try to avoid using data items that are being tested by the transfer pricing method (for example, if sales are controlled, then the denominator of the balance sheet ratio should not be sales) (3) a short term interest rate should be used, and (4) an interest factor (i/(1+i)) ¹⁰ rather

than a rate (i) should be used in the adjustments for receivables and payables.

Less frequently seen but still potentially important in some cases is the adjustment for differences in relative levels of PP&E between a tested entity and the comparables. Ideally, comparables and the entity being tested will have fairly similar relative levels of PP&E, since major differences can be a sign of fundamentally different functions and risks. In other cases, however, differences in relative levels of PP&E can indicate more of a buy-or-lease difference, variations in the age of assets, or capital-labor choices rather than any functional difference between the companies. In these cases, adjustments similar to those for receivables, inventories, and payables have been made. The PP&E adjustment has, however, been made using a longer term interest rate than the short term rates used for the other balance sheet adjustments.

Additional adjustments, used much more infrequently, include those for dif

Regulations, ¹³ then under Reg. § 1.482–1(e)(2)(iii)(A) the arm’s length range includes the results of all of the comparables (from the least to the greatest). However, the APA Program has only rarely identified cases meeting the requirements for the full range. If the comparables are of lesser quality, then under

13 For such comparables, “it is likely that all material differences have been identified” between the uncontrolled comparables and the controlled transaction. Further, each identified difference has “a definite and reasonably ascertainable effect on price or profit, and an adjustment is made to eliminate the effect of each such difference.” Reg. § 1.4821(e)(2)(iii)(A).

DISCUSSION

Reg. § 1.482–1(e)(1) of the transfer pricing regulations states that sometimes a pricing method will yield “a single result that is the most reliable measure of an arm’s length result.” Sometimes, however, a method may yield “a range of reli

9 The formulas in Appendix B do not represent the formal IRS position on adjustments. Rather, they are examples of adjustment mechanisms that have been used by the APA Program. 10 This factor may have the holding period incorporated into it. 11 See above for a discussion of currency risk.

able results,” called the “arm’s length range.” A taxpayer whose results fall within the arm’s length range will not be subject to adjustment.

Under Reg. § 1.482–1(e)(2)(i), such a range is normally derived by considering a set of more than one comparable uncontrolled transaction, ¹² of similar comparability and reliability. If these comparables are of very high quality, as defined in the

12 The term “transaction” here can include many transactions by one company, considered on an aggregate basis. See Reg. § 1.482-1(f)(2)(iv) (product lines).

2000–16 I.R.B. 939 April 17, 2000

Reg. § 1.482–1(e)(2)(iii)(B) “the reliability of the analysis must be increased, where it is possible to do so, by adjusting the range through application of a valid statistical method to the results of all of the uncontrolled comparables.” One such method, the “interquartile range,” is “ordinarily . . . acceptable,” although a different statistical method “may be applied if it provides a more reliable measure.” The “interquartile range” is defined as, roughly, the range from the 25th to the 75th percentile of the comparables’ results. (A precise definition is given in Reg. § 1.482–1(e)(2)(iii)(C).) In the case of bilateral APAs, other methods for setting a range have been agreed upon as a result of compromise negotiations between the Competent Authorities.

Some APAs involving financial products have employed a “statistical confidence interval” to compare pricing of a large set of controlled transactions with a comparable set of uncontrolled transactions. An example is a financial institution with fairly autonomous branches in several countries. Pursuant to the business profits article of the applicable income tax treaties and Prop. Reg. § 1.482–8(b), APAs have been executed allowing the taxpayer to allocate profits between branches with reference to the branches’ internal accounting methods, taking into account all trades, including interbranch and/or interdesk trades. In order for this method to provide a reliable result, however, it is necessary to ensure that all such controlled trades be priced on the same market basis as uncontrolled trades. To test whether this is so, a branch’s controlled trades are matched with that branch’s comparable uncontrolled trades made at times close to the controlled trades. A statistical test is performed to detect pricing bias, by which the controlled trades might as a whole be priced higher or lower than the uncontrolled trades. This has been accomplished by construction of a statistical “confidence interval” (typically 95%), with the tested hypothesis being that controlled trades are priced on the same basis as uncontrolled trades. An adjustment is necessary if the results of the controlled trades fall outside of this confidence interval.

Adjustments

Under Reg. § 1.482–1(e)(3), if a taxpayer’s results fall outside the arm’s length range, the Service may adjust the result “to any point within the arm’s length range.” Accordingly, an APA may permit or require a taxpayer and its related parties to make an adjustment after the year’s end to put the year’s results within the range, or at the point, specified by the APA. Similarly, to enforce the terms of an APA, the Service may make such an adjustment. Where the APA specifies a range, the adjustment is sometimes to the closest edge of the range, and sometimes to another point such as the median of the interquartile range. Depending on the facts of each case, such automatic adjustments are not always permitted. Some APAs specify that if a tax

A variant on the interquartile range involves a “Tukey filter,” as follows. First, the set of comparables is used to derive a standard interquartile range. Then the difference D between the top and bottom of the interquartile range is computed. Next, all comparables whose results are more than a certain multiple of D (often the multiple 1.5 is used) outside the interquartile range are discarded as “outliers.” Finally, the reduced set of comparables (without the outliers) is used to compute a second interquartile range, which is then used as the arm’s length range. This approach has only occasionally been used for APAs (see Table16). The Tukey filter has been used to eliminate companies that were so anomalous that they arguably should not have been included as comparables in the first place.

bles may yield a range of possible arm’s length royalty rates. However, as a matter of business practice, companies typically fix precise royalty rates in advance. Therefore, APAs often require a specific royalty rate.

APAs also have tended to adopt a point rather than a range when applying profit split methods. In a comparable profit split under Reg. §1.482–6(c)(2), total profit is split in the same ratio as the profit of comparable uncontrolled parties is split. Typically this method produces a specific ratio of profit split, although if more than one set of comparable parties were used it would be possible to derive a range. In a residual profit split under Reg. § 1.482–6(c)(3), each party is first assigned a routine return, and any residual profit or loss is split according to each party’s relative contribution to pertinent intangible property. As normally implemented, this method has yielded a specific result for both routine returns and the split of the residual profit, although in some cases it would be possible to derive ranges. Other methods in which a point rather than a range has been used include CUP, resale price, and cost plus. Sometimes only one comparable transaction is used, ¹⁴ yielding a specific result rather than a range. However, in some cases APAs have specified a modest range around the specific result, to accommodate changing business practices and conditions.

Some APAs specify not a point or a range, but a “floor” or a “ceiling.” When a floor is used, the tested party’s result must be greater than or equal to some particular value. When a ceiling is used, the tested party’s result must be less than or equal to some particular value. Such an approach has been used, for example, where the TPM is a CPM with OM as the PLI and the comparable transactions reflect certain current business conditions that might improve. The APA required that the tested party’s operating margin should always be above the bottom of the interquartile range, but that the operating margin could go above the top of the interquartile range if conditions improved.

14 The use of only one comparable transaction is more likely when that transaction is an “internal” comparable uncontrolled transaction, that is, a transaction that involves one of the related parties under evaluation.

Many times, even though a set of comparables could yield a range of results, APAs have specified a single or specific result, also called a “point.” This approach was used in some APAs to avoid the possibility of manipulation to produce a result near the bottom of a specified range. For bilateral APAs, each country might be concerned about the potential for such manipulation, making it easier for the two countries to agree on a specific result than on a range. In many APAs, the specific point has been the median point of the set of comparables’ results. However, in some APA cases arguments for a different point have been made and accepted.

APAs have often used a point in establishing a royalty rate. A set of compara

April 17, 2000 940 2000–16 I.R.B.

payer’s results fall outside the applicable point or range, the APA will be canceled or revoked. Some bilateral APAs specify that in such a case there will be a negotiation between the Competent Authorities involved to determine whether and to what extent an adjustment should be made. Some APAs permit automatic adjustments unless the result is far outside the range specified in the APA. Thus they provide flexibility and efficiency (permitting adjustments when normal business fluctuations and uncertainties push the result somewhat outside the range), while guarding against abuse of the adjustment mechanism.

In order to conform the taxpayer’s books to these tax adjustments, the APA usually permits a “compensating adjustment” as long as certain requirements are met. Such compensating adjustments may be paid between the related parties with no interest, and the amount transferred will not be considered for purposes of penalties for failure to pay estimated tax.

TERM LENGTHS (Section 521(b)(2)(D)(x))

The various term lengths for existing APAs are set forth in Table 17 below:

TABLE 17 TERMS OF APAs

15 Partial tax years and short full tax years are both counted as full years.

or similar transfer pricing issue for those earlier years) . Rollbacks, however, are not under the jurisdiction of the APA Program, but rather of the District Director bearing responsibility for examination of the taxpayer. Accordingly, rollback years are not included in or covered by the APA, and the APA Program office has not systematically tracked rollbacks. In some cases, the APA Program may not be informed whether a rollback of the APA methodology has been applied to back years, as that decision may be made after the APA is executed and closed by the Chief Counsel’s office. For the future, the APA Program intends as part of IRS modernization to implement procedures for better coordination of rollbacks with the examination function.

Due to the foregoing, the APA Program is unable to provide complete information about rollbacks in this report. In 1999, however, as part of an unrelated project, the APA Program surveyed the Districts that had participated in APAs in an attempt to determine how and to what extent rollbacks had been applied. The results of that survey are summarized in Table 18 below:

TABLE 18 APA ROLLBACKS

1. A statement identifying all material differences between the Taxpayer’s business operations, functions performed, risks assumed, and assets employed during the APA Year and the description of the Taxpayer’s business operations as contained in Taxpayer’s request for this APA or, if there have been no such material differences, a statement to that effect.
2. A statement identifying all relevant and material changes in the Taxpayer’s accounting methods and classifications from those described or used in Taxpayer’s request for this APA or, if there have been no such material changes, a statement to that effect.
3. The Taxpayer’s Financial Statements for the APA Year as prepared in accordance with U.S. GAAP.
4. A financial analysis demonstrating Taxpayer’s compliance with the

NATURE OF DOCUMENTATION

REQUIRED (Section 521(b)(2)(D)(xi)) One significant component of any APA agreement is the requirement that a taxpayer demonstrate compliance with the agreed-upon TPM or, alternatively, that any adjustment required by the TPM is accurately calculated. To accomplish this objective, the APA agreement includes documentation requirements, which are found in Section 5 (Financial Statements and APA Records) and Section 8 (Annual Report) of the model APA.

The APA agreement generally provides in part that “[t]he determination whether a taxpayer has complied with this APA will be based on its United States income tax return; its financial statements as prepared in accordance with generally accepted accounting principles (‘GAAP’) on a consistent basis (the ‘Financial Statements’); the additional records (‘APA Records’) specified in Appendix B; and all information referenced in section 8 of this APA.” The agreement also generally states that a “Taxpayer shall file a timely Annual Report for each APAYear pursuant to the rules of section 11.01 of Rev. Proc. 96–53.”

Typically, the APA requires a taxpayer to demonstrate compliance with the agreed-upon TPM by providing the following documents in such an annual report:

2000–16 I.R.B. 941 April 17, 2000

TPM including a computation of the TPM amount and a reconciliation of the TPM amount to the financial statements. 5. A description of any failure to meet Critical Assumptions or, if there have been no such failures, a statement to that effect. 6. A description of the reason for, and financial analysis of, any Compensating Adjustments with respect to the APA Year, including the means by which any such Compensating Adjustment has been or will be satisfied. 7. A copy of the certified public accountant’s opinion described in section 5 of this APA for the APA Year. The documentation provisions referred to above are necessary to establish whether a taxpayer has complied with the agreed-upon TPM, including whether any adjustment required to bring the taxpayer into compliance with the TPM is accurately calculated. Under the APA, a taxpayer must retain all documents required to be included in the annual report, as well as all work papers, records, or other documents that support the information provided in such documents. Compliance by a taxpayer with the APA documentation provisions also constitutes compliance with the record maintenance requirements of Sections 6038A and 6038C of the Internal Revenue Code with respect to the covered transactions during the APA term.

The documentation provisions generally require a taxpayer to submit audited financial statements for the APA Year prepared in accordance with U.S. GAAP. The IRS relies on audited financial statements – as opposed to unaudited financial statements – because they contain an unqualified opinion by an independent accountant that the Taxpayer’s financial condition is fairly presented. Audited financial statements also represent the company’s financial condition as it is presented to shareholders and the public. Additionally, audited financial statements prepared in accordance with GAAP ensure that a taxpayer’s financial operations are reflected based on known accounting principles.

In addition to the requirements identified above, APA agreements may also re

quire documentation tailored to specific industries. For example, the nature of records kept by taxpayers engaged in the financial products business often differs from that of taxpayers in other industries. Therefore financial products APAs would have record keeping requirements tailored to that industry. For example, such APAs might typically require some or all of the following additional documents:

calculating the annual cost sharing payment. These additional requirements are intended to document transactions germane to cost sharing arrangements, including the buy in and buy out payments related to existing and work-in-progress R&D, the expenses comprising the cost pool, as well as the allocation of those expenses to the participating members of the cost sharing arrangement.

Finally, the documentation provisions of an APA can be tailored to address a tax

(1) annual profit & loss statements of

the U.S. taxpayer; (2) summaries of currencies used to

account for payments or allocations to parent or head office; (3) leave order confirmations; (4) daily revaluation reports; (5) historical pricing data for currency

transactions; (6) schedule of costs of hedging con

tracts; and (7) historical market quotations. The documents outlined above support transactions that are specific to financial product APAs, such as hedging transactions and the allocation of global trading expenses.

APAs covering cost sharing arrangements may also generate additional documentation requirements, such as requiring a taxpayer to provide:

(1) amendments to cost sharing or

technology license agreement; (2) summaries of each product in cluded in cost sharing agreement; (3) reconciliations of R&D costs to

cost sharing payments, including invoices for cost sharing payments; (4) lists of affiliates included and ex cluded in each cost sharing group; (5) summaries of intangibles that each

affiliate brings to the cost sharing agreement; and (6) internal documents relied upon in

payer’s specific business or specific accounting system. For example, some APAs have required a taxpayer to document sales from specific product lines or to compile sales and expense data for specific factories. In this situation, the information sought might be used to evaluate the financial results or the functions performed by a specific affiliate in a consolidated group. Along the same lines, information regarding a company’s worldwide ratio of R&D expenses to sales may shed light on the R&D functions being performed by a domestic subsidiary as compared to a foreign parent.

Alternatively, some annual reports have required information such as third party royalty agreements, which would be used to support a CUT analysis, and U.S. Customs filings, if there is an issue regarding the inconsistent valuation of imported tangible property. Some APAs have also required a taxpayer’s business plan or a reconciliation of financial projections with actual financial results to ascertain whether the financial projections that formed the basis for the TPM approximated the actual financial results.

Other types of required documents may include the production of IRS Forms 5471 and 5472 (Information returns outlining transactions between controlled parties) and IRS Form 3115 (Information return outlining changes in accounting methods). Taxpayers may also be required to explain extraordinary transactions with a foreign parent that exceed a certain dollar limitation.

The type of information described above is necessary in evaluating whether there have been changes to a taxpayer’s business or accounting methods that could have a material impact on the application of the TPM. Through the APA documentation requirements, the Service can ensure taxpayer compliance with the agreed-upon TPM or, alternatively, the need for an accurate calculation of any adjustment designed to bring a taxpayer into compliance.

EFFORTS TO ENSURE COMPLIANCE WITH APAs

(Section 521(b)(2)(F)) As described above in “Nature of Documentation Required,” each APA contains documentation provisions, based on the facts of that case, designed to enable the Service to ensure compliance with the

April 17, 2000 942 2000–16 I.R.B.

TPM and other terms of the APA. As part of these provisions, the taxpayer is required to file an annual report demonstrating compliance with the APA for each covered APA year, and putting the Service on notice if critical assumptions have been violated or material facts have changed.

When the annual report is received by the APA Program, it is reviewed by a member of the professional staff. One Team Leader has been assigned the lead role in this review, and is responsible not only for reviewing most of the annual reports received by the APA Program office, but also for maintaining a database that tracks the annual reports required by each APA to ensure that taxpayers are complying with their obligation to file the reports in a timely manner. At times, another member of the APA staff will be responsible for the initial review of a given annual report, for example, the team leader who negotiated the APA in question if the level of complexity makes it more efficient for

a person already familiar with the case to review the report; or a request to renew the APA to which the annual report relates might be in process, in which case the team leader assigned the renewal might be assigned the annual report for similar reasons of efficiency.

The APA Program reviews the annual report to make sure that the information required is included in the report, and to determine whether the taxpayer has, on the face of the report, complied with the terms of the APA, including proper application of the TPM. For the most part, the APA Program does not attempt to audit the accuracy of the numbers contained in the report, but will look at issues such as proper classification of expenses. If this review determines that there is a question as to whether the taxpayer is in compliance, the APA Program (in coordination with the relevant District) will contact the taxpayer to discuss the issue and request further information, as necessary. If the APA Program’s review does not detect

any problems on the face of the annual report, the report is forwarded to the District with examination jurisdiction over the taxpayer – typically, the District that participated in the APA negotiations. The District is responsible for deciding whether or to what extent to audit the underlying data, for example, substantiating expenses or reviewing allocations used by the taxpayer in arriving at the conclusion that it complied with the APA.

To date, this multifunctional review procedure has indicated that taxpayers comply with the requirements of the APA in the great majority of cases. As of December 31, 1999, out of 239 annual reports that had been reviewed, the Service had identified proposed adjustments to taxable income with respect to fifteen APAs. Such adjustments totaled approximately $132 million, though in some cases these amounts have not been agreed to by the taxpayers.

2000–16 I.R.B. 943 April 17, 2000

Appendix A

MODEL ADVANCE PRICING AGREEMENT

ADVANCE PRICING AGREEMENT

between TAXPAYER

and

THE INTERNAL REVENUE SERVICE

ADVANCE PRICING AGREEMENT

between TAXPAYER

and

THE INTERNAL REVENUE SERVICE THIS ADVANCE PRICING AGREEMENT (“APA”) is made by and between Taxpayer and the Internal Revenue Service (“Service”), acting through the Associate Chief Counsel (International).

WHEREAS, Taxpayer and the Service (the “Parties”) wish to establish a method for determining whether certain prices used in international transactions involving Taxpayer are in accordance with the principles of section 482 of the Internal Revenue Code of 1986 as amended (the “Code”) and attendant Regulations and, to the extent applicable, income tax conventions to which the United States is a party;

NOW, THEREFORE, in consideration of the mutual promises contained herein, the Parties agree as follows:

1. Identifying information . Taxpayer’s EIN is __________. [Taxpayer is included in the consolidated federal income tax return filed by ________________, EIN ________. All references to Taxpayer’s United States income tax return in this APA refer to that consolidated return, and all references in this APA to “Taxpayer” shall refer to the ______________ consolidated return group.]

2. Covered transactions . This APA governs the pricing of the transactions specified in Appendix A (the “Covered Transactions”).

3. Legal Effect. 3.1. Taxpayer agrees to comply with the terms and conditions of this APA, including the transfer pricing methodology (“TPM”) that is described in Appendix A. If Taxpayer complies with the terms and conditions of this APA, then the Service will not contest the application of the TPM to the Covered Transactions and will not make or propose any reallocation or adjustment under section 482 of the Code with respect to Taxpayer concerning the transfer prices in Covered Transactions for the years covered by this APA (the “APA Years”).

3.2. Regardless of the date on which Taxpayer filed its request for this APA, Taxpayer and the Service agree, unless otherwise specified to the contrary in this APA, that Rev. Proc. 96–53, 1996–2 C.B. 375, and not any predecessor to Rev. Proc. 96–53, governs the interpretation, administration, and legal effect of this APA.

3.3. If, for any APA Year, Taxpayer does not comply with the terms and conditions of this APA, then the Service may: i. enforce the terms of this APA and propose adjustments to the income, expenses, deductions, credits, or allowances reported

on Taxpayer’s U.S. federal income tax return in keeping with the terms of this APA; ii. cancel or revoke this APA pursuant to section 11.05 or 11.06 of Rev. Proc. 96–53; or iii. revise this APA, upon agreement on revision with Taxpayer. 3.4. [This APA addresses the arm’s length nature of prices charged or received in the aggregate between Taxpayer and [name of foreign group], and except as explicitly provided in this APA does not address, and does not bind the Service with respect to, prices charged or received, or the relative amounts of income or loss realized, by particular legal entities that are members of Taxpayer or that are members of [foreign group]. The true taxable income of a member of an affiliated group filing a U.S. consolidated return shall be determined under the regulations governing consolidated returns. See, e.g., Treas. Reg. section 1.1502–12. Similarly, to the extent relevant for United States tax purposes, and except as explicitly provided in this APA, the relative amounts of income of different entities that are members of [foreign group] shall be determined under the arm’s length standard of section 482 without reference to this APA.]

3.5. The Parties agree that nonfactual oral and written representations, within the meaning of sections 10.04 and 10.05 of Rev. Proc. 96–53 (including any proposals to use particular TPMs), made in conjunction with this request constitute statements made in compromise negotiations within the meaning of Rule 408 of the Federal Rules of Evidence.

4. Term . This APA shall apply only to the APA Years, which shall include only ________________.
5. Financial Statements and APA Records . The determination whether Taxpayer has complied with this APA will be based on its United States income tax return; its financial statements as prepared in accordance with generally accepted accounting principles (“GAAP”) on a consistent basis (the “Financial Statements”); the additional records (“APA Records”) specified in Appendix B; and all information specified in section 8 of this APA. Taxpayer will not be in compliance with the TPM unless an independent certified public accountant renders an opinion that the Financial Statements present fairly, in all material respects, the financial position of Taxpayer and the results of its operations, in accordance with GAAP. Taxpayer agrees to maintain the Financial Statements and APA

April 17, 2000 944 2000–16 I.R.B.

Records and to make them available within thirty days of a request by the Service in connection with an examination described in section 11.03 of Rev. Proc. 96–53. Compliance with this section 5 of the APA will constitute compliance with the provisions of sections 6038A and 6038C of the Code, with respect to Covered Transactions during the APA Years.

6. Critical Assumptions . The Critical Assumptions of this APA, within the meaning of section 5.07 of Rev. Proc. 96–53, are listed in Appendix C.

7. Tax and Compensating Adjustments . In the event Taxpayer’s actual transactions did not result in compliance with the TPM described in Appendix A, Taxpayer’s taxable income must nevertheless be reported in an amount consistent with the TPM and the requirements of the APA, either on a timely filed original return or on an amended return. Taxpayer may make Compensating Adjustments as described in and subject to the rules of section 11.02 of Rev. Proc. 96–53, and subject to any restrictions stated in this APA.

8. Annual Report . Taxpayer shall file a timely Annual Report for each APA Year pursuant to the rules of section 11.01 of Rev. Proc. 96–53. The Annual Report shall contain the information described in Appendix D. In connection with an examination described in section 11.03 of Rev. Proc. 96–53, the District Director may request and Taxpayer shall provide additional facts, computations, data or information reasonably necessary to clarify the Annual Report or verify compliance with the APA.

9. Disclosure . This APA, and the information, data, and documents related to this APA and Taxpayer’s APA request are: (1) considered “return information” pursuant to section 6103(b)(2)(C) of the Code; and (2) not subject to public inspection as a “written determination” pursuant to section 6110(b)(1) of the Code. Pursuant to section 521 of the Tax Relief Extension Act of 1999, however, the Secretary of the Treasury is obligated to prepare a report for public disclosure that would include certain specifically designated information concerning all APAs, including this APA, in such form as not to reveal taxpayers’ identities, trade secrets, and proprietary or confidential business or financial information.

10. Disputes . Should a dispute arise concerning the interpretation of this APA, the Parties agree to seek resolution of the dispute by the Associate Chief Counsel (International), to the extent reasonably practicable, prior to seeking alternative remedies. Disputes not related to the interpretation of this APA shall be pursued consistent with section 11.03(4) of Rev. Proc. 96–53.

11. Section Captions . The section captions contained in this APA are for convenience and reference only and shall not affect in any way the interpretation or application of this APA.

12. Notice . Any notices required by this APA or Rev. Proc. 96–53 shall be in writing. Taxpayer shall send notices to the Service at the address and in the manner prescribed in section 5.13(2) of Rev. Proc. 96–53. The Service shall send notices to Taxpayer at _____________________________________.

13. Effective date . This APA shall become binding when both Parties have executed the APA [,and the competent authorities of ____________ and the United States have executed a mutual agreement that is consistent with this APA].

14. Counterparts . This APA may be executed in counterparts, with each counterpart deemed an original. IN WITNESS WHEREOF, the Parties have executed this APA on the dates indicated below.

TAXPAYER By: Date:

[Name of Signature]

[Title]

INTERNAL REVENUE SERVICE By: Date:

[Name of Signature]

[Deputy] Associate Chief Counsel (International)

APPENDIX A TRANSFER PRICING METHODOLOGY For each APA Year:

H. Covered Transactions .

The Covered Transactions for this APA consist of .

I. Transfer Pricing Methodology (“TPM”).

APPENDIX B APA RECORDS

1. All documents listed in Appendix D for inclusion in the Annual Report, as well as all documents, notes, work papers, records, or other writings that support the information provided in such documents.

2. [Insert here other records.]

2000–16 I.R.B. 945 April 17, 2000

APPENDIX C CRITICAL ASSUMPTIONS

1. The business activities, functions performed, risks assumed, assets employed, and financial [and tax] accounting methods and classifications [and methods of estimation] of Taxpayer shall remain materially the same as described or used in Taxpayer’s request for this APA.

2. [Insert here other Critical Assumptions.]

APPENDIX D ANNUAL REPORT

Taxpayer shall include the following in its Annual Report for each APA Year:

1. A statement identifying all material differences between Taxpayer’s business operations (including functions performed, risks assumed and assets employed) during the APA Year and the description of the same contained in Taxpayer’s request for this APA, or if there have been no such material differences a statement to that effect.

2. A statement identifying all material changes in Taxpayer’s accounting methods and classifications [and methods of estimation] from those described or used in Taxpayer’s request for this APA, or if there have been no such material changes a statement to that effect.

3. The Financial Statements.

4. A financial analysis demonstrating Taxpayer’s compliance with the TPM.

5. A description of any failure to meet Critical Assumptions, or if there have been no such failures, a statement to that effect.

6. A description of the reason for, and financial analysis of, any Compensating Adjustments with respect to the APA Year, including the means by which any such Compensating Adjustment has been or will be satisfied.

7. A copy of the certified public accountant’s opinion, described in section 5 of this APA, for the APA Year.

8. [Insert here other items to be included in Annual Report.]

Appendix B FORMULAS FOR BALANCE SHEET ADJUSTMENTS

Definitions of Variables:

AP = average accounts payables AR = average trade receivables, net of allowance for bad debt cogs = cost of goods sold INV = average inventory, stated on FIFO basis opex = operating expenses (general, sales, administrative, and depreciation expenses) PPE = property, plant, and equipment, net of accumulated depreciation sales = net sales

h = average holding period, stated as a fraction of a year (for AP or AR) i = interest rate

t ^{= entity being tested}

c ^{= comparable}

Equations:

If Cost of Goods Sold is controlled (generally, sales in denominator of PLI):

Receivables Adjustment (“RA”): RA = {[(ARt / salest) x salesc] - ARc} x {i/[1+(i x hc)]} Payables Adjustment (“PA”): PA = {[(APt / salest) x salesc] - APc} x {i/[1+(i x hc)]} Inventory Adjustment (“IA”): IA = {[(INVt / salest) x salesc] - INVc } x i PP&E Adjustment (“PPEA”): PPEA = {[(PPEt / salest) x salesc] - PPEc} x i

If Sales are controlled (generally, costs in the denominator of PLI): ¹⁶

16 Depending on the specific facts, the equations below may use cost of goods sold as shown or total costs, which is defined as (cogs + opex).

April 17, 2000 946 2000–16 I.R.B.

Receivables Adjustment (“RA”): RA = {[(ARt / cogst) x cogsc] - ARc} x {i/[1+(i x hc)]} Payables Adjustment (“PA”): PA = {[(APt / cogst) x cogsc] - APc} x {i/[1+(i x hc)]} Inventory Adjustment (“IA”): IA = {[(INVt / cogst) x cogsc] - INVc } x i PP&E Adjustment (“PPEA”): PPEA = {[(PPEt / cogst) x cogsc] - PPEc} x i

then:

adjusted salest = salest + RA adjusted cogst = cogst + PA - IA adjusted opext = opext - PPEA

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Correction of final regulations.

SUMMARY: This document contains corrections to final regulations (T.D. 8865, 2000–7 I.R.B. 589) which were published in the Federal Register on Tuesday, January 25, 2000 (65 FR 3820), relating to the amortization of certain intangible property.

DATES: This correction is effective January 25, 2000.

FOR FURTHER INFORMATION CONTACT: John Huffman at (202) 622-3110 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

The final regulations that are subject to these corrections are under sections 167 and 197 of the Internal Revenue Code.

Need for Correction

As published, the final regulations (TD 8865) contain errors that may prove to be misleading and are in need of clarification.

Correction of Publication

Accordingly, the publication of the final regulations (TD 8865), which were the subject of FR Doc. 00–1380, is corrected as follows:

§1.197–2 [Corrected]

1. On page 3834, column 3, §1.197–2(g)(3), line 22, the language, “increase. The provisions of paragraph” is corrected to read “increase, except as provided in §1.743–1(j)(f)(i)(B)( 2 ). The provisions of paragraph”.

2. On page 3834, column 3, §1.197–2(g)(4)(i), lines 10 through 13,

Subchapter S Subsidiaries; Cor- rection

Announcement 2000–36

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Correction to final regulations.

SUMMARY: This document contains corrections to final regulations (T.D. 8869, 2000-6 I.R.B. 498) which were published in the Federal Register on Tuesday, January 25, 2000 (65 FR 3843), relating 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.

DATES: This correction is effective January 25, 2000.

FOR FURTHER INFORMATION CONTACT: Jeanne M. Sullivan at (202) 6223050 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

The final regulations that are subject to these corrections are under sections 1361, 1362, and 1374 of the Internal Revenue Code.

Need for Correction

As published, the final regulations (T.D. 8869) contain errors that may prove to be misleading and are in need of clarification.

Correction of Publication

Accordingly, the publication of the final regulations (TD 8869), which were the subject of FR Doc. 00-1718, is corrected as follows:

1. On page 3845, column 1, under the caption “ Explanation of Provisions ”, line 14 from the top of the column, the

language, “2 I.R.B.1, which provides that the” is corrected to read “2 I.R.B. 288, which provides that the”.

2. On page 3845, column 1, the caption “b. QSUB Termination” is corrected to read “b. QSub Termination”.

§1.1361–4 [Corrected]

3. On page 3852, column 2, §1.1361–4(d) Example 3, line 15, the language, “2000, the day after the acquisition date” is corrected to read “2002, the day after the acquisition date”.

§1.1361–5 [Corrected]

4. On page 3853, column 1, §1.1361–5(b)(1)(i), line 9, the language, “corporation. he tax treatment of this” is corrected to read “corporation. The tax treatment of this”.

§1.1362–8 [Corrected]

5. On page 3855, column 3, §1.1362–8(d) Example 2 (ii), line 1, the language, “(ii) Four-fifths ($12,000/15,000) of the” is corrected to read “(ii) Four- fifths ($12,000/$15,000) of the”.

6. On page 3855, column 3, §1.1362–8(d) Example 2 (ii), line 13, the language, “Under these facts, $41 ($920/1,900 of” is corrected to read “ Under these facts, $41 ($920/$1,900 of”.

Dale D. Goode, Federal Register Liaison, Assistant Chief Counsel (Corporate).

(Filed by the Office of the Federal Register on March 27, 2000, 8:45 a.m., and published in the issue of the Federal Register for March 28, 2000, 65 F.R. 16317)

Amortization of Intangible Property; Correction

Announcement 2000–37

2000–16 I.R.B. 947 April 17, 2000

the language, “either the curative or remedial allocation methods described in the regulations under section 704(c). See §1.704–3(c) and (d)” is corrected to read “any of the permissible methods described in the regulations under section 704(c). See §1.704–3”. 3. On page 3834, column 1, §1.197–2(g)(4)(ii), line 6, the language, “the intangible is not amortizable by the” is corrected to read “the intangible is not amortizable under section 197 by the “.

4. On page 3839, column 3, §1.197–2(k) Example 6 (i), third line from the top of the column, the language “consideration paid for all assets acquired in” is corrected to read “consideration paid excluding any amount treated as interest or original issue discount under applicable provisions of the Internal Revenue Code, for all assets acquired in”.

5. On page 3839, column 3, §1.197–2(k) Example 6 (ii), lines 15 through 18, the language, “Although the payments under the agreement ($270,000) exceed the amount allocated to the covenant by $45,000, all of the remaining consideration ($50,000) is allocated to Class” is corrected to read “All of the remaining consideration after allocation to the covenant and other Class VI assets, ($50,000) is allocated to Class”.

6. On page 3839, column 3, §1.197–2(k) Example 7 (ii), line 7, the language, “amecause it does not have a term of less than” is corrected to read “amount because it does not have a term of less than”.

7. On page 3843, column 1, §1.197–2(k) Example 27 (i), lines 4 and 5, the language, “which A owns a 60-percent, and B owns a 40-percent, interest in profits and capital. A” is corrected to read “which A owns a 40-percent, and B owns a 60-percent, interest in profits and capital. A”

8. On page 3843, column 2, §1.197–2(l)(4)(iii), line 14, the language, “before a federal court, the taxpayer must” is corrected to read “ before a Federal court, the taxpayer must”.

Dale D. Goode, Federal Register Liaison, Assistant Chief Counsel (Corporate).

(Filed by the Office of the Federal Register on March 27, 2000, 8:45 a.m., and published in the issue of the Federal Register for March 28, 2000, 65 F.R. 16318)

Financial Asset Securitization Investment Trusts; Real Estate Mortgage Investments Conduits; Correction

Announcement 2000–38

This document contains a correction to proposed regulations (REG–100276–97, 2000–8 I.R.B. 682), relating to financial asset securitization investment trusts (FASITs) and real estate mortgage investment conduits (REMICs).

In the title to the document, the citation of the proposed regulation number “REG–100276–97” is incorrect. The correct citation should read as follows:

“REG–100276–97; REG–122450–98”.

Deletions From Cumulative List of Organizations Contributions to Which Are Deductible Under Section 170 of the Code

Announcement 2000–39

The name of organizations that no longer qualify as organizations described in section 170(c)(2) of the Internal Revenue Code of 1986 are listed below.

Generally, the Service will not disallow deductions for contributions made to a listed organization on or before the date of announcement in the Internal Revenue Bulletin that an organization no longer qualifies. However, the Service is not precluded from disallowing a deduction for any contributions made after an organization ceases to qualify under section 170(c)(2) if the organization has not timely filed a suit for declaratory judgment under section 7428 and if the contributor (1) had knowledge of the revocation of the ruling or determination letter, (2) was aware that such revocation was imminent, or (3) was in part responsible for or was aware of the activities or omissions of the organization that brought about this revocation.

If on the other hand a suit for declaratory judgment has been timely filed, contributions from individuals and organizations described in section 170(c)(2) that are otherwise allowable will continue to be deductible. Protection under section 7428(c) would begin on April 17, 2000, and would end on the date the court first determines that the organiza

Taxation of Tax-Exempt Organizations’ Income From Corporate Sponsorship; Correction

Announcement 2000–40

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Correction to notice of proposed rulemaking and notice of public hearing.

SUMMARY: This document contains corrections to proposed regulations (REG–209601–92, 2000–12 I.R.B. 829), which were published in the Federal Register on Wednesday, March 1, 2000 (65 FR 11012), relating to the tax treatment of sponsorship payments received by exempt organizations.

FOR FURTHER INFORMATION CONTACT: Stephanie Lucas Caden at (202) 622-6080.

SUPPLEMENTARY INFORMATION:

Background

The proposed regulations that are the subject of this correction are under section 512 of the Internal Revenue Code.

tion is not described in section 170(c)(2) as more particularly set forth in section 7428 (c)(1). For individual contributors, the maximum deduction protected is $1,000, with a husband and wife treated as one contributor. This benefit is not extended to any individual, in whole or in part, for the acts or omissions of the organization that were the basis for revocation.

Aguila Improvement Association, Inc.

Aguila, AZ Arizona Educational Enrichment Trust

Phoenix, AZ Central Arizona Charitable Trust

Phoenix, AZ Liberation Collective

Portland, OR Peoria Charitable Trust

Phoenix, AZ Southern California Institute, Inc.

Loma Linda, CA WorkAmerica, Inc.

Pomoroy, OH

April 17, 2000 948 2000–16 I.R.B.

§1.1320–9(b), A-21, paragraph (a), line 2, the language “Employer-and” is corrected to read “Employer and”.

6. On page 4395, column 2, §1.132–9(b), A-21, paragraph (b), line 8, the language “132(f)(5)(B) and Q/A2- of this section.” is corrected to read “132(f)(5)(B) and Q/A-2 of this section.”.

7. On page 4396, column 1, §1.132–9(b), A-22, paragraph (b), line 7, the language “monthly limit under section 132(f) are” is corrected to read “monthly limit under section 132(f) is”.

8. On page 4396, column 3, the title of the official signing the document, “Commissioner of Internal Revenue” is corrected to read “Deputy Commissioner of Internal Revenue Service”.

Dale D. Goode, Federal Register Liaison, Assistant Chief Counsel (Corporate).

(Filed by the Office of the Federal Register on March 28, 2000, 8:45 a.m., and published in the issue of the Federal Register for March 29, 2000, 65 F.R. 16545)

Partial Withdrawal of Notice of Proposed Rulemaking Relating to Diesel Fuel Excise Tax; Dye Injection Systems

Announcement 2000–42

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Partial withdrawal of notice of proposed rulemaking.

SUMMARY: This document withdraws the notice of proposed rulemaking as it relates to diesel fuel dye injection systems, which was published on March 14, 1996. It affects certain enterers, refiners, terminal operators, and throughputters.

FOR FURTHER INFORMATION CONTACT: Frank Boland, (202) 622-3130 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

On March 14, 1996, the IRS issued proposed regulations (PS-6-95 [1996–1 C.B. 859]; REG–209753–95) relating to diesel fuel dye injection systems and the

Need for Correction

As published, the proposed regulations

[REG–209601–92] contain errors that may prove to be misleading and are in need of clarification.

Correction of Publication

Accordingly, the publication of the proposed regulations [REG–209601–92], which were the subject of FR Doc. 00–4848, is corrected as follows:

1. On page 11012, third column, in the preamble, the last sentence under the caption ADDRESSES is corrected to read, “The public hearing will be held in room 4718, Internal Revenue Building, 1111 Constitution Avenue, NW., Washington, DC.”.

2. On page 11012, third column, in the preamble, the text under the caption FOR is corrected to read, “Concerning the regulations, Stephanie Lucas Caden at (202) 622–6080; concerning submissions and the hearing, LaNita VanDyke at (202) 622-7180 (not toll-free numbers).”.

3. On page 11015, second column, the first sentence of the second paragraph under the caption Comments and Public Hearing is corrected to read, “A public hearing has been scheduled for June 21, 2000, at 10 a.m. in room 4718, Internal Revenue Building, 1111 Constitution Avenue, NW., Washington, DC.”.

§1.513–4 [Corrected]

4. On page 11018, third column, in the 22 ^nd line of §1.513–4(f) Example 8, the language “Music Shop’s name and address in the lobby” is corrected to read, “Music Shop’s name, address and telephone number in the lobby”.

Dale D. Goode, Federal Register Liaison, Assistant Chief Counsel (Corporate).

(Filed by the Office of the Federal Register on April 4, 2000, 8:45 a.m., and published in the issue of the Federal Register for April 5, 2000, 65 F.R. 17829)

Qualified Transportation Fringe Benefits; Correction

Announcement 2000–41

AGENCY: Internal Revenue Service

(IRS), Treasury. ACTION: Correction to the notice of proposed rulemaking.

SUMMARY: This document contains corrections to proposed regulations (REG–113572–99, 2000–7 I.R.B. 624) which were published in the Federal Register on Thursday, January 27, 2000 (65 F.R. 4388), relating to qualified transportation fringe benefits.

FOR FURTHER INFORMATION CONTACT: John Richards at (202)622-6040 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

The proposed regulations that are the subject of these corrections reflect the changes to the law made by the Energy Policy Act of 1992, the Taxpayer Relief Act of 1997, and the Transportation Equity Act for the 21st Century.

Need for Correction

As published, this notice of proposed rulemaking contains errors in need of clarification.

Correction of Publication

Accordingly, the publication of the notice of proposed rulemaking (REG– 113572–99), which was the subject of FR Doc. 00–1859, is corrected as follows:

§1.132–9 [Corrected]

1. On page 4392, column 2, §1.132–9(b), A-7, paragraph (d), line 3, the language “Q/A7” is corrected to read “Q-A-7”.

2. On page 4293, column 1, §1.132–9(b), Q-11, line 2, the language “fringes be provided pursuant to a” is corrected to read “fringes be provided to employees pursuant to a”.

3. On page 4393, column 3, §1.132–9(b), A-14, paragraph (d), line 4, the language “paragraph (a)(3) of the Q/A-14, an” is corrected to read “paragraph (c) of this Q/A-14, an”.

4. On page 4395, column 1, §1.132–9(b), Q-16, paragraph (d)(2), line 8, the language “that it will be used it during the month.” is corrected to read “that it will be used during the month.”.

5. On page 4395, column 2,

2000–16 I.R.B. 949 April 17, 2000

measurement of taxable fuel (61 FR 10490). The Treasury Department does not have any plans at the present time to issue final regulations relating to dye injection systems.

• ---

Withdrawal of Notice of Proposed Rulemaking

Accordingly, under the authority of 26 U.S.C. 7805, the notice of proposed rulemaking as it relates to dye injection systems that was published in the Federal Register on March 14, 1996 (61 FR 10490) is withdrawn.

Robert E. Wenzel, Deputy Commissioner

of Internal Revenue.

(Filed by the Office of the Federal Register on March 30, 2000, 8:45 a.m., and published in the issue of the Federal Register for March 31, 2000, 65 F.R. 17211)

April 17, 2000 950 2000–16 I.R.B.