Part IV. Items — Internal Revenue Bulletin 2001-4

section 641(c) by the Internal Revenue Service Restructuring and Reform Act of 1998, Public Law 105–206 (112 Stat. 6007(f)(2)) (July 22, 1998).

Explanation of Provisions

Overview

Prior to the 1996 Act, the only trusts that were permitted S corporation shareholders were wholly-owned grantor trusts, voting trusts, certain grantor trusts after the grantor’s death, and qualified subchapter S trusts (QSSTs). These trusts are not taxed at the trust level, and the deemed owner or owners are taxed directly on the tax items of the trusts, except for certain testamentary trusts described in §1.1361–1(j)(7)(ii). QSSTs are required to have a single income beneficiary, and all of the income must be currently distributed to such beneficiary. The 1996 Act created ESBTs to allow more flexibility in the types of trusts that are permitted S corporation shareholders and, in particular, to facilitate family financial planning. H. Rep. No. 586, 104 ^th Cong., 2d Sess. 82 (1996), S. Rep. No. 281, 104 ^th Cong., 2d Sess. 46 (1996). Unlike a QSST, an ESBT may have multiple beneficiaries and may also accumulate trust income.

Section 1361(e)(1) defines the term electing small business trust as any trust if: (1) the trust does not have as a beneficiary any person other than an individual, an estate, or an organization described in section 170(c)(2) through (5); (2) no interest in the trust was acquired by purchase; and (3) an election has been made with respect to the trust.

Section 1361(c)(2)(B)(v) provides that, for purposes of section 1361(b)(1) (the S corporation shareholder limitations), each potential current beneficiary of an ESBT will be treated as a shareholder. During any period that there is no potential current beneficiary of an ESBT, the trust shall be treated as the shareholder.

ESBT Beneficiaries

Notice 97–49 (1997–2 C.B. 304) clarifies the definitions of beneficiary (for purposes of section 1361(e)(1)(A)(i)) and potential current beneficiary (for purposes of section 1361(e)(2)) and also clarifies

Notice of Proposed Rulemaking; Notice of Proposed Rulemaking by Cross Reference to Temporary Regulations; and Notice of Public Hearing

Electing Small Business Trust

REG–251701–96

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking; notice of proposed rulemaking by cross reference to temporary regulations; and notice of public hearing.

SUMMARY: This document contains proposed regulations relating to the qualification and treatment of electing small business trusts (ESBTs). The proposed regulations interpret the rules added to the Internal Revenue Code (Code) by section 1302 of the Small Business Job Protection Act of 1996 and section 1601 of the Taxpayer Relief Act of 1997. In addition, the text of the temporary regulations published in T.D. 8915, page 359, also serves as the text of these proposed regulations with respect to an ESBT or a trust described in section 401(a) or section 501(c)(3) that is exempt from taxation under section 501(a) not being treated as a deferral entity for purposes of §1.444–2T. The proposed regulations affect S corporations and certain trusts that own S corporation stock. This document also provides notice of a public hearing on these regulations.

DATES: Written or electronic comments must be received by April 4, 2001. Requests to speak (with outlines of oral comments to be discussed) at a public hearing scheduled for April 25, 2001, at 10 a.m. must be received by April 4, 2001.

ADDRESSES: Send submissions to: CC:M&SP:RU (REG–251701–96), room 5226, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand delivered between the hours of 8 a.m. and 5 p.m. to: CC:M&SP:RU (REG–251701–96), 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 the Internal Revenue Building Auditorium, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, Bradford Poston or James A. Quinn, (202) 622-3060; concerning submissions and the hearing, Sonya M. Cruz, (202) 622-7190; (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information in this notice of proposed rulemaking have been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under control numbers 1545–1523 and 1545–1591. An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a valid control number assigned by the Office of Management and Budget.

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

Background

This document contains proposed amendments to the Income Tax Regulations (26 CFR Part 1) relating to S corporations and electing small business trusts (ESBTs). Section 1302 of the Small Business Job Protection Act of 1996, Public Law 104–188 (110 Stat. 1755) (August 20, 1996) (the 1996 Act), amended sections 641 and 1361 of the Code to permit an ESBT to be an S corporation shareholder. Further amendments were made to section 1361(e) by the Taxpayer Relief Act of 1997, Public Law 105–34 (111 Stat. 1601(c)(1)) (August 5, 1997). Prior section 641(d) was redesignated as

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the treatment of ESBT distributions. The proposed regulations, when finalized, will modify and replace the rules of Notice 97–49.

Beneficiary

The proposed regulations provide guidance as to who is an ESBT beneficiary. Generally, a beneficiary includes any person who has a present, remainder, or reversionary interest in the trust other than a remote, contingent interest. If an ESBT makes distributions to another trust (the distributee trust), the distributee trust is not treated as a beneficiary of the ESBT. However, the beneficiaries of the distributee trust will be counted as beneficiaries of the ESBT. Persons whose future beneficial interest is so remote as to be negligible are not beneficiaries. Generally, when the probability that a person will receive any distribution from the trust is less than 5 percent, at a particular time, that person’s interest would be so remote as to be negligible. Finally, the term ben- eficiary does not include a person in whose favor a power of appointment may be exercised until the power is actually exercised.

Interests Acquired by Purchase

The proposed regulations provide guidance regarding the prohibition on acquiring an interest in an ESBT by purchase. The proposed regulations provide that the prohibition applies if any portion of a beneficiary’s basis in the beneficiary’s interest is determined under section 1012. Thus, a part-gift, part-sale of a beneficial interest will terminate the trust’s status as an ESBT. Beneficiaries may not purchase interests in the trust, but the ESBT itself is allowed to purchase S corporation stock.

Grantor Trusts

The proposed regulations provide that a trust, all or a portion of which is treated as owned by an individual under subpart E, part I, subchapter J, chapter 1 of the Internal Revenue Code (Code) (a grantor trust), may elect to be an ESBT. The Treasury Department and the IRS believe that Congress did not intend to preclude this type of trust, which is a common family estate planning tool, from electing ESBT status. The proposed regulations

provide rules for the treatment of grantor trusts electing ESBT status.

Potential Current Beneficiaries

The proposed regulations provide that the term potential current beneficiary means, with respect to any period, any person who at any time during such period is entitled to, or at the discretion of any person may receive, a distribution from the principal or income of the trust. In general, a person who may receive a distribution from the ESBT under a currently exercisable power of appointment is a potential current beneficiary. In addition, in the case of an ESBT that is a grantor trust, the proposed regulations provide that the deemed owner of the grantor trust is also to be treated as a potential current beneficiary.

Under the definitions set forth in the proposed regulations, a potential current beneficiary is not necessarily a beneficiary of the trust and vice versa. For example, a person in whose favor property could currently be appointed, but to whom no such appointment has been made, is a potential current beneficiary, but not a beneficiary. Conversely, a person who is a non-contingent remainder beneficiary of a non-grantor trust is a beneficiary, but not a potential current beneficiary.

The proposed regulations provide special rules if current distributions can be made to a distributee trust. If the distributee trust does not qualify to be a shareholder of an S corporation under section 1361(c)(2)(A), then the trust is considered the potential current beneficiary and thus a shareholder. In that case, the corporation’s S election terminates because the corporation has an ineligible shareholder. For this purpose, a trust is deemed to qualify to be a shareholder of an S corporation under section 1361(c)(2)(A) if it would be eligible to make a QSST or ESBT election if it owned S corporation stock.

If the distributee trust does qualify to be a shareholder of an S corporation under section 1361(c)(2)(A), in general, the potential current beneficiaries of the distributing ESBT will include the potential current beneficiaries of the distributee trust. However, if the distributee trust is a former grantor trust prior to the owner’s death (that is, a trust described in section 1361(c)(2)(A)(ii)), or is a trust receiving a

distribution of S stock from a decedent’s estate (that is, a trust described in section 1361(c)(2)(A)(iii)), the estate of the decedent is treated as the only potential current beneficiary of the trust . In no case will the same person be counted twice when determining the number of S corporation shareholders.

ESBT Election

Notice 97–12 (1997–1 C.B. 385) provides the procedures for making the ESBT election. Under that notice, the ESBT election is required to contain certain information and representations, and is required to be filed with the service center where the S corporation files its income tax returns. These proposed regulations, when finalized, will modify and replace the rules in Notice 97–12.

Under the proposed regulations, the trustee of an ESBT makes a single ESBT election by filing a statement with the service center where the ESBT files its Form 1041, U.S. Income Tax Return for Estates and Trusts. This procedure will be more convenient for taxpayers than the procedures of Notice 97–12 if the ESBT holds stock in more than one S corporation. No trust documents are required to be attached to the election statement.

The proposed regulations provide that if a trust satisfies the ESBT requirements and makes an ESBT election, the trust will be treated as an ESBT for federal income tax purposes as of the effective date of the ESBT election. These effective dates generally follow the rules of §1.1361–1(j)(6)(iii) for qualified subchapter S trust (QSST) elections. Protective ESBT elections, which are intended to become effective only if the trust fails to satisfy the requirements for a trust described in section 1361(c)(2)(A)(i) through (iv), are prohibited. Unlike a protective QSST election, a protective ESBT election could result in a change in the incidence of taxation from the owner of the trust to the trust itself. If a trust fails to qualify as an eligible S corporation shareholder under section 1361(c)(2), and consequently the S corporation election is ineffective or terminated, relief may be available under section 1362(f) for an inadvertent ineffective S corporation election or an inadvertent S corporation termination.

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already an eligible S corporation shareholder and the trust makes an ESBT election during the trust’s taxable year, the electing trust will be treated as a separate taxpayer for purposes of allocating S corporation items under section 1377(a)(1). However, the ESBT election does not result in the prior trust being treated as terminating its entire interest in its S corporation stock for purposes of §1.1377–1(b), unless the prior trust is one described in section 1361(c)(2)(A)(ii) or (iii). Therefore, the S corporation is generally not permitted to make the election to terminate the taxable year under section 1377(a)(2). The trust will be treated as a single taxpayer for purposes of determining the taxation of distributions from the trust. Thus, distributions made after the effective date of the ESBT election may still carry out distributable net income of the trust earned during the taxable year before the effective date of the ESBT election.

The proposed regulations provide that for purposes of determining whether the exception to estimated taxes under section 6654(d)(1)(B) applies, the trust will not be considered a different taxpayer as a result of the ESBT election. Therefore, if the ESBT makes estimated tax payments equal to 100 percent of the prior year’s tax liability, no penalties will apply.

The proposed regulations provide that interest expenses paid on loans used to purchase the S corporation stock must be allocated to the S portion of the ESBT but are not deductible by the S portion because they are not administrative expenses.

ESBT Terminations

The proposed regulations provide that generally a trustee must seek the consent of the Commissioner to revoke its ESBT election by obtaining a private letter ruling. However, the Commissioner’s consent is granted for revocations that occur on the conversion of an ESBT to a QSST under the procedures set forth in the proposed regulations.

The proposed regulations provide that if an ESBT fails to meet the definitional requirements of an ESBT under section 1361(e), the trust’s ESBT status terminates immediately upon such failure to qualify. However, if an ESBT acquires an ineligible potential current beneficia

Conversions of QSSTs and ESBTs

Rev. Proc. 98–23 (1998–1 C.B. 662) provides procedures for the conversion of a QSST to an ESBT and an ESBT to a QSST. The proposed regulations, when finalized, will modify and replace the procedures of Rev. Proc. 98–23 and provide rules with respect to these conversions.

The conversion procedure provided in the proposed regulations differs from that provided in Rev. Proc. 98–23, in that the election must be filed with the service center where the trust files its income tax return, as well as with the service center where the S corporation files its income tax return. The election must be filed in both service centers if the service center for the trust is different from the service center for the S corporation because QSST elections are filed with the service center where the S corporation files its income tax return and ESBT elections will be filed where the trust files its income tax return under the new procedures set forth in these proposed regulations, when finalized. The IRS and the Treasury Department specifically request comments on whether the rules for filing QSST elections similarly should be changed to permit the filing of a QSST election with the service center where the trust files its return rather than with the service center for the S corporation(s).

Consent to the S Corporation Election

Notice 97–12 provides that, for purposes of the ESBT’s consent to the S corporation election under section 1362(a), only the trustee needs to consent to the S corporation election because the ESBT is taxed on the S corporation’s income and the trustee makes the ESBT election. These proposed regulations, when finalized, will modify and replace the rules in Notice 97–12.

Under the proposed regulations, if the ESBT is also a grantor trust, the deemed owner must also consent to the S corporation election because such owner will be taxed on all or a portion of the S corporation’s income. If there is more than one trustee, the trustee or trustees with authority to legally bind the trust must consent to the S corporation election.

ESBT Taxation

The proposed regulations provide that, for federal income tax purposes, an ESBT

consists of an S portion, a non-S portion, and in some instances a grantor portion. The items of income, deduction, and credit attributable to any portion of the ESBT treated as owned by a person under the grantor trust rules of subpart E, including S corporation stock and other property (the grantor portion), are taken into account on that individual’s tax return pursuant to the normal rules applicable to grantor trusts. Other items of income, deduction, and credit are, pursuant to these proposed regulations, attributed to either the S portion, which includes the S corporation stock, or the non-S portion, which includes all other assets of the trust. The S portion is subject to tax under the special rules of section 641(c), while the non-S portion is subject to the normal trust taxation rules of subparts A through D of subchapter J.

The proposed regulations provide that if an otherwise allowable deduction of the S portion is attributable to a charitable contribution paid by the S corporation, the contribution will be deemed to be paid by the S portion pursuant to the terms of the trust’s governing instrument within the meaning of section 642(c)(1). The other requirements of section 642(c)(1) must also be met for the contribution to be deductible by the S portion, and the deduction is limited to the amount of the gross income of the S portion. If a payment is made to a charitable organization by the ESBT pursuant to the terms of its governing instrument, such payment is deductible, subject to the provisions of section 642(c)(1), to the extent it is paid from the gross income of the non-S portion of the trust. Thus, if the ESBT contributes S corporation stock to a charitable organization, no deduction is allowed under section 642(c)(1) because the contribution is not paid out of the gross income of the non-S portion.

The proposed regulations provide guidance regarding the treatment of proceeds received by an ESBT from the sale of S corporation stock when income from the sale is reported on the installment method under section 453. The income recognized with respect to the installment proceeds is taken into account by the S portion. The interest on the installment obligation is taken into account by the non-S portion.

The proposed regulations provide that if a trust holds S corporation stock and is

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ry, the ESBT has 60 days in which to dispose of all of its S corporation stock to prevent termination of the S corporation election. If the S corporation stock is not disposed of within the 60-day period, then the S corporation election will terminate as of the first day that the ineligible person became a potential current beneficiary.

Finally, the proposed regulations provide that an ESBT election generally is terminated if the ESBT fails to hold any S corporation stock. However, a trust will continue to be treated as an ESBT if it is reporting income from the sale of S corporation stock under the installment method of section 453.

Section 444 Elections

The text of the temporary regulations published in T.D. 8915 serves as the text of these proposed regulations with respect to an ESBT and a trust described in section 401(a) or section 501(c)(3) that is exempt from taxation under section 501(a). These temporary regulations provide that an ESBT and a trust described in section 401(a) or section 501(c)(3) that is exempt from taxation under section 501(a) are not deferral entities for purposes of §1.444–2T.

Proposed Effective Date

The regulations regarding ESBTs under §1.641–1(d) through (k), §1.1361–1(h)(1)(vi), (h)(3)(i)(F), (j)(12), and (m), §1.1362–6(b)(2)(iv), §1.1377–1(a)(2)(iii) and (c) Example 3 are proposed to apply on and after the date the final regulations are published in the Federal Register . The IRS and the Treasury Department have become aware of potentially abusive transactions involving ESBTs that assume the applicability of the rules of section 641(c) to the taxation of the grantor portion of such trusts. See Notice 2000–61, 2000–49 I.R.B. 1. Thus, the regulations regarding taxation of ESBTs under §1.641(c)–1(a), (b) and (c) are proposed to be applicable for taxable years of ESBTs that end on and after the proposed regulations are filed in the Federal Register .

Effect on Other Documents

The following documents are proposed to be superseded as of the date the final

regulations are published in the Federal Register :

Notice 97–12 (1997–1 C.B. 385). Notice 97–49 (1997–2 C.B. 304). Rev. Proc. 98–23 (1998–1 C.B. 662).

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 is hereby certified that the collection of information in the regulations will not have a significant economic impact on a substantial number of small entities. This certification is based upon the fact that the estimated average burden per trust in complying with the collections of information in §1.1361–1(m) is 1 hour. Therefore, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of the Code, 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 business.

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 Treasury Department specifically request comments on the clarity of the proposed regulations and how they can be made easier to understand. All comments will be available for public inspection and copying.

A public hearing has been scheduled for April 25, 2001, at 10:00 a.m. in the Internal Revenue Building Auditorium, 1111 Constitution Avenue NW., Washington, DC. Because of access restrictions, visitors will not be admitted beyond the Internal Revenue Building lobby more than 15 minutes before the hearing starts.

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 by April 4, 2001, 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 April 4, 2001.

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 authors of these regulations are Bradford Poston and James A. Quinn of the Office of Associate Chief Counsel (Passthroughs and Special Industries), IRS. However, other personnel from the IRS and Treasury Department participated in their development.

Proposed Amendments to the Regulations

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

PART I—INCOME TAXES

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

Authority: 26 U.S.C. 7805. * * * Section 1.444–4 is also issued under 26 U.S.C. 444(g).

Par. 2. Section 1.444–4 is added to read as follows:

§1.444–4 Tiered structure.

[The text of this proposed section is the same as the text of §1.444–4T published T.D. 8915].

Par. 3. Sections 1.641(c)–0 and 1.641(c)–1 are added to read as follows:

§ 1.641(c)–0 Table of contents.

This section lists the following captions contained in §1.641(c)–1:

§1.641(c)–1 Electing small business trust.

(a) In general. (b) Definitions. (1) Grantor portion. (2) S portion. (3) Non-S portion. (c) Taxation of grantor portion.

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(d) Taxation of S portion. (1) In general. (2) Section 1366 amounts. (3) Gains and losses on disposition of S stock. (4) State and local income taxes and administrative expenses. (e) Tax rates and exemption of S portion. (1) Income tax rate. (2) Alternative minimum tax exemption. (f) Taxation of non-S portion. (1) In general. (2) Dividend income under section 1368(c)(2). (3) Interest on installment obligations. (4) Charitable deduction. (g) Allocation of state and local income taxes and administration expenses. (h) Treatment of distributions from the trust. (i) Termination or revocation of ESBT election. (j) Effective date. (k) Examples.

§ 1.641(c)–1 Electing small business trust.

(a) In general . An electing small business trust (ESBT) within the meaning of section 1361(e) is treated as two separate trusts for purposes of determining income tax. The portion of an ESBT that consists of stock in one or more S corporations (the S portion) is treated as one trust. The portion of an ESBT that consists of all the other assets in the trust is treated as a separate trust. The grantor or another person may be treated as the owner of all or a portion of either or both such trusts under subpart E, part I, subchapter J, chapter 1 of the Internal Revenue Code. In addition, the non-S portion may consist of more than one share pursuant to section 663(c). See § 1.1361–1(m) for the treatment of an ESBT as a single trust for administrative purposes.

(b) Definitions —(1) Grantor portion . The grantor portion of an ESBT is the portion of the trust that is treated as owned by the grantor or another person under subpart E.

(2) S portion . The S portion of an ESBT is the portion of the trust that consists of S corporation stock and that is not treated as owned by the grantor or anoth

er person under subpart E.

(3) Non-S portion . The non-S portion of an ESBT is the portion of the trust that consists of all assets other than S corporation stock and that is not treated as owned by the grantor or another person under subpart E.

(c) Taxation of grantor portion . The grantor or another person who is treated as the owner of a portion of the ESBT includes in computing taxable income items of income, deductions, and credits against tax attributable to that portion of the ESBT under section 671.

(d) Taxation of S portion —(1) In gener- al . The taxable income of the S portion is determined by taking into account only the items of income, loss, deduction, or credit specified in paragraphs (d)(2), (3), and (4) of this section, to the extent not attributable to the grantor portion.

(2) Section 1366 amounts —(i) In gener- al . The S portion takes into account the items of income, loss, deduction, or credit that are taken into account by an S corporation shareholder pursuant to section 1366 and the regulations thereunder. Normal rules applicable to trusts apply in determining the extent to which any loss, deduction, or credit may be taken into account in determining the taxable income of the S portion. See § 1.1361–1(m)(3)(iv) for allocation of those items in the taxable year in which the ESBT election is made if, before the effective date of the election, the trust was a shareholder of the S corporation.

(ii) Special rule for charitable contri- butions . If a deduction described in paragraph (d)(2)(i) of this section is attributable to a charitable contribution paid by the S corporation, the contribution will be deemed to be paid by the S portion pursuant to the terms of the trust’s governing instrument within the meaning of section 642(c)(1) . The other requirements of section 642(c)(1) must also be met for the contribution to be deductible in computing the taxable income of the S portion. Such a deduction cannot exceed the amount of gross income of the S portion.

(iii) Multiple S corporations . If an ESBT owns stock in more than one S corporation, items of income, loss, deduction, or credit from all the S corporations are aggregated for purposes of determining the S portion’s taxable income.

(3) Gains and losses on disposition of S stock —(i) In general . The S portion takes into account any gain or loss from the disposition of S corporation stock. No deduction is allowed under section 1211(b)(1) and (2) for capital losses that exceed capital gains.

(ii) Installment method . If income from the sale or disposition of stock in an S corporation is reported by the trust on the installment method, the income recognized under this method is taken into account by the S portion. See paragraph (f)(3) of this section for the treatment of interest on the installment obligation. See §1.1361–1(m)(5)(ii) regarding treatment of a trust as an ESBT upon the sale of all S corporation stock using the installment method.

(iii) Distributions in excess of basis. Gain recognized under section 1368(b)(2) from distributions in excess of the ESBT’s basis in its S corporation stock is taken into account by the S portion.

(4) State and local income taxes and administrative expenses —(i) In general . State and local income taxes and administrative expenses directly related to the S portion and those allocated to that portion in accordance with paragraph (g) are taken into account by the S portion.

(ii) Special rule for certain interest . Interest paid by the trust on money borrowed by the trust to purchase stock in an S corporation is allocated to the S portion but is not a deductible administrative expense for purposes of determining the taxable income of the S portion.

(e) Tax rates and exemption of S por- tion —(1) Income tax rate . Except for capital gains, the highest marginal trust rate provided in section 1(e) is applied to the taxable income of the S portion. See section 1(h) for the rates that apply to the S portion’s net capital gain.

(2) Alternative minimum tax exemption . The exemption amount of the S portion under section 55(d) is zero.

(f) Taxation of non-S portion —(1) In general . The taxable income of the non-S portion is determined by taking into account all items of income, deduction, and credit to the extent not taken into account by either the grantor portion or the S portion. The items attributable to the non-S portion are taxed under subparts A through D of part I, subchapter J, chapter 1 of the Internal Revenue Code.

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(2) Dividend income under section 1368(c)(2) . Any dividend income within the meaning of section 1368(c)(2) is includible in the gross income of the nonS portion.

(3) Interest on installment obligations . If income from the sale or disposition of stock in an S corporation is reported by the trust on the installment method, the interest on the installment obligation is includible in the gross income of the nonS portion. See paragraph (d)(3)(ii) of this section for the treatment of income from such a sale or disposition.

(4) Charitable deduction . For purposes of applying section 642(c)(1) to payments made by the trust for a charitable purpose, the amount of gross income of the trust is limited to the gross income of the non-S portion. See paragraph (d)(2)(ii) of this section for special rules concerning charitable contributions paid by the S corporation that are deemed to be paid by the S portion.

(g) Allocation of state and local income taxes and administration expens- es . Whenever state and local income taxes or administration expenses relate to more than one portion of an ESBT, they must be allocated between or among the portions to which they relate. These items may be allocated in any manner

that is reasonable in light of all the circumstances, including the terms of the governing instrument, local law, and the practice of the trustee with respect to the trust if it is reasonable and consistent. The taxes and expenses apportioned to each portion of the ESBT are taken into account by that portion.

(h) Treatment of distributions from the trust . Distributions to beneficiaries from the S portion or the non-S portion, including distributions of the S corporation stock, are deductible under section 651 or 661 in determining the taxable income of the non-S portion, and are included in the gross income of the beneficiaries under section 652 or 662. However, the amount of the deduction or inclusion cannot exceed the amount of the distributable net income of the non-S portion. Items taken into account by the grantor portion or the S portion are excluded for purposes of determining the distributable net income of the non-S portion of the trust.

(i) Termination or revocation of ESBT election . If the ESBT election of the trust terminates pursuant to §1.1361–1(m)(5) or the ESBT election is revoked pursuant to §1.1361–1(m)(6), the rules contained in this section are thereafter not applicable to the trust. If, upon termination or revocation, the S portion has a net operating

loss under section 172; a capital loss carryover under section 1212; or deductions in excess of gross income; then any such loss, carryover, or excess deductions shall be allowed as a deduction, in accordance with the regulations under section 642(h), to the trust, or to the beneficiaries succeeding to the property of the trust if the entire trust terminates.

(j) Effective date . This section generally is applicable on and after the date the final regulations are published in the Federal Register . However, paragraphs (a), (b) and (c) of this section are applicable for taxable years of ESBTs that end on and after December 28, 2000.

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

Example 1 . Comprehensive example . (i) Trust has a valid ESBT election in effect. Under section 678, B is treated as the owner of a portion of Trust consisting of a 10% undivided fractional interest in Trust. No other person is treated as the owner of any other portion of Trust under subpart E, part I, subchapter J. Trust owns stock in X, an S corporation, and in Y, a C corporation. During 2000, Trust receives a distribution from X of $5,100, of which $5,000 is applied against Trust’s adjusted basis in the X stock in accordance with section 1368(c)(1) and $100 is a dividend under section 1368(c)(2). Trust makes no distributions to its beneficiaries during the year.

(ii) For 2000, Trust has the following items of income and deduction:

Ordinary income attributable to X under section 1366Y . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$5,000 Dividend income from Y . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$900 Dividend from X representing C corporation earnings and profits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$100

Total trust income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$6,000

Charitable contributions attributable to X under section1366 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$300 Trustee fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$200 State and local income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$100

(iii) Trust’s items of income and deduction are divided into a grantor portion, an S portion, and a non-S portion for purposes of determining the taxation of those items. Income is allocated to each portion as follows:

B must take into account the items of income attributable to the grantor portion, that is, 10% of each item, as follows: Ordinary income from X . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$500 Dividend income from Y . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$90 Dividend income from X . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$10 Total grantor portion income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$600

The total income of the S portion is $4,500, determined as follows: Ordinary income from X . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$5,000 Less: Grantor portion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .($500) Total S portion income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$4,500

The total income of the non-S portion is $900 determined as follows: Dividend income from Y (less grantor portion) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$810 Dividend income from X (less grantor portion) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$90 Total non-S portion income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$900

(iv) The administrative expenses and the state and local income taxes relate to all three portions and under state law would be allocated ratably to the $6,000 of trust income. Thus, these items would be allocated 10% (600/6000) to the grantor portion, 75% (4500/6000) to the S portion and 15% (900/6000) to the non-S portion.

(v) B must take into account the following deductions attributable to the grantor portion of the trust:

Charitable contributions from X . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$30

2001–4 I.R.B. 401 January 22, 2001

Trustee fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$20 State and local income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$10

(vi) The taxable income of the S portion is $4,005, determined as follows: Ordinary income from X . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$4,500 Less: Charitable contributions from X (less grantor portion) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .($270)

75% of trustee fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .($150) 75% of state and local income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .($75) Taxable income of S portion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$4,005

(vii) The taxable income of the non-S portion is $755, determined as follows: Dividend income from Y . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$810 Dividend income from X . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$90

Total non-S portion income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$900 Less: 15 % of trustee fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .($30)

15% state and local income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .($15) Personal exemption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .($100) Taxable income of non-S portion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$755

Example 2 . Sale of S stock . Trust has a valid ESBT election in effect and owns stock in X, an S corporation. No person is treated as the owner of any portion of Trust under subpart E, part I, subchapter J. In 2001, Trust sells all of its stock in X and recognizes a capital gain of $5,000. This gain is taken into account by the S portion and is taxed using the appropriate capital gain rate found in section 1(h).

Example 3 . (i) Sale of S stock for an installment note . Assume the same facts as in Example 2, except that Trust sells its stock in X for a $400,000 installment note payable with stated interest over ten years. After the sale, Trust does not own any S corporation stock.

(ii) Loss on installment sale . Assume Trust’s basis in its X stock was $500,000. Therefore, Trust sustains a capital loss of $100,000 on the sale. Upon the sale, the S portion terminates and the excess loss, after being netted against the other items taken into account by the S portion, is made available to the entire trust as provided in section 641(c)(4).

(iii) Gain on installment sale . Assume Trust’s basis in its X stock was $300,000 and that the $100,000 gain will be recognized under the installment method of section 453. Interest income will be recognized annually as part of the installment payments. The portion of the $100,000 gain recognized annually is taken into account by the S portion. However, the annual interest income is includible in the gross income of the non-S portion.

Example 4 . Charitable lead annuity trust . Trust is a charitable lead annuity trust which is not treated as owned by the grantor or another person under subpart E. Trust acquires stock in X, an S corporation, and elects to be an ESBT. During the taxable year, pursuant to its terms, Trust pays $10,000 to a section 170(c)(2) charitable organization. The non-S portion of Trust receives an income tax deduction for the charitable contribution under section 642(c) only to the extent the amount is paid out of the gross income of the non-S portion. To the extent the amount is paid from the S portion, no charitable deduction is available to the S portion.

Example 5 . ESBT distributions . (i) As of January 1, 2000, Trust owns stock in X, a C corporation. No portion of Trust is treated as owned by the grantor or another person under subpart E. X elects to be an S corporation effective January 1, 2001, and Trust elects to be an ESBT effective January 1, 2001. For

2001, Trust’s share of X ’s section 1366 items is $5,000 of ordinary income. For the year, Trust has no other income and no expenses or state or local taxes. On February 1, 2001, X makes an $8,000 distribution to Trust, of which $3,000 is treated as a dividend from accumulated earnings and profits under section 1368(c)(2) and the remainder is applied against Trust’s basis in the X stock under section 1368(b). The trustee of Trust makes a distribution of $4,000 to Beneficiary during 2001.

(ii) For 2001, Trust has $5,000 of taxable income in the S portion. This income is taxed to Trust at the maximum rate provided in section 1(e). Trust also has $3,000 of distributable net income (DNI) in the non-S portion. The non-S portion of Trust receives a distribution deduction under section 661(a) of $3,000, which represents the amount distributed to the beneficiary during the year ($4,000), not to exceed the amount of DNI ($3,000). The beneficiary must include this amount in gross income under section 662(a). As a result, the non-S portion has no taxable income.

Par. 4. Section 1.1361–0 is amended by adding entries for § 1.1361–1(j)(12) and (m) to read as follows:

§ 1.1361–0 Table of contents.

§1.1361–1 S corporation defined.

(j) * * * (12) Converting a QSST to an ESBT.

(m) Electing small business trust (ESBT). (1) Definition. (2) ESBT election. (3) Effect of ESBT election. (4) Potential current beneficiaries. (5) ESBT terminations. (6) Revocation of ESBT election. (7) Converting an ESBT to a QSST. (8) Effective date. (9) Examples.

Par. 5. Section 1.1361–1 is amended by:

Adding paragraphs (h)(1)(vi), (h)(3)(i)(F), and (j)(12).
Adding a sentence to the end of paragraph (k)(2)(i).
Adding paragraph (m). The additions read as follows:

§ 1.1361–1 S corporation defined.

(h) * * * (1) * * * (vi) Electing small business trusts . An electing small business trust (ESBT) under section 1361(e). See paragraph (m) of this section for rules concerning ESBTs including the manner of making the election to be an ESBT under section 1361(e)(3). * * * * * (3) * * * (i) * * * (F) If S corporation stock is held by an ESBT, each potential current beneficiary is treated as a shareholder. However, if for any period there is no potential current beneficiary of the ESBT, the ESBT is treated as the shareholder during such period. See paragraph (m)(4) of this section for the definition of potential current beneficiary.

(j) * * * (12) Converting a QSST to an ESBT . For a trust that wishes to convert from a QSST to an ESBT, the consent of the Commissioner is hereby granted to revoke the QSST election as of the effective date of the ESBT election, if all the following requirements are met:

(i) The trust meets all of the requirements to be an ESBT under paragraph (m)(1) of this section except for the

January 22, 2001 402 2001–4 I.R.B.

requirement under paragraph (m)(1)(iv)(A) of this section that the trust not have a QSST election in effect.

(ii) The trustee and the current income beneficiary of the trust sign the ESBT election. The ESBT election must be filed with the service center where the S corporation files its income tax return and also with the service center where the trust files its income tax return. This ESBT election must state at the top of the document “ATTENTION ENTITY CONTROL—CONVERSION OF A QSST TO AN ESBT PURSUANT TO SECTION 1.1361–1(j)” and include all information otherwise required for an ESBT election under paragraph (m)(2) of this section. A separate election must be made with respect to the stock of each S corporation held by the trust.

(iii) The trust has not converted from an ESBT to a QSST within the 36-month period preceding the effective date of the new ESBT election.

(iv) The date on which the ESBT election is to be effective cannot be more than 15 days and two months prior to the date on which the election is filed and cannot be more than 12 months after the date on which the election is filed. If an election specifies an effective date more than 15 days and two months prior to the date on which the election is filed, it will be effective 15 days and two months prior to the date on which it is filed. If an election specifies an effective date more than 12 months after the date on which the election is filed, it will be effective 12 months after the date it is filed.

(k) * * * (2) * * * (i) * * * Paragraphs (h)(1)(vi), (h)(3)(i)(F), and (j)(12) of this section are applicable on and after the date the final regulations are published in the Federal Register .

(m) Electing small business trust (ESBT) —(1) Definition —(i) General rule . An electing small business trust (ESBT) means any trust if it meets the following requirements: the trust does not have as a beneficiary any person other than an individual, an estate, or an organization described in section 170(c)(2) through (5); no interest in the trust has been acquired by purchase; and the trustee of the trust makes a timely ESBT election for the trust.

(ii) Qualified beneficiaries —(A) In general . For purposes of this section, a beneficiary includes a person who has a present, remainder, or reversionary interest in the trust other than a remote, contingent interest within the meaning of paragraph (m)(1)(ii)(D) of this section.

(B) Distributee trusts . Any person who has a beneficial interest in a distributee trust is a beneficiary of the ESBT. However, if the distributee trust is an organization described in section 170(c)(2) or (3), the distributee trust itself is the beneficiary of the ESBT. A distributee trust is a trust that is receiving or may receive a distribution from an ESBT, whether the rights to receive the distribution are fixed or contingent, or immediate or deferred.

(C) Powers of appointment . A person in whose favor a power of appointment could be exercised is not a beneficiary of an ESBT until the holder of the power of appointment actually exercises the power in favor of such person.

(D) Remote beneficiaries . A person whose interest in the trust is so remote as to be negligible is not a beneficiary of an ESBT. With respect to any portion of the trust, a person’s interest in either the corpus or the income therefrom is, at any time, so remote as to be negligible when the probability that such person will ever receive a distribution from the trust is less than 5 percent, taking into consideration the interests of other entities and other individuals living at that time.

(E) Nonresident aliens . A nonresident alien as defined in section 7701(b)(1)(B) is an eligible beneficiary of an ESBT. However, see paragraph (m)(5)(iii) of this section if the nonresident alien is a potential current beneficiary of the ESBT.

(iii) Interests acquired by purchase . A trust does not qualify as an ESBT if any interest in the trust has been acquired by purchase. If any portion of a beneficiary’s basis in the beneficiary’s interest in the trust is determined under section 1012, such interest has been acquired by purchase. The trust itself may acquire S corporation stock by purchase.

(iv) Ineligible trusts . An ESBT does not include—

(A) Any qualified subchapter S trust (as defined in section 1361(d)(3)) if an election under section 1361(d)(2) applies with

respect to any corporation the stock of which is held by the trust;

(B) Any trust exempt from tax or not subject to tax under subtitle A; or

(2) ESBT election –(i) In general . The trustee of the trust must make the ESBT election by signing and filing, with the service center where the trust files its income tax return, a statement that meets the requirements of paragraph (m)(2)(ii) of this section. If there is more than one trustee, the trustee or trustees with authority to legally bind the trust must sign the election statement. Only one ESBT election is made for the trust, regardless of the number of S corporations whose stock is held by the ESBT.

(ii) Election statement . The election statement must include—

(A) The name, address, and taxpayer identification number of the trust, the potential current beneficiaries, and the S corporations in which the trust currently owns stock;

(B) An identification of the election as an ESBT election made under section 1361(e)(3); (C) The first date on which the trust owned stock in each S corporation;

(D) The date on which the election is to become effective (not earlier than 15 days and two months before the date on which the election is filed); and

(E) Representations signed by the trustee stating that—

( 1 ) The trust meets the definitional requirements of section 1361(e)(1); and

( 2 ) All potential current beneficiaries of the trust meet the shareholder requirements of section 1361(b)(1).

(iii) Due date for ESBT election . The ESBT election must be filed within the time requirements prescribed in paragraph (j)(6)(iii) of this section for filing a qualified subchapter S trust (QSST) election. If the trust and the corporation file their tax returns with the same service center, the trustee may attach the ESBT election to the Form 2553, “ Election by a Small Business Corporation,” in the case of a newly electing S corporation.

(iv) Election by a trust described in sec- tion 1361(c)(2)(A)(ii) or (iii) . A trust that is a qualified S corporation shareholder under section 1361(c)(2)(A)(ii) or (iii)

2001–4 I.R.B. 403 January 22, 2001

may elect ESBT treatment at any time during the 2-year period described in those sections or the 16-day-and-2-month period beginning on the date after the end of the 2-year period. If the trust makes an ineffective ESBT election, the trust will continue to qualify as an eligible S corporation shareholder for the remainder of the period described in section 1361(c)(2)(A)(ii) or (iii). (v) No protective election . A trust cannot make a protective ESBT election that would be effective in the event the trust fails to meet the requirements for an eligible trust described in section 1361(c)(2)(A)(i) through (iv). If a trust attempts to make a protective ESBT election and fails to qualify as an eligible S corporation shareholder under section 1361(c)(2)(A)(i) through (iv), the S corporation election will be ineffective or will terminate because the corporation will have an ineligible shareholder. Relief may be available under section 1362(f) for an inadvertent ineffective S corporation election or an inadvertent S corporation election termination.

(3) Effect of ESBT election —(i) General rule . If a trust makes a valid ESBT election, the trust will be treated as an ESBT for purposes of chapter 1 of the Internal Revenue Code as of the effective date of the ESBT election.

(ii) Employer Identification Number . An ESBT has only one employer identification number (EIN). If an existing trust makes an ESBT election, the trust continues to use the EIN it currently uses.

(iii) Taxable year . If an ESBT election is effective on a day other than the first day of the trust’s taxable year, the ESBT election does not cause the trust’s taxable year to close. The trust files one tax return for the taxable year.

(iv) Allocation of S corporation items . If an ESBT election is effective on a day other than the first day of the trust’s taxable year, and the trust held S corporation stock and was an eligible S corporation shareholder under section 1361(c)(2)(A)(i) through (iv) prior to the effective date of the ESBT election, the S corporation items are allocated between the two eligible trusts under section 1377(a). For purposes of section 1377(a), the first day the ESBT is a shareholder is the effective date of the ESBT election, and the last day the other trust is a shareholder is the day

before the effective date of the ESBT election. See § 1.1377–1(a)(2)(iii).

(v) Estimated taxes . If an ESBT election is effective on a day other than the first day of the trust’s taxable year, the trust is considered one trust for purposes of estimated taxes under section 6654.

(4) Potential current beneficiaries —(i) In general . For purposes of determining whether a corporation is a small business corporation within the meaning of section 1361(b)(1), each potential current beneficiary of an ESBT generally is treated as a shareholder of the corporation. Subject to the provisions of this section (m)(4), a potential current beneficiary generally is, with respect to any period, any person who at any time during such period is entitled to, or in the discretion of any person may receive, a distribution from the principal or income of the trust.

(ii) Grantor trusts . If all or a portion of an ESBT is treated as owned by a person under subpart E, part I, subchapter J, chapter 1 of the Internal Revenue Code, such owner is a potential current beneficiary in addition to persons described in paragraph (m)(4)(i) of this section.

(iii) Special rule for dispositions of stock . Notwithstanding the provisions of paragraph (m)(4)(i) of this section, if a trust disposes of all of its S corporation stock, any person who first met the definition of a potential current beneficiary during the 60-day period ending on the date of such disposition is not a potential current beneficiary with respect to that corporation.

(iv) Distributee trusts —(A) In general . This paragraph (m)(4)(iv) contains the rules for determining who are the potential current beneficiaries of an ESBT if a distributee trust becomes entitled to, or at the discretion of any person may receive, a distribution from principal or income of an ESBT. A distributee trust does not include a trust that is not currently in existence. For this purpose, a trust is not currently in existence if the trust has no assets and no items of income, loss, deduction, or credit. Thus, if a trust instrument provides for a trust to be funded at some future time, the future trust is not a distributee trust.

(B) If the distributee trust is not a trust described in section 1361(c)(2)(A), then the distributee trust is the potential current beneficiary of the ESBT and the corporation’s S corporation election terminates.

(C) If the distributee trust is a trust described in section 1361(c)(2)(A), the persons who would be its potential current beneficiaries (as defined in paragraph (m)(4)(i) and (ii) of this section) if the distributee trust were an ESBT are treated as the potential current beneficiaries of the ESBT. Notwithstanding the preceding sentence, however, if the distributee trust is a trust described in section 1361(c)(2)(A)(ii) or (iii), the estate described in section 1361(c)(2)(B) (ii) or (iii) is treated as the potential current beneficiary of the ESBT for the 2-year period for which such trust is permitted as a shareholder.

(D) For the purposes of paragraph (m)(4)(iv)(C) of this section, a trust will be deemed to be described in section 1361(c)(2)(A) if such trust would be eligible to make a QSST election under section 1361(d) or an ESBT election under section 1361(e) if it owned S corporation stock.

(v) Contingent distributions . A person who is entitled to receive a distribution only after a specified time or upon the occurrence of a specified event (such as the death of the holder of a power of appointment) is not a potential current beneficiary until such time or the occurrence of such event.

(vi) Current powers of appointment . A person to whom a distribution is or may be made during a period pursuant to a power of appointment is a potential current beneficiary. Thus, if any person has a general lifetime power of appointment over the trust, the corporation’s S corporation election will terminate because the number of potential current beneficiaries will exceed the 75-shareholder limit of section 1361(b)(1)(A).

(vii) Number of shareholders . Each potential current beneficiary of the ESBT, as defined in paragraphs (m)(4)(i) through (vi) of this section, is counted as a shareholder of any S corporation whose stock is owned by the ESBT. During any period in which the ESBT has no potential current beneficiaries, the ESBT is counted as the shareholder. A person is counted as only one shareholder of an S corporation even though that person may be treated as a shareholder of the S corporation by direct ownership and through one or more eligible trusts described in section 1361(c)(2)(A). Thus, for exam

January 22, 2001 404 2001–4 I.R.B.

ple, if a person owns stock in an S corporation and is a potential current beneficiary of an ESBT that owns stock in the same S corporation, that person is counted as one shareholder of the S corporation. Similarly, if a husband owns stock in an S corporation and his wife is a potential current beneficiary of an ESBT that owns stock in the same S corporation, such husband and wife will be counted as one shareholder of the S corporation.

(viii) Miscellaneous . Payments made to a third party on behalf of a beneficiary are considered to be payments made directly to the beneficiary. The right of a beneficiary to assign the beneficiary’s interest to a third party does not result in the third party being a potential current beneficiary until that interest is actually assigned.

(5) ESBT terminations –(i) Ceasing to meet ESBT requirements. A trust ceases to be an ESBT on the first day the trust fails to meet the definition of an ESBT under section 1361(e). The last day the trust is treated as an ESBT is the day before the date on which the trust fails to meet the definition of an ESBT.

(ii) Disposition of S stock . In general, a trust ceases to be an ESBT on the first day following the day the trust disposes of all S corporation stock. However, if the trust is using the installment method to report income from the sale or disposition of its stock in an S corporation, the trust ceases to be an ESBT on the day following the earlier of the day the last installment payment is received by the trust or the day the trust disposes of the installment obligation.

(iii) Potential current beneficiaries that are ineligible shareholders . If a potential current beneficiary of an ESBT is not an eligible shareholder of a small business corporation within the meaning of section 1361(b)(1), the S corporation election terminates. For example, the S corporation election will terminate if a nonresident alien becomes a potential current beneficiary of an ESBT. Such a potential current beneficiary is treated as an ineligible shareholder beginning on the day such person becomes a potential current beneficiary, and the S corporation election terminates on that date. However, see the special rule of paragraph (m)(4)(ii) of this section. If the S corporation election ter

minates, relief may be available under section 1362(f).

(6) Revocation of ESBT election . An ESBT election may be revoked only with the consent of the Commissioner. The application for consent to revoke the election must be submitted to the Internal Revenue Service in the form of a letter ruling request under the appropriate revenue procedure.

(7) Converting an ESBT to a QSST . For a trust that wishes to convert from an ESBT to a QSST, the consent of the Commissioner is hereby granted to revoke the ESBT election as of the effective date of the QSST election, if all the following requirements are met:

(i) The trust meets all of the requirements to be a QSST under section 1361(d). (ii) The trustee and the current income beneficiary of the trust sign the QSST election. The QSST election must be filed with the service center where the S corporation files its income tax return and also with the service center where the trust files its income tax return. This QSST election must state at the top of the document “ATTENTION ENTITY CONTROL—CONVERSION OF AN ESBT TO A QSST PURSUANT TO SECTION 1.1361–1(m)” and include all information otherwise required for a QSST election under § 1.1361–1(j)(6). A separate election must be made with respect to the stock of each S corporation held by the trust.

(iii) The trust has not converted from a QSST to an ESBT within the 36-month period preceding the effective date of the new QSST election.

(iv) The date on which the QSST election is to be effective cannot be more than 15 days and two months prior to the date on which the election is filed and cannot be more than 12 months after the date on which the election is filed. If an election specifies an effective date more than 15 days and two months prior to the date on which the election is filed, it will be effective 15 days and two months prior to the date on which it is filed. If an election specifies an effective date more than 12 months after the date on which the election is filed, it will be effective 12 months after the date it is filed.

(8) Effective date . This paragraph (m) is applicable on and after the date the final

regulations are published in the Federal Register .

(9) Examples . The provisions of this paragraph (m) are illustrated by the following examples in which it is assumed, unless otherwise specified, that all noncorporate persons are citizens or residents of the United States:

Example 1 . (i) ESBT election with section 663(c) separate shares . On January 1, 2000, M contributes S corporation stock to Trust for the benefit of M ’s three children A, B, and C . Pursuant to section 663(c), each of Trust’s separate shares for A, B, and C will be treated as separate trusts for purposes of determining the amount of distributable net income (DNI) in the application of sections 661 and 662. On January 15, 2000, the trustee of Trust files a valid ESBT election for Trust effective January 1, 2000. Trust will be treated as a single ESBT and will have a single S portion taxable under section 641(c).

(ii) ESBT acquires stock of an additional S cor- poration . On February 15, 2000, Trust acquires stock of an additional S corporation. Because Trust is already an ESBT, Trust does not need to make an additional ESBT election.

(iii) Section 663(c) shares of ESBT convert to separate QSSTs . Effective January 1, 2001, A, B, C, and Trust’s trustee elect to convert each separate share of Trust into a separate QSST pursuant to paragraph (m)(7) of this section. They file a separate election for each S corporation the stock of which is held by Trust for each separate share. Each separate share will be treated as a separate QSST.

Example 2 . (i) Invalid potential current beneficia- ry . Effective January 1, 2000, Trust makes a valid ESBT election. On January 1, 2001, A, a nonresident alien, becomes a potential current beneficiary of Trust. Trust does not dispose of all of its S corporation stock within 60 days after January 1, 2001. As of January 1, 2001, A is a potential current beneficiary of Trust, and therefore is treated as a shareholder of the S corporation. Because A is not an eligible shareholder of an S corporation under section 1361(b)(1), the S corporation election of any corporation in which Trust holds stock terminates effective January 1, 2001. Relief may be available under section 1362(f).

(ii) Invalid potential current beneficiary and dis- position of S stock . Assume the same facts as in Example 2 (i) except that within 60 days after January 1, 2001, trustee of Trust disposes of all Trust’s S corporation stock. A is not considered a potential current beneficiary of Trust and therefore is not treated as an S corporation shareholder of any S corporation in which Trust previously held stock.

Example 3 . Subpart E trust . M transfers stock in X, an S corporation, and other assets to Trust, for the benefit of B and B ’s siblings. M retains no powers or interest in Trust. Under section 678(a), B is treated as the owner of a portion of Trust which includes a portion of the X stock. No beneficiary has acquired any portion of his or her interest in Trust by purchase and Trust is not an ineligible trust under paragraph (m)(1)(iv) of this section. Trust is eligible to make an ESBT election.

Example 4 . Determining ESBT beneficiaries . Trust holds stock in an S corporation and makes an ESBT election. Trust’s instrument provides that

2001–4 I.R.B. 405 January 22, 2001

income is to be paid to A for A ’s life. Upon A ’s death the remainder interest is to be paid to a separate trust for the benefit of A ’s three children. If on A ’s death none of A ’s children is alive, then the remainder is to be paid to A ’s ten grandchildren. If on A ’s death none of A ’s children or grandchildren is alive, the remainder will be paid to State exclusively for public purposes. A, A ’s children, and A ’s grandchildren are all beneficiaries of Trust. Assuming the probability that State will ever receive any distribution from Trust is less than 5 percent, State is not considered a beneficiary for purposes of paragraph (m)(1)(ii) of this section. If the probability that State will receive a distribution from Trust ever equals or exceeds 5 percent, State would then be considered a beneficiary of the ESBT. Because State is an organization described in section 170(c)(1), rather than section 170(c)(2) through (5), State would be an ineligible beneficiary and the corporation’s S corporation election would terminate.

Example 5 . Potential current beneficiaries and distributee trusts . (i) Distributee trust holding S cor- poration stock . Trust-1 has a valid ESBT election in effect. The trustee of Trust-1 has the power to distribute to A directly or to any trust created for the benefit of A . On January 1, 2000, M creates Trust-2 for the benefit of A . Also on January 1, 2000, the trustee of Trust-1 distributes some S corporation stock to Trust-2. The current income beneficiary of Trust-2 makes a timely and effective election to treat Trust-2 as a QSST. Because Trust-2 is a valid S corporation shareholder, the distribution to Trust-2 does not terminate the ESBT election of Trust-1. Trust-2 itself will not be counted toward the 75-shareholder limit of section 1361(b)(1)(A). Additionally, because A is already counted as an S corporation shareholder because of A ’s status as a potential current income beneficiary of Trust-1, A is not counted again by reason of A ’s status as the deemed owner of Trust-2.

(ii) Distributee trust not holding S corporation stock . Assume the same facts as in paragraph (i) of this Example 5, except that no S corporation stock is distributed to Trust-2. Because Trust-2 would be eligible to make a QSST election or an ESBT election if it owned S corporation stock, under paragraph (m)(4)(iv)(D) of this section it is deemed to be a trust described in section 1361(c)(2)(A). Under paragraph (m)(4)(iv)(C) of this section, the potential current beneficiaries of Trust-2 are considered the potential current beneficiaries of Trust-1. Because A, the potential current beneficiary of Trust-2, is already a potential current beneficiary of Trust-1, A is not counted twice for purposes of the 75-shareholder limit of the S corporation.

Example 6 . Potential current beneficiaries and distributee trust . (i) Distributee trust that would itself qualify as an ESBT . Trust-1 holds stock in X, an S corporation, and has a valid ESBT election in effect. Under the terms of the governing instrument of Trust-1, the trustee has discretion to make distributions to A, B and Trust-2, a trust for the benefit of A and B ’s children, C, D and E . Trust-2 would qualify to be an ESBT, but it owns no S corporation stock and has made no ESBT election. Under paragraph (m)(4)(iv) of this section, Trust-2’s potential current beneficiaries are treated as the potential current beneficiaries of Trust-1 and are counted as shareholders for purposes of section 1361(b)(1). Thus, A, B, C, D

and E are potential current beneficiaries of Trust-1 and are counted as shareholders for the purposes of section 1361(b)(1). Trust-2 itself will not be counted as a shareholder of Trust-1 for purposes of section 1361(b)(1). (ii) Distributee trust that would not qualify as an ESBT . Assume the same facts as in Example 6 (i) except that D is a non-resident alien. Trust-2 would not be eligible to make an ESBT or QSST election if it owned S corporation stock and therefore Trust-2 is a potential current beneficiary of Trust-1. Since Trust-2 is not an eligible shareholder, X ’s S corporation election terminates.

Example 7 . Potential current beneficiaries and powers of appointment . M creates Trust for the benefit of A . A also has a current power to appoint income or principal to anyone except A, A ’s creditors, A ’s estate, and A ’s estate’s creditors. The potential current beneficiaries of Trust will be A and all other persons except for A ’s creditors, A ’s estate, and A ’s estate’s creditors. This number will exceed the 75- shareholder limit of section 1361(b)(1)(A). If Trust holds S corporation stock, the corporation’s S election will terminate.

Par. 6. Section 1.1362–6 is amended by revising paragraph (b)(2)(iv) to read as follows:

§ 1.1362–6 Election and consents.

(b) * * * (2) * * * (iv) Trusts . In the case of a trust described in section 1361(c)(2)(A) (including a trust treated under section 1361(d)(1)(A) as a trust described in section 1361(c)(2)(A)(i) and excepting an electing small business trust described in section 1361(c)(2)(A)(v) (ESBT)), only the person treated as the shareholder for purposes of section 1361(b)(1) must consent to the election. When stock of the corporation is held by a trust, both husband and wife must consent to any election if the husband and wife have a community interest in the trust property. See paragraph (b)(2)(i) of this section for rules concerning community interests in S corporation stock. In the case of an ESBT, the trustee and the owner of any portion of the trust that consists of the stock in one or more S corporations under subpart E, part

(iii) Distributee trust that is a section 1361(c)(2)(A)(ii) trust . Assume the same facts as in Example 6 (i) except that Trust-2 is a trust treated as owned by A under section 676 because A had the power to revoke Trust-2 at any time prior to A ’s death. On January 1, 2001, A dies. Because Trust-2 is a trust described in section 1361(c)(2)(A)(ii) during the 2-year period beginning on the day of A ’s death, under paragraph (m)(4)(iv)(C) of this section, Trust-2’s only potential current beneficiary is the person listed in section 1361(c)(2)(B)(ii), A ’s estate.

I, subchapter J, chapter 1 of the Internal Revenue Code must consent to the S corporation election. If there is more than one trustee, the trustee or trustees with authority to legally bind the trust must consent to the S corporation election.

Par. 7. Section 1.1362–7 is amended by adding a sentence to the end of paragraph (a) to read as follows:

§ 1.1362–7 Effective date.

(a) * * * Section 1.1362–6(b)(2)(iv) is applicable on and after the date the final regulations are published in the Federal Register .

Par. 8. Section 1.1377–1 is amended by:

Adding paragraph (a)(2)(iii).
Adding Example 3 to paragraph (c). The additions read as follows:

§ 1.1377–1 Pro rata share.

(a) * * * (2) * * * (iii) Electing small business trust (ESBT) election . If an ESBT election is effective on a day other than the first day of trust’s taxable year, and the trust was already an eligible S corporation shareholder under a different provision of section 1361(c)(2), then section 1377 applies to allocate S corporation income between the two types of trusts. The first day the ESBT is treated as an S corporation shareholder is the effective date of the ESBT election. The ESBT election does not result in the prior trust being treated as terminating its entire interest in its S corporation stock for purposes of paragraph (b) of this section, unless the prior trust was described in section 1361(c)(2)(A)(ii) or (iii).

(c) * * * Example 3 . Effect of conversion of a qualified subchapter S trust (QSST) to an electing small busi- ness trust (ESBT) . (i) On January 1, 2000, Trust receives 100% of the stock of S corporation. Trust’s current income beneficiary makes a timely QSST election under section 1361(d)(2), effective January 1, 2000. Later, the trustee and current income beneficiary of Trust elect pursuant to §1.1361–1(j)(12), to terminate the QSST election and convert to an ESBT, effective July 1, 2002. In 2002, Trust’s pro rata share of S corporation’s nonseparately computed income is $100,000.

(ii) For purposes of computing the income allocable to the QSST and to the ESBT, Trust is treated

January 22, 2001 406 2001–4 I.R.B.

Internal Revenue Code (Code). Section 904(j) exempts individuals from the foreign tax credit limitation of section 904(a) in certain limited circumstances, and provides that no foreign taxes may be carried to or from a year for which a taxpayer has elected to apply section 904(j).

TRA 1997 also added to the Code section 904(b)(2)(C), which provides that the Secretary may issue regulations to modify the application of section 904(b)(2) and (3) to properly reflect capital gain rate differentials under sections 1(h) and 1201(a) and the computation of net capital gain. The proposed regulations provide guidance for the application of section 904(b), including the application of that section in years in which section 1(h) provides for more than one capital gains rate.

Explanation of Provisions

I. Effect of Loss of Domestic Corporate Shareholder on Pooling of Earnings and Taxes in Computing Deemed Paid Credits: §1.902–1

Under section 902(c)(3), the multi-year pools of post-1986 undistributed earnings and post-1986 foreign income taxes of a foreign corporation are determined by taking into account only periods beginning on and after the first day of the foreign corporation’s first taxable year in which a domestic corporation (a “qualifying shareholder”) owns 10 percent or more of its voting stock or, in the case of a lower-tier foreign corporation in a “qualified group” described in section 902(b)(2), owns indirectly at least 5 percent of its voting stock.

Under section 902(c)(6)(B), dividends are treated as paid first out of the post1986 pooled earnings. Pre-1987 accumulated profits (defined in section 902(c)(6)(A) and §1.902–1(a)(10) to include both earnings accumulated in pre1987 years and earnings accumulated in post-1986 years preceding the year in which the section 902 ownership requirements are met) are treated as distributed only after the pools are exhausted, and then out of annual layers of earnings and taxes on a last-in, first-out basis. Distributions out of pre-1987 accumulated profits are governed by the section 902 rules in effect under pre-1987 law. Section 902(c)(6)(A).

as a QSST through June 30, 2002, and Trust is treated as an ESBT beginning July 1, 2002. Pursuant to section 1377(a)(1), the pro rata share of S corporation income allocated to the QSST is $49,589 ($100,000 x 181 days/365 days), and the pro rata share of S corporation income allocated to the ESBT is $50,411 ($100,000 x 184 days/365 days).

Par. 9. Section 1.1377–3 is amended by revised to read as follows:

§ 1.1377–3 Effective date.

Section 1.1377–1 and 1.1377–2 apply to taxable years of an S corporation beginning after December 31, 1996, except that § 1.1377–1(a)(2)(iii) and (c) Example 3 are applicable on and after the date the final regulations are published in the Federal Register .

Robert E. Wenzel, Deputy Commissioner

of Internal Revenue .

(Filed by the Office of the Federal Register on December 28, 2000, 8:45 a.m., and published in the issue of the Federal Register for December 29, 2000, 65 F.R. 82963)

Notice of Proposed Rulemaking and Notice of Public Hearing

Application of Section 904 to Income Subject to Separate Limitations and Computation of Deemed-Paid Credit under Section 902

REG–104683–00

AGENCY: Internal Revenue Service (IRS), Treasury.

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

SUMMARY: This document contains proposed Income Tax Regulations relating to the computation of the section 902 deemed-paid credit, the section 904(d) foreign tax credit limitation, and to an example in the section 954 regulations relating to the exclusion of certain export financing interest from foreign personal holding company income. Changes to the applicable law were made by the Tax Reform Act of 1986, the Technical and Miscellaneous Revenue Act of 1988, and the Taxpayer Relief Act of 1997. These regulations would provide guidance needed to comply with these changes and would affect individuals and corporations

reporting subpart F income and claiming foreign tax credits.

This document also provides a notice of a public hearing on these proposed regulations.

DATES: Written or electronic comments must be received by April 2, 2001. Outlines of topics to be discussed at the public hearing scheduled for April 26, 2001, at 10 a.m. must be received by April 5, 2001.

ADDRESSES: Send submissions to: Regulations Unit CC (REG–104683–00), room 5226, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. In the alternative, submissions may be hand-delivered between the hours of 8 a.m. and 5 p.m. to Regulations Unit CC (REG–104683–00), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW., Washington, DC or sent electronically, via the IRS Internet site at: http://www.irs.gov/tax_regs/regslist.html. The public hearing will be held in the IRS Auditorium, 7 ^th floor, Internal Revenue Building, 1111 Constitution Ave., NW., Washington, DC. FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, Bethany A. Ingwalson (202) 622-3850; concerning submissions of comments, the hearing, and/or to be placed on the building access list to attend the hearing, Sonya Cruse, (202) 622-7180 (not tollfree numbers).

SUPPLEMENTARY INFORMATION:

Background

Treasury and the IRS provided guidance regarding section 904(d) (enacted in 1986) in T.D. 8214 (1988–2 C.B. 220), T.D. 8412 (1992–1 C.B. 271), T.D. 8556 (1994–2 C.B. 165), T.D. 8805 (1999–1 C.B. 371), and in final regulations (T.D. 8916) published on page 360 of this Bulletin. Final regulations regarding the computation of the deemed paid credit under section 902 (also enacted in 1986) were published as T.D. 8708 (1997–1 C.B. 137). The proposed regulations provide further guidance with respect to the application of sections 902 and 904(d).

The proposed regulations also provide guidance regarding the application of section 904(j). The Taxpayer Relief Act of 1997 (Public Law 105–34, 111 Stat. 788) (TRA 1997) added section 904(j) to the

2001–4 I.R.B. 407 January 22, 2001

The rule limiting the multi-year pools of earnings and taxes to post-1986 taxable years beginning with the year in which a foreign corporation first has a qualifying shareholder alleviates the administrative difficulties such shareholders face in reconstructing accumulated earnings and taxes accounts in connection with their acquisition of stock in a pre-existing foreign corporation. While section 902 provides that pooling of earnings and taxes begins only when the foreign corporation first has a qualifying shareholder entitled to compute a credit for deemed-paid taxes, the statute does not provide for any change in a foreign corporation’s post-1986 undistributed earnings and taxes pools following a stock disposition or other transaction after which the foreign corporation no longer has a qualifying shareholder. Section 1.902–1(a)(13)(i) currently provides that, once a foreign corporation begins to maintain pools of earnings and taxes, the pools include periods during which the stock ownership requirements of section 902 are not met. Should such a corporation later again have a qualifying shareholder, such a shareholder would have to reconstruct the post-1986 undistributed earnings and taxes pools to include undistributed earnings and taxes for periods during which there was no qualifying shareholder, in order to compute deemed-paid credits with respect to distributions of earnings and profits accumulated during later periods in which the ownership requirements were met.

Treasury and the IRS believe that the policy concerns underlying the rule deferring the start of pooling until the corporation has a qualifying shareholder also apply to the situation where a foreign corporation once had, but no longer has, such a shareholder. Therefore, Treasury and the IRS believe it is appropriate to stop the multi-year pooling of earnings and taxes at the foreign corporation level when a foreign corporation no longer has a qualifying shareholder.

The proposed regulations would amend §1.902–1(a)(10) to provide that pre-1987 accumulated profits subject to the annual layering rules of pre-1987 law include not only the actual pre-1987 earnings and profits and pre-pooling earnings

and profits described in the current final regulation, but also formerly pooled earnings and profits of a less-than-10%-U.S.owned foreign corporation attributable to post-1986 years during which the section 902 stock ownership requirements were met, and post-pooling earnings and profits accumulated during subsequent taxable years during which the foreign corporation did not have a qualifying shareholder. The formerly pooled earnings would be considered pre-1987 accumulated profits of the last taxable year of the foreign corporation as of the end of which the ownership requirements were met. Distributions out of formerly pooled earnings would be subject to the same pre-1987 law rules as distributions of other pre-1987 accumulated profits, except that the formerly pooled foreign income taxes related to the formerly pooled earnings would continue to be maintained in U.S. dollars. The proposed regulations would also amend §1.902–1(a)(13) to provide that pooling of earnings and taxes would resume in the first subsequent taxable year as of the end of which the foreign corporation again has a qualifying shareholder. Formerly pooled earnings would continue to be treated as pre-1987 accumulated profits even if the foreign corporation later began to maintain pools of earnings and taxes again.

Treasury and the IRS believe the proposed rules would be easier for taxpayers to apply than the current regulations, which require pooling to continue through periods when the foreign corporation has no shareholders entitled to compute a deemed-paid credit. These proposed amendments complement the proposed amendments to the section 904 regulations, described below, concerning the effect of intervening noncontrolled status on the look-through pools of post-1986 undistributed earnings and taxes maintained by a controlled foreign corporation. The proposed regulations also would be consistent with the approach taken in recently proposed amendments to the regulations under section 367(b) relating to the carryover of earnings and taxes accounts in reorganizations involving foreign corporations (REG–116050–99, 2000–48 I.R.B. 520, published in the Federal Register (65 FR 69138) on November 15, 2000).

II. Separate Categories: §1.904–4

A. The active rents and royalties exception

Section 1.904–4(b)(2) sets forth the active rents and royalties exception to the separate limitation for passive income. This exception currently applies only to payments from unrelated payors. Several commentators have requested that Treasury and the IRS amend the regulations to provide that royalties received from a member of the recipient’s affiliated group (including foreign affiliates) may qualify for the exception if the royalties are derived in the conduct of an active trade or business and the payor uses the underlying property in an active trade or business. As explained below, Treasury and the IRS propose to adopt a modified version of the suggested change.

Section 904(d)(2)(A)(i) defines passive income as foreign personal holding company income, as defined in section 954(c). The section 904(d) active rents and royalties exception derives from section 954(c)(2)(A), which excludes from foreign personal holding company income, and thus from passive income, any rents or royalties derived in the active conduct of a trade or business and received from an unrelated person. The current final regulations at §1.904–4(b)(2)(ii) modify this exception to take into account activities of members of the recipient’s affiliated group in determining whether the recipient meets the active trade or business prong of the test for section 904(d) purposes.

Treasury and the IRS have consistently declined to extend look-through treatment to payments from foreign non-controlled payors. See T.D. 8412 (1992–1 C.B. 271, 273). Treasury and the IRS continue to believe that the nature of the income earned by a foreign non-controlled payor from the use of the licensed property should not determine whether a rent or royalty payment constitutes income from the active conduct of a trade or business of the recipient.

However, Treasury and the IRS have decided that it is appropriate to eliminate the distinction between royalties received from related and unrelated payors in applying the active rents and royalties exception for purposes of section 904(d).

January 22, 2001 408 2001–4 I.R.B.

Therefore, these regulations propose to amend prospectively §1.904–4(b)(2) to provide that for purposes of section 904 (but not for purposes of section 954), the active rents and royalties exception will not require that the rents and royalties be received from an unrelated payor. This change is proposed to apply to rents and royalties paid or accrued more than 60 days after the date that these regulations are published in final form.

B. Restriction of affiliated group special rule for active rents and royalties exception

As noted, §1.904–4(b)(2)(ii) provides that, for purposes of the active rents and royalties exception from passive income under section 904, rents or royalties will be treated as derived in the active conduct of a trade or business by a United States person or controlled foreign corporation if any member of the recipient’s affiliated group (defined to include foreign corporations) meets the requirements of section 954(c)(2)(A) with respect to the licensed property. The proposed regulations would amend the definition of affiliated group for purposes of §1.904–4(b)(2)(ii) to include only U.S. corporations and controlled foreign corporations in which United States members of the affiliated group own, directly or indirectly, at least 80 percent of the stock (by vote and value). This requirement is consistent with the affiliated group rules of §1.904–4(e)(3)(ii), which consider the activities of other members of the affiliated group for purposes of determining whether an entity is a financial services entity. The proposed regulations revise the affiliated group rule in the active rents and royalties exception due to administrative concerns regarding the difficulty of determining whether related, but non-controlled, foreign corporations engage in the active conduct of a trade or business with respect to licensed property.

C. Effect of intervening noncontrolled or less-than-10%-U.S.-owned status on distributions from a controlled foreign corporation or other look-through corporation

Under section 904(d)(2)(E)(i) and §1.904–4(g)(3)(i), dividends from a controlled foreign corporation (CFC) are

treated as dividends from a noncontrolled section 902 corporation to the extent that the distribution is out of earnings and profits accumulated during periods in which the distributing corporation was not a CFC. Proposed §1.904–4(g)(3)(i)(C)( 1 ) provides rules to address the effect of intervening noncontrolled status on the eligibility for look-through treatment of distributions of pre-2003 accumulations of pooled earnings and profits from a CFC. Consistent with the proposed amendments to §1.902–1(a) previously discussed, proposed §1.904–4(g)(3) (i)(C)( 2 ) provides rules to address the effect of intervening less-than-10%-U.S.owned status on the post-1986 undistributed earnings and taxes pools and pre1987 accumulated profits of a foreign corporation and the application of the look-through rules to distributions from such a foreign corporation. The proposed regulations anticipate to some extent, but do not provide comprehensive guidance, regarding the changes to the statutory look-through rules for 10/50 companies that become effective for post-2002 taxable years. Additional conforming changes to the provisions of §§1.904–4 and 1.904–5 will be required to reflect the changes in terminology reflected in the proposed regulations that are necessitated by these statutory changes.

The proposed regulations provide that, when a CFC becomes a non-look-through 10/50 corporation (because it ceases to be controlled by United States shareholders, but has at least one qualifying shareholder, in a taxable year beginning before January 1, 2003), post-1986 undistributed earnings that were accumulated through the end of the taxable year preceding the taxable year in which the decontrolling event occurred and that were previously eligible for look-through treatment will be consolidated in, and constitute the opening balance of, a single non-look-through pool at the foreign corporation level. The regulations provide that distributions of the prior look-through earnings will continue be treated as dividends from a nonlook-through 10/50 corporation, and will not be eligible for look-through treatment, even if the foreign corporation later becomes a CFC again or becomes eligible for look-through treatment with respect to earnings accumulated in post-2002 taxable years.

Distributions of post-1986 undistributed earnings in the non-look-through pool will be treated as dividends from a non-lookthrough 10/50 corporation (10/50 dividend income) when distributed to a qualifying shareholder, or as passive income when distributed to any other shareholder. Pre-1987 accumulated profits distributed after a decontrolling event will similarly be treated as 10/50 dividend income or as passive income when distributed, depending on the status of, and the amount of stock owned by, the shareholder at the time of distribution. Because the separate limitation treatment of distributions during the taxable year is computed with reference to year-end pools of post-1986 undistributed earnings under section 902, the proposed regulations provide that distributions to a qualifying shareholder that are made in the taxable year in which a decontrolling event occurs are treated as 10/50 dividend income to qualifying shareholders, or passive income to other shareholders, whether made before or after the decontrolling event. Similarly, under §1.904–4(g)(3)(iii), earnings and profits accumulated in the year in which a foreign corporation becomes a CFC are treated as accumulated after the corporation became a CFC. Such earnings will be eligible for look-through treatment when distributed to a United States shareholder during the taxable year in which the distributing corporation becomes a CFC or during any subsequent taxable year until the distributing corporation ceases to be a CFC or other look-through corporation.

As noted, the proposed regulations do not permit look-through treatment for earnings and profits accumulated in pre2003 taxable years while the distributing corporation was a CFC if the earnings are distributed after an intervening period ending before 2003 during which the corporation was not a CFC, even if the corporation is a CFC or other look-through corporation at the time of distribution. Earnings and profits previously eligible for look-through treatment will be placed in a single non-look-through pool with new earnings accumulated in taxable years beginning before January 1, 2003, while the corporation is not a CFC. The proposed rule would eliminate the need to determine whether distributions made while the corporation is a non-lookthrough 10/50 corporation (or, after 2002, a 10/50 look-through corporation) are

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made out of look-through earnings accumulated in pre-2003 years prior to the decontrolling event or pre-2003 non-lookthrough earnings accumulated afterwards. Treasury and the IRS believe this rule would be simpler to apply with respect to pre-2003 periods during which the records necessary to establish lookthrough treatment are less likely to be maintained by a foreign corporation that is not controlled by United States shareholders.

This intervening noncontrolled status situation differs from the special situation described in §1.904–4(g)(3)(ii), which allows look-through treatment on distributions to a more-than-90-percent United States shareholder after August 6, 1997, of earnings and profits that were accumulated while the distributing corporation was a CFC. In the latter case, pre-acquisition post-1986 undistributed earnings of a CFC with a more-than-90-percent United States shareholder were required to be maintained in a non-look-through pool prior to the effective date of the amendment to section 904(d)(2)(E)(i) by TRA 1997. During the entire period the non-look-through pool was required to be maintained, the corporation was a CFC that was more-than-90-percent-owned by a single domestic corporation. Accordingly, the rules governing the effect of the 1997 repeal of the rule limiting look-through treatment to earnings accumulated while the more-than-90-percent United States shareholder was a United States shareholder of the distributing corporation do not provide an appropriate model for resolving the ongoing issue addressed by the proposed regulations.

Section 904(d)(4) as amended by section 1105(b) of TRA 1997 effective for taxable years beginning after December 31, 2002, will generally extend the lookthrough rules to distributions of earnings accumulated by a 10/50 company in post2002 taxable years. Accordingly, nonlook-through 10/50 corporations will not exist after 2002, although 10/50 lookthrough corporations will continue to maintain non-look-through pools of earnings and taxes accumulated in pre-2003 taxable years. Therefore, if the regulations are finalized prospectively, the effect of proposed §1.904–4(g)(3)(i)(C)( 1 ) generally would be limited to situations

involving a CFC that is decontrolled after the regulations become final but before January 1, 2003, and to earnings that are accumulated in taxable years beginning before January 1, 2003, and that are not treated as distributed to the CFC’s U.S. shareholders under section 1248 in connection with the decontrolling event. Comments are requested as to whether the simplification objectives of the regulation could best be met by extending the effective date to cover decontrolling events that occurred in prior periods.

Consistent with the proposed amendments to §1.902–1(a) and with the approach taken with respect to the pre-2003 decontrol situation, §1.904–4(g)(3)(i)(C)( 2 ) of the proposed regulations provides that distributions out of formerly pooled earnings that are converted to an annual layer of pre-1987 accumulated profits when a foreign corporation no longer has a qualifying shareholder will be treated as distributions from a non-look-through 10/50 corporation, even if the foreign corporation later becomes a look-through corporation again.

The proposed regulations reserve on the treatment of distributions from a 10/50 look-through corporation, including the treatment of distributions out of earnings and profits accumulated in periods before the taxpayer acquired its stock. Comments are requested on whether additional guidance is needed to clarify the rules governing distributions from CFCs, and on how the regulations should be modified to reflect the rules of section 1105(b) of TRA 1997, extending look-through treatment to distributions from 10/50 corporations out of earnings and profits accumulated in post-2002 taxable years.

D. Additional separate categories

Treasury and the IRS propose to add a new paragraph (m) to §1.904–4, to provide that if section 904(a), (b), and (c) are applied separately to any category of income under the Code (for example, under section 901(j), 865(h), or 904(g)(10)), that category of income (additional category) will be treated for purposes of the Code and regulations (including, for example, section 904(f)) as if it were a separate category listed in sections 904(d)(1) and 904(d)(3)(F)(i). This amendment is intended to clarify the treatment of such additional separate categories without the need for

specific cross-references to such categories each time a provision refers to the separate categories listed in section 904(d). Sections 1.904–4(a) and 1.904–5(a)(1) are amended to include a reference to such additional separate categories.

III. Allocation and Apportionment of Taxes to Separate Categories: §1.904–6

Treasury and the IRS propose to amend §1.904–6(a)(1) to clarify the rules for determining the amount of income (in each U.S. separate category) taxed by a foreign country, in situations in which foreign law does not provide expense allocation rules. In such cases, for purposes of determining the amount of income taxed by the foreign country in order to allocate and apportion foreign taxes to separate categories, a taxpayer must allocate the expenses that are deductible under foreign law using the same methods that the taxpayer uses to allocate expenses that are deductible under U.S. law for purposes of determining the amount of taxable income.

IV. Capital Gain and Loss Adjustments: §1.904(b)–1

A. Section 904(b) capital gain and loss adjustments

The proposed regulations provide guidance regarding the rule of section 904(b)(2)(A) that foreign source capital gain may not exceed the lesser of capital gain net income from sources outside the United States or worldwide capital gain net income. A similar rule applies with respect to net capital gain. The regulations also provide guidance regarding the rule of section 904(b)(2)(B) that capital gains from foreign and U.S. sources, and capital losses from foreign sources, must be adjusted based on capital gain rate differential amounts. The proposed regulations exercise the regulatory authority granted under section 904(b)(2)(C) (authorizing regulations to modify the application of section 904(b)(2) and (3) to properly reflect capital gain rate differentials and the computation of net capital gain) and section 904(d)(6) (authorizing such regulations as may be necessary and appropriate for the purposes of section 904(d)).

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The proposed regulations first provide guidance concerning the adjustments required when foreign source capital gains exceed the lesser of capital gain net income (or net capital gain) from sources outside the United States or capital gain net income (or net capital gain) from all sources. Section 904(b)(2)(A) and section 904(b)(2)(B)(i) provide that, for purposes of section 904, foreign source capital gains that are included in foreign source taxable income may not exceed the lesser of capital gain net income from sources outside the United States or capital gain net income from all sources. Section 904(b)(2)(A), (3)(A). Similar rules apply for purposes of determining foreign source net capital gain. Section 904(b)(3)(B). After the 1986 enactment of separate limitation categories in section 904(d), the issue arises as to the extent to which foreign source capital gains should be adjusted if the taxpayer has foreign source capital gains and losses in more than one separate category.

The proposed regulations provide that foreign source capital gains included in foreign source taxable income in any separate category are reduced by reason of section 904(b)(2)(A) and section 904(b)(2)(B)(i) only by foreign source capital losses in the same separate category and by a ratable portion of the excess of capital gain net income from foreign sources (in the aggregate, considering all of the taxpayer’s separate categories) over capital gain net income from all sources (considering capital gains and losses from sources within and outside the United States, from all of the taxpayer’s separate categories). Thus, the proposed rule would reduce capital gain net income from foreign sources in any separate category only if the taxpayer has a net U.S.source capital loss, and not in instances where foreign-source capital gains in one separate category are offset only by foreign-source capital losses from another separate category. This rule implements Congress’s intent that section 904(b)(2)(A) and section 904(b)(2)(B)(i) should prevent foreign-source capital gains from inappropriately increasing the numerator of the foreign tax credit limitation fraction under section 904(a) if those capital gains were offset by U.S.-source capital losses, while avoiding the potential

for double counting of foreign-source losses that might result if foreign-source gains in one separate category were reduced by reason of foreign-source losses that reduce ordinary income in another separate category.

The regulations further provide that if the taxpayer’s capital gain net income from sources outside the United States exceeds the taxpayer’s capital gain net income from all sources (i.e., where there is a net U.S. capital loss), a pro rata portion of such excess reduces the capital gain net income from sources outside the United States in each of the taxpayer’s separate limitation categories and, within each separate category, in each rate group. The pro rata portion is determined based on the relative amounts of net capital gain from sources outside the United States in each separate category or rate group.

In addition, the proposed regulations provide guidance on adjusting capital gains and foreign capital losses to reflect capital gain rate differentials. Section 904(a) limits the foreign tax credit to the lesser of 1) foreign tax paid or accrued; or 2) pre-credit U.S. tax multiplied by a fraction equal to foreign source taxable income over worldwide taxable income (the limitation fraction). Multiplying the pre-credit U.S. tax by the limitation fraction is meant to determine the portion of U.S. taxes that are attributable to foreign source income. Section 904(b)(2)(B) adjusts capital gains in the numerator and denominator, and foreign source capital losses in the numerator, of the limitation fraction if capital gains are taxed at lower rates than ordinary income, as is often the case under current law for individuals. Unless capital gains and foreign capital losses are adjusted to account for this difference, the limitation fraction will not accurately reflect the portion of the total pre-credit U.S. tax that is properly attributable to foreign source income.

The rate differential adjustments to capital gains and foreign source capital losses, under section 904(b) and the proposed regulations, apply only if the specific taxpayer has net capital gain that is subject to reduced tax rates for the taxable year. Treasury and the IRS request comments with respect to applying on an elective basis adjustments based on rate differentials for taxable years in which the

Code applies reduced tax rates to capital gains generally, but the specific taxpayer has capital losses that equal or exceed capital gains. Any such elective rule would need to include ordering rules for determining the source, the separate category, and the rate group of the capital losses that are taken into account for the current taxable year, including those capital losses that are currently deductible to the extent of $3,000 under section 1211(b) against ordinary income, and those losses that are subject to the capital loss carryover rules.

As noted, section 904(b)(2)(C) grants regulatory authority to modify the application of section 904(b)(2) and (3) “to the extent necessary to properly reflect any capital gain rate differential under section 1(h) or 1201(a) and the computation of net capital gain.” The proposed regulations exercise this authority and adjust the section 904(b)(2)(B) calculations to reflect the fact that, for taxable years ending after May 6, 1997, section 1(h) contains multiple capital gains rates. The proposed regulations thus require that capital gain net income, from sources outside the United States and from all sources, must be adjusted pursuant to section 904(b)(2)(B)(i) and (ii) by the rate differential portion of each rate group of the taxpayer’s net capital gain from sources outside the United States and from all sources, respectively.

The proposed regulations also provide guidance on adjusting foreign source capital losses under section 904(b)(2)(B)(iii). The regulations clarify that such capital losses (after netting against foreign source capital gains in the same rate group, as defined in the regulations) should be reduced based on the tax rate applicable under section 1(h) to the net capital gains that are offset by such net capital losses in the determination of the taxpayer’s taxable income. Although section 904(b)(2)(B)(iii) provides for such adjustment in instances when net foreign losses have offset U.S. source capital gains, the existence of multiple separate categories after 1986 may result in foreign source capital gains and losses in separate categories offsetting one another. Therefore, the regulations require adjustment of foreign capital losses that offset foreign source capital gains associated with dif

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ferent capital gains rates, in addition to foreign capital losses that offset U.S. source capital gains.

In determining which capital gains are offset by capital losses from sources outside the United States in different rate groups, the proposed regulations provide that net capital losses from sources within the United States will not be taken into account, in order to simplify this determination. Treasury and the IRS request comments regarding whether the regulations should take net capital losses from sources within the United States into account for such purposes, and, if so, what type of ordering rules should be applied.

The IRS is considering providing a simplified worksheet for performing the section 904(b)(2)(B) adjustments in the Form 1116 instructions, for taxpayers whose capital gains are subject only to 10 or 20 percent tax rates under section 1(h) (similar to the simplified worksheet provided in the 1999 Form 1040 instructions as an alternative to Schedule D for taxpayers whose capital gains are subject only to 10 and 20 percent tax rates under section 1(h)). Treasury and the IRS request comments on this approach.

B. Appropriate tax rates for AMT foreign tax credit calculation

The proposed regulations provide that the alternative minimum tax (AMT) rates, rather than the regular tax rates, apply for purposes of carrying out the section 904(b) capital gains rates adjustments for the AMT foreign tax credit. Section 904(b) generally adjusts capital gains and foreign source capital losses based on the difference between the maximum U.S. tax rate and the tax applicable to capital gains under section 1(h). This adjustment is necessary to calculate more accurately the amount of U.S. tax that is attributable to foreign source income (as determined by application of the section 904(a) fraction). Section 59(a)(1)(B) provides that the AMT foreign tax credit must be determined as if “section 904 were applied on the basis of alternative minimum taxable income,” and therefore requires the application of section 904(b) in determining the AMT foreign tax credit. In order to reflect more accurately the amount of precredit tentative minimum tax attributable to foreign source AMT income, these reg

ulations provide that, for purposes of applying section 904(b) in determining the AMT foreign tax credit, the maximum AMT rates should be used rather than the rates specified in section 1.

In addition, the regulations clarify that section 904(b)(2)(B)(ii) (relating to capital gains from all sources), as well as section 904(b)(2)(B)(i) and (iii) (relating to foreign source capital gains and losses, respectively) apply (in modified form, as provided in section 59) to the determination of the AMT foreign tax credit. The regulations also clarify that section 904(b) applies to taxpayers electing to apply the simplified foreign tax credit limitation rules under section 59(a)(4).

V. Coordination of Section 904(j) with Carryforward and Carryback Rules: §1.904(j)

Section 904(j) allows a taxpayer to elect not to apply section 904(a) (the foreign tax credit limitation fraction) if the taxpayer’s creditable foreign taxes paid or accrued for the year are $300 or less ($600 or less for joint filers), the taxpayer’s foreign source gross income consists entirely of passive income, and such income and taxes are reported to the taxpayer on a payee statement. If a taxpayer elects to apply section 904(j) for any taxable year, no foreign taxes paid or accrued in such year may be carried over to any other year, and no foreign taxes paid or accrued in any other year may be carried over to the section 904(j) election year.

The proposed regulations clarify that a taxpayer may elect to apply section 904(j) for a taxable year only if all of the taxes paid or accrued for the taxable year and for which a credit is allowable to the taxpayer under section 901 for the taxable year are creditable foreign taxes (as defined in section 904(j)(3)(B). For example, suppose that in year 2, the taxpayer accrues and pays foreign tax that was not shown on a payee statement furnished to the taxpayer and that is related to general limitation income that was recognized and included in income for U.S. tax purposes in year 1. If the foreign taxes in the general limitation category are creditable under section 901 for year 2, the taxpayer may not elect to apply section 904(j) for year 2, even if all of the taxpayer’s income in year 2 is qualified passive income.

In addition, taxpayers requested clarification on the application of the carryover provisions in taxable years following section 904(j) election years. Because hightaxed income, as defined in section 904(d)(2)(F), is calculated by reference to the highest rate of tax specified in section 1 or 11 (whichever is applicable), Treasury and the IRS expect that some individual taxpayers who are eligible to elect the application of section 904(j) may have foreign tax credit carryovers in the passive income category.

The proposed regulations clarify that the amount of a foreign tax credit carryover to or from a non-section-904(j)-election year is not reduced to account for the part of the carryover that (but for section 904(j)) could have been used in intervening section 904(j)-election years. Section 904(j) was intended to allow taxpayers to avoid computing the section 904(a) limitation fraction. See Committee on the Budget, U.S. House of Representatives, Report on Revenue Reconciliation Act of 1997, June 24, 1997, at 520-21. Requiring taxpayers to compute the amount of carryover that could have been used in the election year would be inconsistent with the statutory purpose of making the credit provisions less complex and less burdensome for taxpayers with small amounts of solely passive foreign-source income reported on payee statements. (Taxpayers may, of course, choose to perform the calculations to determine whether electing the application of section 904(j) would be more advantageous for them, particularly for years in which a foreign tax credit carryover will expire.)

However, the section 904(j) election does not extend the carryforward and carryback periods under section 904(c). For example, if a carryforward expires in 2000, and the taxpayer elects the application of section 904(j) for the 2000 taxable year, the carryforward cannot be used in 2000 (pursuant to section 904(j)(1)(C)) or in any later year (pursuant to the expiration of the carryforward period).

Similarly, the determination of whether the taxpayer paid or accrued more than $300 (or $600) of creditable foreign taxes is made without regard to carryovers. For example, a single taxpayer who pays $300 of creditable foreign taxes in 2001, and has a $500 carryover to 2001 from a pre

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vious year, is eligible to elect the application of section 904(j) for the 2001 year. However, if the election is made, the taxpayer cannot claim a credit in 2001 for the $500 otherwise treated as a carryover.

VI. Removal of Example in §1.954–2

The proposed regulations remove Example 2 under §1.954–2(b)(2)(iv), which was intended to illustrate the application of the rules under §1.954–2(b)(2) for the exception from foreign personal holding company for certain export financing interest. Treasury and the IRS are concerned that the example may be unintentionally confusing. For this reason, it is being removed. Comments are invited concerning whether a replacement example is necessary.

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 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 Code, this notice of proposed rulemaking 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 electronic or written comments (a signed original and eight (8) copies) that are submitted timely to the IRS. The IRS and Treasury Department request comments on the clarity of the proposed rules and how they can be made easier to understand. All comments will be available for public inspection and copying.

A public hearing has been scheduled for April 26, 2001, beginning at 10 a.m. in the IRS Auditorium, 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 electronic or 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 April 5, 2001. 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 Rebecca I. Rosenberg of the Office of Associate Chief Counsel (International), within the Office of Chief Counsel, Internal Revenue Service. However, other personnel from the IRS and Treasury participated in their development.

Proposed Amendments to the Regulations

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

PART 1—INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

Paragraph 1. The authority citation for part 1 is amended by removing the entry for “Section 1.902–1 and 902–2” and §1.904–4 through 1.904–7”, and adding entries in numerical order to read in part as follows:

Authority: 26 U.S.C. 7805 * * * Section 1.902–1 also issued under 26

U.S.C. 902(c)(7). * * * Section 1.904–4 also issued under 26 U.S.C. 904(b)(2)(C) and 904(d)(5). Section 1.904–5 also issued under 26 U.S.C. 904(d)(5). Section 1.904–6 also issued under 26 U.S.C. 904(d)(5). Section 1.904–7 also issued under 26 U.S.C. 904(d)(5). * * *

Par. 2. Section 1.902–0 is amended by:

Revising the entry for §1.902–1(a) (13)(ii).
Adding an entry for §1.902–1(a) (13)(iii).

The revisions and additions read as follows:

§1.902–0 Outline for regulations provisions for section 902.

§1.902–1 Credit for domestic corporate shareholder of a foreign corporation for foreign income taxes paid by the foreign corporation.

(a) * * * (13) * * * (ii) Resumption of pooling. (iii) Examples.

Par 3. Section 1.902–1 is amended as follows:

Paragraph (a)(8)(ii) is amended by revising the second sentence.
Paragraph (a)(10)(i) is revised.
Paragraph (a)(10)(iii) is amended by revising the last sentence and adding one sentence.
Paragraphs (a)(13)(i)(A) and (a)(13) (i)(B) are revised.
Paragraphs (a)(13)(i)(C) and (a)(13) (i)(D) are added.
Paragraph (a)(13)(ii) is revised.
Paragraph (a)(13)(iii) is added. The revisions and additions read as follows:

§1.902–1 Credit for domestic corporate shareholder of a foreign corporation for foreign income taxes paid by the foreign corporation.

(a) * * * (8) * * * (ii) * * * Foreign income taxes (other than taxes attributable to formerly pooled earnings that are maintained in United States dollars) that are deemed paid with

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respect to a distribution of pre-1987 accumulated profits shall be translated from the functional currency of the lower-tier corporation into dollars at the spot exchange rate in effect on the date of the distribution. * * *

(10) * * * (i) The term pre-1987 accumulated profits means the amount of the earnings and profits of a foreign corporation computed in accordance with section 902 and attributable to its taxable years beginning before January 1, 1987 (pre1987 earnings). If the special effective date of paragraph (a)(13)(i) of this section applies, pre-1987 accumulated profits also includes any earnings and profits (computed in accordance with section 964(a) and 986) attributable to the foreign corporation’s taxable years beginning after December 31, 1986, but before the first day of the first taxable year of the foreign corporation in which the ownership requirements of section 902(c)(3)(B) and paragraphs (a)(1) through (4) of this section are met with respect to that corporation (pre-pooling earnings). Pre-1987 accumulated profits also includes any post-1986 undistributed earnings formerly maintained by a less-than-10%-U.S.owned foreign corporation (as defined in §1.904–4(g)(1)) that are attributable to the foreign corporation’s taxable years beginning after December 31, 1986, as of the end of which such ownership requirements were met (formerly pooled earnings). Such formerly pooled earnings shall be considered pre-1987 accumulated profits of the last taxable year of the foreign corporation in which such ownership requirements were met as of the end of the taxable year. Pre-1987 accumulated profits also includes earnings and profits accumulated during subsequent taxable years of such a less-than-10%-U.S.-owned foreign corporation as of the end of which such ownership requirements were not met (post-pooling earnings). All four types of pre-1987 accumulated profits described in this paragraph (a)(10)(i) are also sometimes referred to as pre-pooling annual layers.

(iii) * * * Foreign income taxes deemed paid with respect to a distribution of pre-1987 accumulated profits shall be translated from the functional currency of the distributing corporation into United

States dollars at the spot exchange rate in effect on the date of the distribution, except that foreign income taxes attributable to formerly pooled earnings described in the third sentence of paragraph (a)(10)(i) of this section shall be maintained in United States dollars as originally translated in accordance with section 986(a). Post-1986 foreign income taxes attributable to such formerly pooled earnings shall be treated as pre-1987 foreign income taxes.

(13) * * * (i) * * * (A) The post-1986 undistributed earnings and post-1986 undistributed foreign income taxes of the foreign corporation shall be determined by taking into account only consecutive taxable years beginning on and after the first day of the first taxable year of the foreign corporation as of the end of which the ownership requirements of section 902(c)(3)(B) and paragraphs (a)(1) through (4) of this section are met and ending before the first day of a subsequent taxable year in which such ownership requirements are not met as of the end of the taxable year;

(B) Earnings and profits accumulated prior to the first day of the first taxable year of the foreign corporation as of the end of which such ownership requirements are met shall be considered pre1987 accumulated profits (which may include both pre-pooling earnings and pre-1987 earnings);

(C) Formerly pooled earnings described in paragraph (a)(10)(i) of this section shall be considered pre-1987 accumulated profits of the taxable year ending immediately before the next taxable year in which such ownership requirements are not met as of the end of the taxable year; and

(D) Earnings and profits accumulated on and after the first day of a taxable year of the foreign corporation as of the end of which such ownership requirements are not met shall be considered pre-1987 accumulated profits (post-pooling earnings).

(ii) Resumption of pooling . If the ownership requirements of section 902(c)(3)(B) and paragraphs (a)(1) through (4) of this section are again met with respect to a foreign corporation that originally maintained pools of post-1986 undistributed earnings and post-1986 for

eign income taxes but converted such pools to pre-1987 accumulated profits (formerly pooled earnings) and associated pre-1987 foreign income taxes because such ownership requirements were not met as of the close of a subsequent post1986 taxable year, then the post-1986 undistributed earnings and post-1986 foreign income taxes of the foreign corporation shall be determined by taking into account only taxable years beginning on and after the first day of the first such subsequent taxable year of the foreign corporation as of the end of which such ownership requirements are met and ending before the first day of a subsequent taxable year in which such ownership requirements are not met as of the end of the taxable year. The post-pooling earnings, formerly pooled earnings, pre-pooling earnings, and pre-1987 earnings of such a foreign corporation shall continue to be considered pre-1987 accumulated profits. The rules of paragraph (a)(13)(i)(B) through (D) of this section shall apply if such a foreign corporation again becomes a less-than-10%-U.S.owned foreign corporation.

(iii) Examples . The following examples illustrate the special effective date rules of this paragraph (a)(13):

Example 1 . As of December 31, 1991, and since its incorporation, foreign corporation A has owned 100 percent of the stock of foreign corporation B. Corporation B is not a controlled foreign corporation. Corporation B uses the calendar year as its taxable year, and its functional currency is the u. Assume 1u equals $1 at all relevant times. On April 1, 1992, Corporation B pays a 200u dividend to Corporation A and the ownership requirements of section 902(c)(3)(B) and paragraphs (a)(1) through (4) of this section are not met at that time. On July 1, 1992, domestic corporation M purchases 10 percent of the Corporation B stock from Corporation A and, for the first time, Corporation B meets the ownership requirements of section 902(c)(3)(B) and paragraph (a)(2) of this section. Corporation M uses the calendar year as its taxable year. Corporation B does not distribute any dividends to Corporation M during 1992. For its taxable year ending December 31, 1992, Corporation B has 500u of earnings and profits (after foreign taxes but before taking into account the 200u distribution to Corporation A) and pays 100u of foreign income taxes that is equal to $100. Pursuant to paragraph (a)(13)(i) of this section, Corporation B’s post-1986 undistributed earnings and post-1986 foreign income taxes will include earnings and profits and foreign income taxes attributable to Corporation B’s entire 1992 taxable year and all subsequent taxable years beginning before the date these regulations are published as final regulations in the Federal Register, as well as later taxable years as of the end of which the ownership requirements of section 902(c)(3)(B) and paragraphs

January 22, 2001 414 2001–4 I.R.B.

(a)(1) through (4) of this section are met. Thus, the April 1, 1992, dividend to Corporation A will reduce post-1986 undistributed earnings to 300u (500u 200u) under paragraph (a)(9)(i) of this section. The foreign income taxes attributable to the amount distributed as a dividend to Corporation A will not be creditable because Corporation A is not a domestic shareholder. Post-1986 foreign income taxes, however, will be reduced by the amount of foreign taxes attributable to the dividend. Thus, as of the beginning of 1993, Corporation B has $60 ($100- [$100 x 40% (200u/500u)]) of post-1986 foreign income taxes. See paragraphs (a)(8)(i) and (b)(1) of this section.

Example 2 . The facts are the same as in Example 1, except that Corporation M sells five percent of the Corporation B stock to an unrelated buyer on July 1, 2003, so that Corporation B no longer meets the ownership requirements of section 902(c)(3)(B) and paragraphs (a)(1) through (4) of this section as of that date. Thus, as of December 31, 2003, Corporation B’s earnings and profits all consist of pre-1987 accumulated profits, comprising pre-1987 earnings for years beginning prior to January 1, 1987, pre-pooling earnings for taxable years 1987 through 1991, no earnings for 1992 through 2001, formerly pooled earnings for 2002 (comprising Corporation B’s post-1986 undistributed earnings for 1992 through 2002), and post-pooling earnings for 2003. Dividends paid by Corporation B to Corporation M at any time during 2003 will be considered paid out of pre-1987 accumulated profits. See paragraphs (a)(10) and (a)(13)(i) of this section. However, Corporation M will be eligible to claim a deemed-paid credit only with respect to dividends received on or before July 1, 2003. See paragraphs (a)(1) and (12) of this section and §1.902–3(a)(1) and (7).

Example 3 . The facts are the same as in Example 2, except that Corporation M purchases an additional five percent of the stock of Corporation B on July 1, 2004, so that Corporation B again meets the ownership requirements of section 902(c)(3)(B) and paragraphs (a)(1) through (4) of this section on December 31, 2004. As of the end of 2004, assume Corporation B has 500u of post-1986 undistributed earnings (after foreign taxes but before taking into account distributions during 2004) and $100 of post1986 foreign income taxes attributable to 2004, 500u of post-pooling earnings and 100u of pre-1987 foreign income taxes attributable to 2003, and 1500u of formerly pooled earnings and $250 of pre-1987 foreign income taxes attributable to 2002 (comprising Corporation B’s post-1986 undistributed earnings and post-1986 foreign income taxes for 1992 through 2002). Corporation B pays dividends to its shareholders of 500u on March 1, 2004, and 500u on September 1, 2004. The March 1, 2004, dividend is out of Corporation B’s post-1986 undistributed earnings in its entirety, and reduces Corporation B’s post1986 undistributed earnings and post-1986 foreign income taxes to zero, even though no shareholder is eligible to claim a credit for deemed-paid taxes. See paragraphs (a)(8)(i) and (b)(1) of this section. The September 1, 2004, dividend is out of 2003 postpooling earnings, and reduces 2003 post-pooling earnings and foreign income taxes to zero. Corporation M, which is a 10% domestic shareholder of Corporation B on that date and receives a dividend of 50u, is deemed to have paid 10u of foreign

income taxes (50u/500u x 100u) with respect to the dividend. Both the dividend and the deemed-paid taxes are translated into dollars at the spot exchange rate on the dividend date, under the law in effect prior to the effective date of the Tax Reform Act of 1986. See paragraphs (a)(10)(i) and (ii) of this section.

Par. 4. Section 1.904–0 is amended as follows:

The entries for §1.904–4 are amended by:

a. Revising the entry for paragraph (b)(2)(iii).

b. Removing the entry for paragraph (b)(2)(iv).

c. Revising the entries for paragraph (g) and (g)(1), adding entries for paragraph (g)(1)(i) through (g)(1)(iii), and revising the entry for paragarph (g)(3)(i)(C).

d. Adding entries for paragraphs (g)(3)(i)(C)( 1 ), (g)(3)(i)(C)( 2 ), and (g)(4).

e. Adding an entry for paragraph (m). 2. The entries for §1.904(b)–1 are amended by:

a. Revising section heading and the entries for all of paragraphs (a), (b), and (c).

b. Adding entries for paragraphs (d), (e), (f), (g), and (h).

Revising the entries for all of §1.904(b)–2.
Removing all the entries for §§1.904(b)–3 and 1.904(b)–4.
Adding entries for §1.904(j)–1. The revisions and additions read as follows:

§1.904–0 Outline of regulation provisions for section 904.

§1.904–4 Separate application of section 904 with respect to certain categories of income.

(b) * * * (2) * * * (iii) Example.

(g) Noncontrolled section 902 corporation and non-look-through 10/50 corporation.

(1) Corporate-level accounts and treatment of distributions to shareholders. (i) Definitions. (ii) Accounts at foreign corporation level. (iii) Inclusion at shareholder level.

(3) * * * (i) * * * (C) Effect of intervening noncontrolled or less-than-10%-U.S.-owned status. ( 1 ) Pre-2003 decontrolling event. ( 2 ) Pool-terminating event.

(4) Special rule for dividends paid by a 10/50 look-through corporation.

(m) Income treated as allocable to an additional separate category.

§1.904(b)–1 Special rules for capital gains and losses.

(a) Capital amounts included in taxable income from sources outside the United States. (1) Limitation on capital gain from sources outside the United States when the taxpayer has net capital losses from sources within the United States. (i) In general. (ii) Allocation of reduction among multiple separate categories or rate groups. (2) Capital losses from sources outside the United States in the same separate category. (3) Exclusivity of rules; no reduction by reason of net capital loss from sources outside the United States in a different separate category. (4) Examples. (b) Capital gain rate differential. (1) Application of adjustments only if capital gain rate differential exists. (2) Determination of whether capital gain rate differential adjustment exists. (c) Rate differential adjustment of capital gains. (1) Rate differential adjustment of capital gains in foreign source taxable income. (2) Rate differential adjustment of capital gains in entire taxable income. (d) Rate differential adjustment of capital losses from sources outside the United States. (1) In general. (2) Determination of which net capital gains are offset by net capital losses from sources outside the United States. (e) Definitions. (1) Alternative tax rate. (2) Capital gain net income.

2001–4 I.R.B. 415 January 22, 2001

(3) Net capital gain. (4) Rate group. (i) Capital gains. (ii) Capital losses. (5) Terms used in sections 1(h), 904(b) or 1222. (f) Examples. (g) Coordination with overall foreign loss recapture rules. (h) Effective date.

§1.904(b)–2 Special rules for application of section 904(b) to alternative minimum tax foreign tax credit.

(a) Application of section 904(b)(2)(B) adjustments. (b) Use of alternative minimum tax rates. (1) Taxpayers other than corporations. (2) Corporate taxpayers. (c) Effective date.

§1.904(j)–1 Certain individuals exempt from foreign tax credit limitation.

(a) Election available only if all foreign taxes are creditable foreign taxes. (b) Coordination with carryover rules. (1) No carryovers to or from election year. (2) Carryovers to and from other years determined without regard to election years. (3) Determination of amount of creditable foreign taxes. (c) Examples. Par. 5. Section 1.904–4 is amended as follows:

Paragraph (a) is amended by removing the period at the end and adding the language “, or in §1.904–4(m) (additional separate categories).”
The first sentence of paragraph (b)(2)(i) is revised.
Paragraph (b)(2)(ii) is revised.
Paragraph (b)(2)(iii) is removed.
Paragraph (b)(2)(iv) is redesignated as paragraph (b)(2)(iii).
The last three sentences of the Example in newly designated paragraph (b)(2)(iii) are revised and three new sentences are added at the end.
The paragraph heading for paragraph (g) is revised.
Paragraph (g)(1) is redesignated as paragraph (g)(1)(i) and a new heading is added for paragraph (g)(1).
Five sentences are added at the end of newly designated paragraph (g)(1)(i).
Paragraphs (g)(1)(ii) and (iii) are added.
The heading of paragraph (g)(3)(i)(C) is revised and the text to paragraph (g)(3)(i)(C) is added.
The text of Example 2 through Example 4 is added to paragraph (g)(3)(i)(D).
Paragraph (g)(4) is added.
The language “and” at the end of paragraph (l)(1)(v) is removed.
The period at the end of paragraph (l)(1)(vi) is removed and “; and” is added in its place.
Paragraph (l)(1)(vii) is added.
Paragraph (m) is added. The revisions and additions read as follows:

§1.904–4 Separate application of section 904 with respect to certain categories of income.

(b) * * * (2) * * * (i) * * * For rents and royalties paid or accrued more than 60 days after the date these regulations are published as final regulations in the Federal Register, passive income does not include any rents or royalties that are derived in the active conduct of a trade or business, regardless of whether such rents or royalties are received from a related or an unrelated person. * * *

(ii) Exception for certain rents and roy- alties . Rents and royalties are considered derived in the active conduct of a trade or business by a United States person or by a controlled foreign corporation (or other entity to which the look-through rules apply) for purposes of section 904 (but not for purposes of section 954) if the requirements of section 954(c)(2)(A) are satisfied by one or more corporations that are members of an affiliated group of corporations (within the meaning of section 1504(a), determined without regard to section 1504(b)(3)) of which the recipient is a member. For purposes of this paragraph (b)(2)(ii), an affiliated group includes only United States corporations and foreign corporations that are controlled foreign corporations in which United States members of the affiliated group own, directly or indirectly, at least 80 percent of the total voting power and

value of the stock. For purposes of this paragraph (b)(2)(ii), indirect ownership shall be determined under section 318 and the regulations under that section.

(iii) * * * Example . * * * Some of the franchisees are unrelated to S and P. Other franchisees are related to S or P and use the licensed property outside of S’s country of incorporation. S does not satisfy, but P does satisfy, the active trade or business requirements of section 954(c)(2)(A) and the regulations thereunder. The royalty income earned by S with regard to both its related and unrelated franchisees is foreign personal holding company income because S does not satisfy the active trade or business requirements of section 954(c)(2)(A) and, in addition, the royalty income from the related franchisees does not qualify for the same country exception of section 954(c)(3). However, all of the royalty income earned by S is general limitation income to S under §1.904–4(b)(2)(ii) because P, a member of S’s affiliated group (as defined therein), satisfies the active trade or business test (which is applied without regard to whether the royalties are paid by a related person). S’s royalty income that is taxable to P under subpart F and the royalties paid to P are general limitation income to P under the look-through rules of §1.904–5(c)(1)(i) and (c)(3), respectively.

(g) Noncontrolled section 902 corpo- ration and non-look-through 10/50 corpo- ration —(1) Corporate-level accounts and treatment of distributions to shareholders —(i) Definitions . * * * Except as otherwise provided, the term “look-through corporation” means a foreign corporation that is subject to the look-through rules of section 904(d)(3) or section 904(d)(4) (as in effect for taxable years beginning after December 31, 2002). The term “non-look-through 10/50 corporation” means any foreign corporation that is not a look-through corporation and with respect to which a domestic corporation meets the stock ownership requirements of section 902(a), or, for purposes of applying the look-through rules described in section 904(d)(3) and §1.904-5, a domestic corporation meets the requirements of section 902(b). The term “less-than-10%-U.S.-owned foreign corporation” means a foreign corporation that is neither a look-through corporation nor a non-look-through 10/50 corporation. The term “look-through pool” means the post-1986 undistributed earnings of a foreign corporation that are subject to the look-through provisions of section 904(d)(3) or section 904(d)(4) as in effect for taxable years beginning after December 31, 2002. The term “non-lookthrough pool” means the post-1986 undis

January 22, 2001 416 2001–4 I.R.B.

tributed earnings of a foreign corporation that were accumulated (or treated as accumulated) while the foreign corporation was a non-look-through 10/50 corporation.

(ii) Accounts at foreign corporation level . The post-1986 undistributed earnings of a controlled foreign corporation or other look-through corporation may consist of look-through pools (comprising post-1986 undistributed earnings accumulated during periods when the foreign corporation was, or was treated as, a lookthrough corporation, which may include post-1986 undistributed earnings in one or more non-look-through pools attributable to dividends paid to the look-through corporation by each separate non-lookthrough 10/50 corporation), as well as one or more non-look-through pools (including post-1986 undistributed earnings accumulated during periods when the foreign corporation was, or was treated as, a non-look-through 10/50 corporation). Similarly, a look-through corporation’s pre-pooling annual layers, as defined in §1.902–1(a)(10)(i), may or may not be subject to the look-through rules, depending on whether the corporation was, or was treated as, a look-through corporation at the time the earnings were accumulated.

(iii) Inclusion at shareholder level . A particular dividend recipient will be entitled to look-through treatment with respect to a particular distribution from a controlled foreign corporation only if the recipient is a United States shareholder, as defined in section 951(b) taking into account section 953(c), of the controlled foreign corporation at the time it receives the dividend. Therefore, a dividend distribution from a controlled foreign corporation to a United States shareholder will be characterized under the look-through rules, whereas a dividend distribution to a less-than-10% shareholder of the controlled foreign corporation will be treated as passive income. Similarly, under section 904(d)(1)(E), only a corporate shareholder calculates a separate foreign tax credit limitation for dividends from each noncontrolled section 902 corporation, and the look-through rules of section 904(d)(4) as in effect for taxable years beginning after December 31, 2002, apply only to applicable dividends out of post2002 earnings of a corporation that is a

noncontrolled section 902 corporation with respect to the taxpayer. Therefore, dividends paid to an individual shareholder by a non-look-through 10/50 corporation, or by a controlled foreign corporation out of a non-look-through pool, will be treated as passive income. Similarly, dividends paid to an individual shareholder by a look-through corporation that is not a controlled foreign corporation will be treated as passive income to such individual, even if the individual owns 10 percent or more of the distributing corporation’s stock.

(3) * * * (i) * * * (C) Effect of intervening noncontrolled or less-than-10%-U.S.-owned status —( 1 ) Pre-2003 decontrolling event . If a controlled foreign corporation becomes a nonlook-through 10/50 corporation, for example, by reason of the corporation’s issuance of additional stock or the disposition of stock by the corporation’s controlling United States shareholders to foreign persons in a taxable year of the controlled foreign corporation beginning before January 1, 2003, (a decontrolling event), and retains that status as of the end of the foreign corporation’s taxable year, then earnings and profits that were accumulated before the decontrolling event during periods when the corporation was a controlled foreign corporation will at all times thereafter be treated as earnings and profits accumulated by a non-look-through 10/50 corporation. The corporation’s post-1986 undistributed earnings (or deficits in post-1986 undistributed earnings) in each separate category shall be combined into, and constitute the opening balance of, a single non-lookthrough pool of post-1986 undistributed earnings accumulated in taxable years beginning before January 1, 2003. The corporation’s post-1986 foreign income taxes in each separate category shall similarly be combined into a single category of post1986 foreign income taxes attributable to the non-look-through pool. Distributions of such earnings and profits after the decontrolling event will not be subject to the lookthrough rules of §1.904-5, even if the corporation subsequently becomes a controlled foreign corporation or other look-through corporation again. The corporation’s pre1987 accumulated profits will also be ineligible for look-through treatment if accumu

lated prior to, and distributed after, the decontrolling event. In determining whether the look-through rules apply to earnings and profits maintained at the distributing corporation level, earnings and profits accumulated or distributed in the taxable year in which a decontrolling event occurs shall be considered accumulated or distributed after the decontrolling event, respectively. However, in determining whether a dividend recipient is entitled to look-through treatment with respect to a particular distribution, only the shareholder’s status and ownership of stock at the time it receives the dividend is relevant. See §1.902–1(a)(1) and paragraph (g)(1)(iii) of this section.

( 2 ) Pool-terminating event . If a lookthrough corporation or a non-lookthrough 10/50 corporation becomes a less-than-10%-U.S.-owned foreign corporation, for example, by reason of the corporation’s issuance of additional stock or the disposition of stock by the corporation’s United States shareholders (a poolterminating event), and retains that status as of the end of the foreign corporation’s taxable year, then earnings and profits that were accumulated before the pool-terminating event will at all times thereafter be treated as pre-1987 accumulated profits accumulated by a non-look-through 10/50 corporation in accordance with §1.902–1(a)(10) and (13). Distributions of such earnings and profits after the poolterminating event will not be subject to the look-through rules of §1.904–5, even if the corporation subsequently becomes a look-through corporation again. Earnings and profits accumulated or distributed in the taxable year in which a pool-terminating event occurs shall be considered accumulated or distributed after the pool-terminating event, respectively. However, in determining whether a dividend recipient is entitled to look-through treatment with respect to a particular distribution, only the shareholder’s status and ownership of stock at the time it receives the dividend is relevant. See §1.902–1(a)(1) and paragraph (g)(1)(iii) of this section.

(D) * * * Example 2 . (i) Facts . X, a domestic corporation, owns all of the stock of S, a controlled foreign corporation. On March 1, 2002, S pays a dividend to X. On July 1, 2002, S issues additional shares of stock to Z, a foreign person, in exchange for a capital contribution. The new stock issuance dilutes X’s inter

2001–4 I.R.B. 417 January 22, 2001

est in S to 40 percent. Thus, S is a non-look-through 10/50 corporation beginning on July 1, 2002. (ii) Result. The March 1, 2002, dividend to X is treated as a dividend from a non-look-through 10/50 corporation. X is not entitled to look-through treatment on the dividend under paragraph (g)(3)(i)(C) of this section.

Example 3 . (i) Facts . X, a domestic corporation, has owned all of the stock of S, a controlled foreign corporation, since S was organized in 1980. Both X and S use the calendar year as the taxable year. On July 1, 2002, X sells 60 percent of the stock of S to Z, a foreign person. On July 1, 2003, X repurchases all of the S stock that it sold to Z in 2002. Thus, S is a controlled foreign corporation for 1980 through June 30, 2002, a non-look-through 10/50 corporation from July 1, 2002, through December 31, 2002, and a look-through corporation from January 1, 2003, forward, as well as a controlled foreign corporation from July 1, 2003, forward.

(ii) Result . Pursuant to paragraph (g)(3)(i)(C) of this section, X is entitled to look-through treatment with respect to distributions before January 1, 2002, of S’s post-1986 undistributed earnings accumulated through December 31, 2001, and of S’s pre-1987 accumulated profits. Distributions after December 31, 2001, of earnings and profits accumulated before January 1, 2003, will be treated as dividends from a non-look-through 10/50 corporation. X is entitled to look-through treatment on distributions of earnings and profits accumulated and distributed after December 31, 2002.

Example 4 . (i) Facts . The facts are the same as in Example 3, except that X sells 95 percent, rather than 60 percent, of the stock of S to Z. Thus, S is a controlled foreign corporation for 1980 through June 30, 2002, a less-than-10%-U.S.-owned foreign corporation from July 1, 2002, through June 30, 2003, and a controlled foreign corporation beginning on July 1, 2003.

(ii) Result . The result is the same as in Example 3, except that distributions from S made between July 1, 2002, and June 30, 2003, will be treated as passive income to X because X owns less than 10 percent of the stock of S during that period. Distributions from S to X made between January 1, 2002, and June 30, 2002, will be treated as dividends from a non-look-through 10/50 corporation. Distributions from S to X made after June 30, 2003, out of earnings and profits accumulated prior to January 1, 2003, will be treated as dividends from a non-look-through 10/50 corporation. X is entitled to look-through treatment of distributions after June 30, 2003, out of earnings and profits accumulated after December 31, 2002.

(4) Special rule for dividends paid by a 10/50 look-through corporation .

[Reserved]

(l) * * * (1) * * * (vii) Income that meets the definitions of a separate category described in paragraph (m) of this section and of any other category of separate limitation income described in section 904(d)(1)(A) through (H) will be subject to the separate limita

tion described in paragraph (m) of this section and will not be treated as general limitation income described in section 904(d)(1)(I).

(m) Income treated as allocable to an additional separate category . If section 904(a), (b), and (c) are applied separately to any category of income under the Internal Revenue Code (for example, under section 56(g)(4)(C)(iii)(IV), 245(a)(10), 865(h), 901(j), or 904(g)(10)), that category of income will be treated for all purposes of the Internal Revenue Code and regulations as if it were a separate category listed in section 904(d)(1) and section 904(d)(3)(F)(i).

Par. 6. In §1.904–5, paragraph (a)(1) is revised to read as follows:

§1.904–5 Look-through rules as applied to controlled foreign corporations and other entities.

(a) * * * (1) The term “separate category” means, as the context requires, any category of income described in section 904(d)(1)(A), (B), (C), (D), (E), (F), (G), (H), or (I) and in §1.904–4(b), (d), (e), (f), and (g), any category of income described in §1.904–4(m), or any category of earnings and profits to which income described in such provisions is attributable.

Par. 7. In §1.904–6, paragraph (a)(1)(ii) is amended by adding two sentences at the end to read as follows:

§1.904–6 Allocation and apportionment of taxes.

(a) * * * (1) * * * (ii) * * * If the taxpayer applies the principles of §§1.861–8 through 1.861–14T for purposes of allocating expenses at the level of the taxpayer (or at the level of the qualified business unit, foreign subsidiary, or other entity that paid or accrued the foreign taxes) under this paragraph (a)(1)(ii), such principles shall be applied (for such purposes) in the same manner as the taxpayer applies such principles in determining the income or earnings and profits for United States tax purposes of the taxpayer (or of the qualified business unit, foreign subsidiary, or other entity that paid or accrued the foreign taxes, as the case may be). For

example, a taxpayer must use the modified gross income method under §1.861–9T when applying the principles of that section for purposes of this paragraph (a)(1)(ii) to determine the amount of a controlled foreign corporation’s income, in each separate category, that is taxed by a foreign country, if the taxpayer applies the modified gross income method under §1.861–9T(f)(3) when applying §1.861–9T to determine the income and earnings and profits of the controlled foreign corporation for United States tax purposes.

Par. 8. Section 1.904(b)–1 is revised to read as follows:

§1.904(b)–1 Special rules for capital gains and losses.

(a) Capital amounts included in tax- able income from sources outside the United States —(1) Limitation on capital gain from sources outside the United States when the taxpayer has net capital losses from sources within the United States —(i) In general . Except as otherwise provided in this section, for purposes of section 904 and this section, taxable income from sources outside the United States (in all of the taxpayer’s separate categories in the aggregate) shall include capital gain net income from sources outside the United States (determined by considering all of the capital gain and loss items in all of the taxpayer’s separate categories in the aggregate) only to the extent of capital gain net income from all sources. Similarly, except as otherwise provided in this section, for purposes of section 904 and this section, net capital gain from sources outside the United States (determined by considering all of the capital gain and loss items in all of the taxpayer’s separate categories in the aggregate) shall not exceed net capital gain from all sources.

(ii) Allocation of reduction among mul- tiple separate categories or rate groups . If capital gain net income (or net capital gain) from sources outside the United States exceeds capital gain net income (or net capital gain), and the taxpayer has capital gain net income (or net capital gain) from sources outside the United States in two or more separate categories or in two or more rate groups, such excess must be

January 22, 2001 418 2001–4 I.R.B.

apportioned on a pro rata basis as a reduction to each such separate category, and then within each separate category, on a pro rata basis among rate groups. For purposes of the preceding sentence, pro rata means based on the relative amounts of the capital gain net income (or net capital gain) from sources outside the United States in each separate category, or in each rate group within a separate category.

(2) Capital losses from sources outside the United States in the same separate category . Except as otherwise provided in paragraph (d) of this section, taxable income from sources outside the United States in each separate category shall be reduced by any capital loss that is allocable or apportionable to sources outside the United States in such separate category to the extent such loss is allowable in determining taxable income for the taxable year (taking into account losses allowable under section 1211(b)).

(3) Exclusivity of rules; no reduction by reason of net capital losses from sources outside the United States in a dif- ferent separate category . Capital gains from sources outside the United States in any separate category shall be limited by reason of section 904(b)(2)(A) and the comparable limitation of section 904(b)(2)(B)(i) only to the extent provided in paragraph (a)(1) of this section (relating to limitation on capital gain from sources outside the United States when taxpayer has net capital losses from sources within the United States) and paragraph (a)(2) of this section (relating to capital losses from sources outside the United States in the same separate category).

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

Example 1 . Taxpayer A, a corporation, has a general limitation category capital loss of $3,000 from sources outside the United States, a passive category capital gain of $3,000 from sources outside the United States, and a capital loss of $2,000 from sources within the United States. A has no capital gain net income from sources outside the United States (in the aggregate, from all separate categories), because the $3,000 passive capital gain less the $3,000 general limitation capital loss yields a net of zero. From all sources, A also has no capital gain net income. (The resulting $2,000 net capital loss is not currently allowable under section 1211(a) because A is a corporation.) Because A’s capital gain net income from sources outside the United States does not exceed A’s capital gain net income from all sources, paragraph (a)(1) of this section does not

require any reduction of A’s passive category capital gain.

Example 2 . Taxpayer B, a corporation, has $500 of capital gain net income from sources outside the United States, of which $300 is in the general limitation category and $200 is in the passive category. B’s capital gain net income from sources outside the United States is $500 ($300 + $200). Because B also incurs a capital loss of $100 from sources within the United States, B’s capital gain net income (from all sources) is $400 ($300 + $200 - $100). Pursuant to paragraph (a)(1)(B) of this section, the $100 excess of capital gain net income from sources outside the United States over capital gain net income from all sources ($500 - $400) must be apportioned, as a reduction, three-fifths ($300/$500 of $100, or $60) to the general limitation category and two-fifths ($200/$500 of $100, or $40) to the passive category. Therefore, for purposes of section 904, the general limitation category includes $240 ($300 - $60) of capital gain net income from sources outside the United States and the passive category includes $160 ($200 - $40) of capital gain net income from sources outside the United States.

Example 3 . Taxpayer C, a corporation, has a $10,000 capital loss from sources outside the United States in the general limitation category, a $4,000 capital gain from sources outside the United States in the passive category, and a $2,000 capital gain from sources within the United States. C’s capital gain net income from sources outside the United States is zero, since losses exceed gains. C’s capital gain net income from all sources is also zero. C’s capital gain net income from sources outside the United States does not exceed its capital gain net income from all sources, and therefore paragraph (a)(1) of this section does not require any reduction of C’s passive category capital gain. For purposes of section 904, C’s passive category includes $4,000 of capital gain net income. C’s general limitation category includes a capital loss of $6,000 because only $6,000 of capital loss is allowable as a deduction in the current year. The entire $4,000 of capital loss in excess of the $6,000 of capital loss that offsets capital gain in the taxable year is carried back or forward under section 1212(a), and none of such $4,000 is taken into account under section 904(a) or (b) for the current taxable year.

(b) Capital gain rate differential —(1) Application of adjustments only if capital gain rate differential exists . Section 904(b)(2)(B) and paragraphs (c) and (d) of this section apply only for taxable years in which the taxpayer has a capital gain rate differential.

(2) Determination of whether capital gain rate differential exists . For purposes of section 904(b) and this section, a capital gain rate differential is considered to exist for the taxable year only if the taxpayer has a net capital gain for the taxable year and—

(i) In the case of a taxpayer other than a corporation, tax is imposed at a reduced rate under section 1(h) for the taxable year; or

(ii) In the case of a corporation, tax is imposed under section 1201(a) on the taxpayer at a rate less than any rate of tax imposed on the taxpayer by section 11, 511, or 831(a) or (b), whichever applies (determined without regard to the last sentence of section 11(b)(1)), for the taxable year.

(c) Rate differential adjustment of cap- ital gains —(1) Rate differential adjust- ment of capital gains in foreign source taxable income . In determining taxable income from sources outside the United States for purposes of section 904 and this section, capital gain net income from sources outside the United States in each separate category, after any reduction pursuant to paragraph (a) of this section, shall be reduced by the sum of the rate differential portions (as defined in section 904(b)(3)(E)) of each rate group of net capital gain from sources outside the United States in such separate category.

(2) Rate differential adjustment of cap- ital gains in entire taxable income . For purposes of section 904 and this section, the entire taxable income shall include gains from the sale or exchange of capital assets only to the extent of capital gain net income reduced by the sum of the rate differential portions (as defined in section 904(b)(3)(E)) of each rate group of net capital gain.

(d) Rate differential adjustment of cap- ital losses from sources outside the United States —(1) In general . In determining taxable income from sources outside the United States for purposes of section 904 and this section, any net capital loss from sources outside the United States included in a separate category pursuant to paragraph (a) of this section shall be reduced by the sum of the rate differential portion of the net capital gains (from the same rate group in other separate categories, from other rate groups in the same or other separate categories, or from sources within the United States) that are offset by such net capital loss in determining the taxpayer’s entire taxable income.

(2) Determination of which net capital gains are offset by net capital losses from sources outside the United States . For purposes of paragraph (d)(1) of this section, in order to determine which net capital gains (from any rate group) are offset by net capital losses from sources outside the United States, the following rules shall apply in the following order:

2001–4 I.R.B. 419 January 22, 2001

(i) Capital losses from sources outside the United States shall first be netted against capital gains from sources outside the United States in the same rate group and the same separate category as the foreign source capital losses.

(ii) Net capital losses from each rate group from sources outside the United States shall be netted against net capital gains from sources outside the United States from the same rate group in other separate categories, ratably to the extent that net capital gains and losses in a particular rate group occur in two or more separate categories.

(iii) Capital losses from sources within the United States shall be netted against capital gains from sources within the United States in the same rate group.

(iv) The net foreign capital losses from each rate group, as determined under paragraph (d)(2)(ii) of this section, shall be netted against the taxpayer’s remaining net capital gains from sources within and outside the United States in the following order, and without regard to any net capital losses, from any rate group, from sources within the United States—

(A) First against net capital gains from sources within the United States in the same rate group;

(B) Next, against net capital gains in other rate groups, in the order in which capital losses offset capital gains for purposes of determining the taxpayer’s taxable income and without regard to whether such net capital gains derive from sources within or outside the United States, as follows:

( 1 ) A short-term capital loss (including any short-term capital loss carryover) is used first to offset short-term capital gain otherwise taxable at ordinary income rates. Any remaining net short-term capital loss is used first to offset any net longterm gain in the 28 percent rate group, then to offset net long-term gain in the 25 percent rate group, and finally to offset net long-term gain in the 20 percent rate group.

( 2 ) A net capital loss in the 28 percent rate group is used first to offset net capital gain in the 25 percent rate group, and then to offset net capital gain in the 20 percent rate group.

( 3 ) A net capital loss in the 20 percent rate group is used first to offset net capital gain in the 28 percent rate group, and then

to offset net capital gain in the 25 percent rate group.

(v) The net capital losses from sources outside the United States in any rate group, to the extent netted against net capital gains in any other separate category under paragraph (d)(2)(ii) of this section or against net capital gains in any other rate group under paragraph (d)(2)(iv) of this section, shall be treated as coming pro rata from each separate category that contains net capital losses from sources outside the United States in that rate group. For example, assume that the taxpayer has $20 of net capital losses in the 20 percent rate group in the passive category and $40 of net capital losses in the 20 percent rate group in the general limitation category, both from sources outside the United States. Further assume that $50 of the total $60 net capital losses from sources outside the United States are netted against net capital gains in the 28 percent rate group (from other separate categories or from sources within the United States). One-third of the $50 of such capital losses would be treated as coming from the passive category, and two-thirds of such $50 would be treated as coming from the general limitation category.

(vi) The determination of which capital gains are offset by capital losses from sources outside the United States under this paragraph is made solely in order to determine the appropriate rate-differential-based adjustments to such capital losses under this section and section 904(b), and does not change the source, allocation, or separate category of any such capital gain or loss for purposes of computing taxable income from sources within or outside the United States or for any other purpose.

(e) Definitions . For purposes of section 904(b) and this section, the following definitions apply:

(1) Alternative tax rate . The term alternative tax rate means, with respect to any rate group, the rate applicable to that rate group under section 1(h) (for taxpayers other than corporations) or 1201(a) (for corporations). For example, the alternative tax rate for unrecaptured section 1250 gain is 25 percent. (2) Capital gain net income . The term capital gain net income means the excess of the gains from the sales or exchanges of capital assets over the losses from such

sales or exchanges. Such term shall include net section 1231 gain, but shall not include gains or losses from the sale or exchange of capital assets to the extent that such gains are not treated as capital gains. In determining capital gain net income, gains and losses which are not from the sale or exchange of capital assets but which are treated as capital gains and losses under the Internal Revenue Code are included.

(3) Net capital gain . The term net capi- tal gain means the excess of the net longterm capital gain (including net section 1231 gain) for the taxable year over the net short-term capital loss for such year, but shall not include gains or losses from the sale or exchange of capital assets to the extent that such gains are not treated as capital gains. In determining net capital gain, gains and losses which are not from the sale or exchange of capital assets but which are treated as capital gains and losses under the Internal Revenue Code are included.

(4) Rate group . For purposes of this section—

(i) Capital gains . With respect to capital gains, the term rate group means the amounts subject to a particular rate of tax under section 1(h). For example, the 20 percent rate group of capital gain net income from sources outside the United States consists of the capital gain net income from sources outside the United States that is subject to tax at a rate of 20 percent under section 1(h).

(ii) Capital losses . With respect to capital losses, the rate group shall be determined as if the sale or exchange that produced the capital loss had instead produced a capital gain. For example, if the sale of an asset held for more than one year yields a capital loss, but any gain generated by the sale would have been subject to tax at a rate of 20 percent under section 1(h), the capital loss is allocated to the 20 percent rate group for purposes of this section.

(5) Terms used in sections 1(h), 904(b) or 1222 . For purposes of this section, any term used in this section and also used in section 1(h), section 904(b) or section 1222 shall have the same meaning given such term by section 1(h), 904(b) or 1222, respectively, except as otherwise provided in this section.

(f) Examples . The following examples illustrate the provisions of this section. In

January 22, 2001 420 2001–4 I.R.B.

these examples, the adjustment for the rate differential portion is shown as a fraction, the numerator of which is the alternative tax rate percentage and the denominator of which is 39.6 percent (the current highest applicable tax rate for individuals under section 1). All of the examples assume that all capital gains and losses are long-term capital gains and losses. (Therefore, in these examples, capital gain net income equals net capital gain, and for convenience both are referred to in the examples as net capital

gain in calculating the rate differential adjustments). In addition, all dollar amounts in the examples are abbreviated from amounts in the thousands ( e.g., $50 represents $50,000). The examples are as follows:

Example 1 . (i) A, an individual, has foreign source items only in the passive category for the taxable year. A has $1,000 of capital gains from sources outside the United States, which would be taxed at a rate of 20 percent under section 1(h). A has $700 of capital losses from sources outside the United States, which resulted from the sale of capital assets held for more than one year. If the sale

had resulted in gain rather than loss, the gain would have been taxed at a rate of 20 percent under section 1(h). For the same taxable year, A has $800 of capital gains from sources within the United States that are taxed at a rate of 28 percent under section 1(h). A also has $100 of capital losses from sources within the United States. If the sale or exchange generating such capital losses had instead yielded a capital gain, such gain would have been subject to tax a rate of 20 percent under section 1(h). A also has $500 of ordinary income from sources within the United States.

(ii) A’s items of ordinary income, capital gain and capital loss for the taxable year are summarized in the following table:

	U.S. source	foreign source: passive
20% rate group	($100)	$1,000 ($700)
25% rate group
28% rate group	$800
ordinary income	$500

(iii) A’s capital gain net income from sources outside the United States ($300) does not exceed A’s capital gain net income from all sources ($1,000). Therefore, paragraph (a)(1) of this section does not require any reduction of A’s capital gain net income in the passive category.

(iv) In computing A’s taxable income from sources outside the United States in the numerator of the section 904(a) foreign tax credit limitation fraction for the passive category, capital gains and losses from sources outside the United States are netted within rate groups and within separate categories. See paragraphs (a)(2), (c)(1), and (d)(1) of this sec

tion. The $1,000 of capital gain less the $700 of capital loss yields $300 of net capital gain in the 20 percent rate group in the passive category. A must adjust the resulting net capital gain in the passive category as required under section 904(b)(2)(B)(i) and paragraph (c)(1) of this section, using 20 percent as the alternative tax rate, as follows: $300(20%/39.6%).

(v) In computing A’s entire taxable income in the denominator of the section 904(a) foreign tax credit limitation fraction, A must combine the $300 net capital gain from sources outside the United States and the $100 net capital loss from sources within the

United States in the same rate group (20 percent). A must adjust the resulting $200 ($300 - $100) of net capital gain in the 20 percent rate group as required under section 904(b)(2)(B)(ii) and paragraph (c)(2) of this section, using 20 percent as the alternative tax rate, as follows: $200(20%/39.6%). A must also adjust the $800 of net capital gain in the 28 percent rate group, using 28 percent as the alternative tax rate, as follows: $800(28%/39.6%).

(vi) A’s passive category foreign tax credit limitation is computed as follows:

$300 (20%/39.6%)

$500 + $200 (20%/39.6%) + $800 (28%/39.6%)

Example 2 . (i) X, an individual, has the following items of ordinary income, capital gain, and capital loss for the taxable year:

	U.S. source	foreign general	n source: passive
20% rate group	$300	($500)	$100
25% rate group	$200
28% rate group	$500	($300)
ordinary income	$1,000	$500	$500

(ii) X’s capital gain net income from sources outside the United States in the aggregate (zero, since losses exceed gains) does not exceed X’s capital gain net income from all sources ($300). Therefore, paragraph (a)(1) of this section does not require any reduction of X’s capital gain net income in the passive category.

(iii) In computing X’s taxable income from sources outside the United States in the numerators of the section 904(a) foreign tax credit limitation fractions for the passive and general limitation cate

gories, X must adjust capital gain net income and net capital losses as provided in section 904(b)(2)(B)(i) and (iii) and paragraphs (c)(1) and (d)(1) of this section.

(A) First, capital gains and losses from sources outside the United States are netted within rate groups and within separate categories. There are no such amounts to be netted in this case.

(B) Because X has net capital losses in the general limitation category, under paragraph (d)(2)(ii) of this section X’s net capital losses from sources out

side the United States in each rate group are netted against net capital gains from sources outside the United States in other separate categories in the same rate group. Thus, $100 of the $500 net capital loss in the 20 percent rate group in the general limitation category offsets $100 of net capital gain in the 20 percent rate group in the passive category. The $100 net capital gain remains in the passive category and is adjusted under paragraph (c)(1) of this section as follows: $100(20%/39.6%). The $100 net capital loss remains in the general limitation catego

2001–4 I.R.B. 421 January 22, 2001

ry and is adjusted under paragraph (d)(1) of this section as follows: $100 (20%/39.6%).

(C) Next, under paragraph (d)(2)(iv)(A) of this section, X’s net capital losses from sources outside the United States in any rate group and in any separate category are netted against net capital gains in the same rate group from sources within the United States. Thus, $300 of the $500 net capital loss in the 20 percent rate group in the general limitation category offsets $300 of net capital gain in the 20 percent rate group from sources within the United States. The $300 of net capital loss remains in the general limitation category and is adjusted under paragraph (d)(1) of this section as follows: $300 (20%/39.6%). Similarly, the $300 of net capital loss in the 28 percent rate group in the general limitation category offsets $300 of net capital gain in the 28 percent rate group from sources within the United States. The

$300 net capital loss remains in the general limitation category and is adjusted under paragraph (d)(1) of this section as follows: $300(28%/39.6%).

(D) Next, under paragraph (d)(2)(iv)(B) of this section, the remaining net capital losses in a rate group are netted against net capital gains from other rate groups from sources within and outside the United States. The remaining $100 of the $500 net capital loss in the 20 percent rate group in the general limitation category offsets $100 of the remaining net capital gain in the 28 percent rate group from sources within the United States. The $100 of net capital loss remains in the general limitation category and is adjusted under paragraph (d)(1) of this section as follows: $100 (28%/39.6%).

(iv) In computing X’s entire taxable income in the denominator of the section 904(a) foreign tax credit limitation fractions, X must adjust capital gain

net income by netting all of X’s capital gains and losses, from sources within and outside the United States, and adjusting any remaining net capital gains, based on rate category, under section 904(b)(2)(B)(ii) and paragraph (c)(2) of this section. X must also include foreign source ordinary income in the numerators, and worldwide ordinary income in the denominator, of the foreign tax credit limitation fractions. The denominator of X’s foreign tax credit limitation fractions reflects $2,000 of worldwide ordinary income, $100 of U.S.-source net capital gain taxed at the 28% rate and adjusted as follows: $100 (28%/39.6%), and $200 of U.S.-source net capital gain taxed at the 25% rate and adjusted as follows: $200 (25%/39.6%).

(v) X’s general limitation foreign tax credit limitation is computed as follows:

$500 - $100 (20%/39.6%) - $300 (20%/39.6%) - $300 (28%/39.6%) -$100 (28%/39.6%)

$1,000 + $500 + $500 + $100 (28%/39.6%) + $200 (25%/39.6%)

(vi) X’s passive category foreign tax credit limitation is computed as follows:

$500 + $100 (20%/39.6%)

$1,000 + $500 + $500 + $100 (28%/39.6%) + $200 (25%/39.6%)

Example 3 . (i) Y, an individual, has the following items of ordinary income, capital gain, and capital loss for the taxable year:

foreign source : U.S. source general passive

20% rate group $300 ($720) $80

25% rate group $200

28% rate group $500 ($150) 50

ordinary income $1,000 $1,000 $500

(ii) Y’s capital gain net income from sources outside the United States (zero, since losses exceed gains) does not exceed Y’s capital gain net income from all sources ($100). Therefore, paragraph (a)(1) of this section does not require any adjustment.

(iii) In computing Y’s taxable income from sources outside the United States in the numerators of the section 904(a) foreign tax credit limitation fractions for the passive and general limitation categories,Y must adjust capital gain net income and net capital losses as provided in section 904(b)(2)(B)(i) and (iii) and paragraphs (c)(1) and (d)(1) of this section. Since Y has no capital gain net income in any separate category, the only adjustments are those required under section 904(b)(2)(B)(iii) and paragraph (d)(1) of this section.

(A) Under paragraph (d)(2)(ii) of this section, $50 of Y’s $150 net capital loss in the 28 percent rate group in the general limitation category offsets $50 of net capital gain in the 28 percent rate group in the passive category. The $50 of net capital loss remains in the general limitation category and is adjusted as follows: $50 (28%/39.6%). The $50 of net capital gain remains in the passive category and is adjusted as follows: $50 (28%/39.6%).

(B) Under paragraph (d)(2)(iv)(A) of this section, the remaining $100 of net capital loss in the 28 percent rate group in the general limitation category

offsets $100 of net capital gain in the 28 percent rate group from sources within the United States. The $100 of net capital loss remains in the general limitation category and is adjusted as follows: $100 (28%/39.6%).

(C) Under paragraph (d)(2)(iv)(A) of this section, the $300 of net capital gain in the 20 percent rate group from sources within the United States is reduced proportionately by the net capital losses in the 20 percent rate group in the passive and general limitation categories. The proportionate amount of the $720 net capital loss remains in the general limitation category, adjusted as follows: $300 ($720/$800) (20%/39.6%). The proportionate amount of the $80 net capital loss remains in the passive category, adjusted as follows: $300 ($80/$800) (20%/39.6%).

(D) Of the remaining $500 of net capital loss in the 20 percent rate group (in the general limitation and passive categories), $400 offsets the remaining $400 of net capital gain in the 28 percent rate group from sources within the United States under paragraph (d)(2)(iv)(B)( 3 ) of this section. The proportionate amount of the $720 net capital loss remains in the general limitation category, adjusted as follows: $400 ($720/$800) (28%/39.6%). The proportionate amount of the $80 net capital loss remains in the passive category, adjusted as follows: $400 ($80/$800) (28%/39.6%).

(E) Under paragraph (d)(2)(iv)(B)( 3 ) of this section, the remaining $100 of net capital loss in the 20 percent rate group (in the general limitation and passive limitation categories) offsets $100 of net capital gain in the 25 percent rate group from sources within the United States. The proportionate amount of the $720 net capital loss remains in the general limitation category, adjusted as follows: $100 ($720/$800) (25%/39.6%). The proportionate amount of the $80 net capital loss remains in the passive category, adjusted as follows: $100 ($80/$800) (25%/39.6%).

(iv) In computing Y’s entire taxable income in the denominator of the section 904(a) foreign tax credit limitation fractions, Y must adjust capital gain net income by netting all of Y’s capital gains and losses, from sources within and outside the United States, and adjusting any remaining net capital gains, based on rate category, under section 904(b)(2)(B)(ii) and paragraph (c)(2) of this section. Y must also include foreign source ordinary income in the numerators, and worldwide ordinary income in the denominator, of the foreign tax credit limitation fractions. The denominator of Y’s foreign tax credit limitation fractions reflects $2,500 of worldwide ordinary income and $100 of U.S.-source net capital gain taxed at the 25% rate and adjusted as follows: $100 (25%/39.6%).

January 22, 2001 422 2001–4 I.R.B.

(v) Y’s general limitation foreign tax credit limitation is computed as follows:

$1,000 - $50 (28%/39.6) - $100 (28%/39.6%) -$300 ($720/$800) (20%/39.6%) - $400 ($720/$800) (28%/39.6%) - $100 ($720/$800) (25%/39.6%)

$1,000 + $1,000 + $500 + $100 (25%/39.6%)

(vi) Y’s passive category foreign tax credit limitation is computed as follows:

$500 + $50 (28%/39.6%) - $300 ($80/$800) (20%/39.6%) -$400 ($80/$800) (28%/39.6%) - $100 ($80/$800) (25%/39.6%)

$1,000 + $1,000 + $500 + $100 (2.5%/39.6%)

(g) Coordination with overall foreign loss recapture rules . Section 904(b) and this section shall apply before the provisions of section 904(f). Therefore, the amount of a taxpayer’s separate limitation income or loss in each separate category, the amount of overall foreign loss, and the amount of any additions to or recapture of separate limitation loss or overall foreign loss accounts pursuant to section 904(f) shall be determined after applying section 904(b) and this section to adjust capital gains and losses in each separate category.

(h) Effective date . This section shall apply to taxable years beginning after the date this regulation is published in the Federal Register as a final regulation.

Par. 9. Section 1.904(b)-2 is revised to read as follows:

§1.904(b)-2 Special rules for application of section 904(b) to alternative minimum tax foreign tax credit.

(a) Application of section 904(b)(2)(B) adjustments . Section 904(b)(2)(B) shall apply for purposes of determining the alternative minimum tax foreign tax credit under section 59 (regardless of whether or not the taxpayer has made an election under section 59(a)(4)).

(b) Use of alternative minimum tax rates —(1) Taxpayers other than corpora- tions . In the case of a taxpayer other than a corporation, for purposes of determining the alternative minimum tax foreign tax credit under section 59—

(i) Section 904(b)(3)(D)(i) shall be applied by substituting “section 55(b)(3)” for “subsection (h) of section 1”;

(ii) Section 904(b)(3)(E)(ii)(I) shall be applied by substituting “section 55(b)(1)(A)(i)” for “subsection (a), (b), (c), (d), or (e) of section 1 (whichever applies)”; and

(iii) Section 904(b)(3)(E)(iii)(I) shall be applied by substituting “the alternative rate of tax determined under section

55(b)(3)” for “the alternative rate of tax determined under section 1(h)”.

(2) Corporate taxpayers . In the case of a corporation, for purposes of determining the alternative minimum tax foreign tax credit under section 59, section 904(b)(3)(E)(ii)(II) shall be applied by substituting “section 55(b)(1)(B)” for “section 11(b)”. (c) Effective date . This section shall apply to taxable years beginning after the date this section is published as a final regulation in the Federal Register .

§§ 1.904(b)–3 and 1.904(b)–4

[Removed]

Par. 10. Sections 1.904(b)–3 and 1.904(b)–4 are removed. Par. 11. Section 1.904(j)–1 is added to read as follows:

§1.904(j)–1 Certain individuals exempt from foreign tax credit limitation.

(a) Election available only if all for- eign taxes are creditable foreign taxes . A taxpayer may elect to apply section 904(j) for a taxable year only if all of the taxes for which a credit is allowable to the taxpayer under section 901 for the taxable year (without regard to carryovers) are creditable foreign taxes (as defined in section 904(j)(3)(B)).

(b) Coordination with carryover rules —(1) No carryovers to or from elec- tion year . If the taxpayer elects to apply section 904(j) for any taxable year, then no taxes paid or accrued by the taxpayer during such taxable year may be deemed paid or accrued under section 904(c) in any other taxable year, and no taxes paid or accrued in any other taxable year may be deemed paid or accrued under section 904(c) in such taxable year. (2) Carryovers to and from other years determined without regard to election years . The amount of the foreign taxes paid or accrued, and the amount of the foreign source taxable income, in any year

for which the taxpayer elects to apply section 904(j) shall not be taken into account in determining the amount of any carryover to or from any other taxable year. However, an election to apply section 904(j) to any year does not extend the number of taxable years to which unused foreign taxes may be carried under section 904(c) and §1.904–2(b). Therefore, in determining the number of such carryover years, the taxpayer must take into account years to which a section 904(j) election applies.

(3) Determination of amount of cred- itable foreign taxes . Otherwise allowable carryovers of foreign tax credits from other taxable years shall not be taken into account in determining whether the amount of creditable foreign taxes paid or accrued by an individual during a taxable year exceeds $300 ($600 in the case of a joint return) for purposes of section 904(j)(2)(B). (c) Examples . The following examples illustrate the provisions of this section: Example 1 . In 2001, X, a single individual using the cash basis method of accounting for income and foreign tax credits, pays $100 of foreign taxes with respect to general limitation income that was earned and included in income for United States tax purposes in 2000. The foreign taxes would be creditable under section 901 but are not shown on a payee statement furnished to X. X’s only income for 2001 from sources outside the United States is qualified passive income, with respect to which X pays $200 of creditable foreign taxes shown on a payee statement. X may not elect to apply section 904(j) for 2001 because some of X’s foreign taxes are not creditable foreign taxes within the meaning of section 904(j)(3)(B).

Example 2 . (i) In 2002, A, a single individual using the cash basis method of accounting for income and foreign tax credits, pays creditable foreign taxes of $250 attributable to passive income. Under section 904(c), A may also carry forward to 2002 $100 of unused foreign taxes paid in 1998 with respect to passive income, $300 of unused foreign taxes paid in 1998 with respect to general limitation income, $400 of unused foreign taxes paid in 1999 with respect to passive income, and $200 of unused foreign taxes paid in 1999 with respect to general limitation income. In 2002, A’s only foreign source

2001–4 I.R.B. 423 January 22, 2001

income is passive income described in section 904(j)(3)(A)(i), and this income is reported to A on a payee statement (within the meaning of section 6724(d)(2)). If A elects to apply section 904(j) for the 2002 taxable year, the unused foreign taxes paid in 1998 and 1999 are not deemed paid in 2002, and A, therefore, cannot claim a foreign tax credit for those taxes in 2002.

(ii) In 2003, A again is eligible for and elects the application of section 904(j). The carryforwards from 1998 expire in 2003. The carryforward period established under section 904(c) is not extended by A’s election under section 904(j). In 2004, A does not elect the application of section 904(j). The $600 of unused foreign taxes paid in 1999 on passive and general limitation income are deemed paid in 2004, under section 904(c), without any adjustment for any portion of those taxes that might have been used as a foreign tax credit in 2002 or 2003 if section 904(j) had not prevented A from carrying over taxes to those years.

SUPPLEMENTARY INFORMATION:

Background

In Rev. Rul. 99–57 (1999–2 C.B. 678), the IRS issued guidance with respect to the tax consequences for a partnership and a corporate partner where the corporate partner contributes its own stock to the partnership, and the partnership later exchanges the stock with a third party in a taxable transaction. Under that ruling, section 1032 will protect a corporate partner from recognizing gain or loss (to the extent allocated to such partner) when the partnership exchanges stock of the corporate partner in a taxable transaction. The ruling also concludes that, under section 705, the corporate partner increases its basis in its partnership interest by an amount equal to its share of the gain resulting from the partnership’s sale or exchange of the stock.

In situations where a corporation acquires an interest in a partnership that holds stock in that corporation, a section 754 election is not in effect with respect to the partnership for the taxable year in which the corporation acquires the interest, and the partnership later sells or exchanges the stock, it may be inconsistent with the intent of section 705 to increase the basis of the corporation’s partnership interest by the full amount of the gain that is not recognized.

For instance, assume that a corporation (A) purchases a 50 percent interest in a partnership for $100,000. The partnership’s only asset is A stock with a basis of $100,000 and a value of $200,000. If the partnership had not made a section 754 election, then when the partnership disposes of the property for $200,000, A would be allocated $50,000 of gain. Under section 1032, the gain allocated to A would not be subject to tax. If A’s basis in the partnership interest were increased to $150,000 under section 705(a)(1), A would recognize a corresponding $50,000 loss (or reduced gain) upon a subsequent sale of the partnership interest. In this situation, it would be inconsistent with the intent of section 705 to increase the basis of A’s partnership interest for the gain that is not recognized. To do so would create a recognizable loss (or reduced gain) in a situation where no economic loss was incurred and no offsetting gain had previously been recognized.

(d) Effective date . Section 1.904(j)–1 applies to taxable years beginning after December 31, 1997.

Par. 12. Section 1.954–2 is amended by:

Revising paragraph (b)(2)(iv), Example 2 .
Removing paragraph (b)(2)(iv), Example 3 .

The revision reads as follows:

§1.954–2 Foreign personal holding company income.

(b) * * * (2) * * * (iv) * * * Example 2 . (i) DS, a domestic corporation, wholly owns two controlled foreign corporations organized in Country A, CFC1 and CFC2. CFC1 purchases from DS property that DS manufactures in the United States. CFC1 uses the purchased property as a component part of property that CFC1 manufactures in Country A within the meaning of §1.954–3(a)(4). CFC2 provides loans described in section 864(d)(6) to unrelated persons in Country A for the purchase of the property that CFC1 manufactures in Country A.

(ii) The interest accrued from the loans by CFC2 is not export financing interest as defined in section 904(d)(2)(G) because the property sold by CFC1 is not manufactured in the United States under §1.927(a)–1T(c). No portion of the interest is export financing interest as defined in this paragraph (b)(2). The full amount of the interest is, therefore, included in foreign personal holding company income under paragraph (b)(1)(ii) of this section.

Robert E. Wenzel, Deputy Commissioner

of Internal Revenue .

(Filed by the Office of the Federal Register on December 29, 2000, 8:45 a.m., and published in the

issue of the Federal Register for January 3, 2001, 66 F.R. 319)

Notice of Proposed Rulemaking and Notice of Public Hearing

Determination of Basis of Partner’s Interest; Special Rules

REG–106702–00

AGENCY: Internal Revenue Service (IRS), Treasury.

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

SUMMARY: This document contains proposed regulations relating to special rules on determination of basis of partner’s interest under section 705 of the Internal Revenue Code. The proposed regulations are necessary to coordinate sections 705 and 1032. This document also provides a notice of public hearing on these proposed regulations.

DATES: Written comments must be received by April 12, 2001. Outlines of topics to be discussed at the public hearing scheduled for May 3, 2001, also must be received by April 12, 2001.

ADDRESSES: Send submissions to: CC:M&SP:RU (REG–106702–00), 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:M&SP:RU (REG–106702–00), 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/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, Barbara MacMillan, (202) 622-3050; concerning submissions, the hearing, and/or to be placed on the building access list to attend the hearing, Sonya Cruse, (202) 622-7180 (not toll-free numbers).

January 22, 2001 424 2001–4 I.R.B.

Accordingly, in Notice 99–57 (1999–2 C.B. 692), the IRS announced that it intended to promulgate regulations under section 705 to address certain situations where a corporation acquires an interest in a partnership that holds stock in that corporation, and a section 754 election is not in effect with respect to the partnership for the taxable year in which the corporation acquired the interest. The IRS announced that rules regarding tiered-entity structures also would be included in the regulations. The IRS requested comments as to the appropriate scope of the regulations regarding other situations where the price paid for a partnership interest reflects built-in gain or accrued income items that will not be subject to tax, or built-in loss or accrued deductions that will be permanently denied, when allocated to the transferee partner, and the partnership has not made an election under section 754. No formal comments were received.

Explanation of Provisions

As discussed in Notice 99–57, these proposed regulations are being issued in order to prevent inappropriate increases or decreases in the adjusted basis of a corporate partner’s interest in a partnership resulting from the partnership’s disposition of the corporate partner’s stock.

The proposed regulations set forth a detailed statement of the purpose for these regulations which is consistent with the discussion in Notice 99–57. The proposed regulations then provide a specific rule implementing this purpose in situations where a corporate partner holds a direct interest in a partnership that owns stock of the corporate partner. This rule applies where a corporation acquires an interest in a partnership that holds stock in that corporation (or the partnership subsequently acquires stock in that corporation in an exchanged basis transaction), the partnership does not have an election under section 754 in effect for the year in which the corporation acquires the interest, and the partnership later sells or exchanges the stock. In these situations, the increase (or decrease) in the corporation’s adjusted basis in its partnership interest resulting from the sale or exchange of the stock equals the amount

of gain (or loss) that the corporate partner would have recognized (absent the application of section 1032) if, for the taxable year in which the corporation acquired the interest, a section 754 election had been in effect.

The purpose of these proposed regulations cannot be avoided through the use of tiered partnerships or other arrangements. For example, the proposed regulations provide that if a corporation acquires an indirect interest in its own stock through a chain of two or more partnerships (either where the corporation acquires a direct interest in a partnership or where one of the partnerships in the chain acquires an interest in another partnership), and gain or loss from the sale or exchange of the stock is subsequently allocated to the corporation, then the bases of the interests in the partnerships included in the chain shall be adjusted in a manner that is consistent with the purpose of the proposed regulations. As stated above, the proposed regulations include a statement describing the purpose of these regulations which is intended to guide taxpayers in making basis adjustments in the tiered partnership context. In addition, the proposed regulations include two examples illustrating the basis adjustments that are required by the proposed regulations where a corporation acquires an indirect interest in its own stock through a chain of two or more partnerships.

Proposed Effective Date

The regulations shall apply to gain or loss allocated with respect to sales or exchanges of stock occurring after December 6, 1999.

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 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 May 3, 2001, beginning at 10 a.m., in room 6718 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 April 12, 2001. 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

2001–4 I.R.B. 425 January 22, 2001

of the Associate 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 an entry in numerical order to read in part as follows:

Authority: 26 U.S.C. 7805 * * * Section 1.705–2 also issued under 26 U.S.C. 705. * * *

Par. 2. Section 1.705–1 is amended by adding paragraph (a)(7) to read as follows:

§1.705–1 Determination of basis of partner’s interest.

(a) * * * (7) For basis adjustments necessary to coordinate sections 705 and 1032 in certain situations in which a corporation directly or indirectly acquires an interest in a partnership that holds stock in that corporation, see §1.705–2.

Par. 3. Section 1.705–2 is added to read as follows:

§1.705–2 Basis adjustments coordinating sections 705 and 1032.

(a) Purpose . This section is intended to prevent inappropriate increases or decreases in the adjusted basis of a corporate partner’s interest in a partnership resulting from the partnership’s disposition of the corporate partner’s stock. The rules under section 705 generally are intended to preserve equality between the adjusted basis of a partner’s interest in a partnership (outside basis) and such partner’s share of the adjusted basis in partnership assets (inside basis). In the situation where a section 754 election was not in effect for the year in which the partner acquired its interest, however, a partner’s inside basis and outside basis may not be equal. In this situation, gain or loss allocated to the partner upon disposition of

the partnership assets that is attributable to the difference between the adjusted basis of the partnership assets absent the section 754 election and the adjusted basis of the partnership assets had a section 754 election been in effect generally will result in an adjustment to the basis of the partner’s interest in the partnership under section 705(a). Such gain (or loss) therefore generally will be offset by a corresponding decrease in the gain or increase in the loss (or increase in the gain or decrease in the loss) upon the subsequent disposition by the partner of its interest in the partnership. Where such a difference exists with respect to stock of a corporate partner that is held by the partnership, gain or loss from the disposition of corporate partner stock attributable to the difference is not recognized by the corporate partner under section 1032. To adjust the basis of the corporate partner’s interest in the partnership for this unrecognized gain or loss would not be appropriate because it would create an opportunity for the recognition of taxable gain or loss on a subsequent disposition of the partnership interest where no economic gain or loss has been incurred by the corporate partner and no corresponding taxable gain or loss had previously been allocated to the corporate partner by the partnership.

(b) Single partnership —(1) Required adjustments . This paragraph (b) applies in situations where a corporation acquires an interest in a partnership that holds stock in that corporation (or the partnership subsequently acquires stock in that corporation in an exchanged basis transaction), the partnership does not have an election under section 754 in effect for the year in which the corporation acquires the interest, and the partnership later sells or exchanges the stock. In these situations, the increase (or decrease) in the corporation’s adjusted basis in its partnership interest resulting from the sale or exchange of the stock equals the amount of gain (or loss) that the corporate partner would have recognized (absent the application of section 1032) if, for the year in which the corporation acquired the interest, a section 754 election had been in effect.

(2) Example . The provisions of this paragraph (b) are illustrated by the following example:

Example . (i) A, B, and C form equal partnership PRS. Each partner contributes $30,000 in exchange for its partnership interest. PRS has no liabilities. PRS purchases stock in corporation X for $30,000, which appreciates in value to $120,000. PRS also purchases inventory for $60,000, which appreciates in value to $150,000. A sells its interest in PRS to X for $90,000 in a year for which an election under section 754 is not in effect. PRS later sells the X stock for $150,000. PRS realizes a gain of $120,000 on the sale of the X stock. X’s share of the gain is $40,000. Under section 1032, X does not recognize its share of the gain.

(ii) Normally, X would be entitled to a $40,000 increase in the basis of its PRS interest for its allocable share of PRS’s gain from the sale of the X stock, but a special rule applies in this situation. If a section 754 election had been in effect for the year in which X acquired its interest in PRS, X would have been entitled to a basis adjustment under section 743(b) of $60,000 (the excess of X’s basis for the transferred partnership interest over X’s share of the adjusted basis to PRS of PRS’s property). See §1.743–1(b). Under §1.755–1(b), the basis adjustment under section 743(b) would have been allocated $30,000 to the X stock (the amount of the gain that would have been allocated to X from the hypothetical sale of the stock), and $30,000 to the inventory (the amount of the gain that would have been allocated to X from the hypothetical sale of the inventory).

(iii) If a section 754 election had been in effect for the year in which X acquired its interest in PRS, the amount of gain that X would have recognized upon PRS’s disposition of X stock (absent the application of section 1032) would be $10,000 (X’s share of PRS’s gain from the stock sale, $40,000, minus the amount of X’s basis adjustment under section 743(b), $30,000). See §1.743–1(j). Accordingly, the increase in the basis of X’s interest in PRS is $10,000.

(c) Tiered partnerships and other arrangements —(1) Required adjustments . The purpose of these proposed regulations as set forth in paragraph (a) of this section cannot be avoided through the use of tiered partnerships or other arrangements. For example, if a corporation acquires an indirect interest in its own stock through a chain of two or more partnerships (either where the corporation acquires a direct interest in a partnership or where one of the partnerships in the chain acquires an interest in another partnership), and gain or loss from the sale or exchange of the stock is subsequently allocated to the corporation, then the bases of the interests in the partnerships included in the chain shall be adjusted in a manner that is consistent with the purpose of this section.

(2) Examples . The provisions of this paragraph (c) are illustrated by the following examples:

January 22, 2001 426 2001–4 I.R.B.

Example 1 . Acquisition of upper-tier partnership interest by corporation . (i) A, B, and C form a partnership (UTP), with each partner contributing $25,000. UTP and D form a partnership (LTP). UTP contributes $75,000 in exchange for its interest in LTP, and D contributes $25,000 in exchange for D’s interest in LTP. Neither UTP nor LTP has any liabilities. LTP purchases stock in corporation E for $100,000, which appreciates in value to $1,000,000. C sells its interest in UTP to E for $250,000 in a year for which an election under section 754 is not in effect for UTP or LTP. LTP later sells the E stock for $2,000,000. LTP realizes a $1,900,000 gain on the sale of the E stock. UTP’s share of the gain is $1,425,000, and E’s share of the gain is $475,000. Under section 1032, E does not recognize its share of the gain.

(ii) With respect to the basis of UTP’s interest in LTP, if all of the gain from the sale of the E stock (including E’s share) were to increase the basis of UTP’s interest in LTP, UTP’s basis in such interest would be $1,500,000 ($75,000 + $1,425,000). The fair market value of UTP’s interest in LTP is $1,500,000. Because UTP did not have a section 754 election in effect for the taxable year in which E acquired its interest in UTP, UTP’s basis in the LTP interest does not reflect the purchase price paid by E for its interest. Increasing the basis of UTP’s interest in LTP by the full amount of the gain that would be recognized (in the absence of section 1032) on the sale of the E stock preserves the conformity between UTP’s inside basis and outside basis with respect to LTP (i.e., UTP’s share of LTP’s cash is equal to $1,500,000, and UTP’s basis in the LTP interest is $1,500,000) and appropriately would cause UTP to recognize no gain or loss on the sale of UTP’s interest in LTP immediately after the sale of the E stock. Accordingly, increasing the basis of UTP’s interest in LTP by the entire amount of gain allocated to UTP (including E’s share) from LTP’s sale of the E stock is consistent with the purpose of this section. The $1,425,000 of gain allocated by LTP to UTP will increase the adjusted basis of UTP’s interest in LTP under section 705(a)(1). The basis of UTP’s interest in LTP immediately after the sale of the E stock is $1,500,000.

(iii) With respect to the basis of E’s interest in UTP, if E’s share of the gain allocated to UTP and then to E were to increase the basis of E’s interest in UTP, E’s basis in such interest would be $725,000 ($250,000 + $475,000) and the fair market value of such interest would be $500,000, so that E would recognize a loss of $225,000 if E sold its interest in UTP immediately after LTP’s disposition of the E stock. It would be inappropriate for E to recognize a taxable loss of $225,000 upon a disposition of its interest in UTP because E would not incur an economic loss in the transaction, and E did not recognize a taxable gain upon LTP’s disposition of the E stock that appropriately would be offset by a taxable loss on the disposition of its interest in UTP. Accordingly, increasing E’s basis in its UTP interest by the entire amount of gain allocated to E from the sale of the E stock is not consistent with the purpose of this section. (Conversely, because A and B were allocated taxable gain on the disposition of the E stock, it would be appropriate to increase A’s and B’s bases in their respective interests in UTP by the full amount of the gain allocated to them.)

(iv) The appropriate basis adjustment for E’s interest in UTP upon the disposition of the E stock by LTP can be determined as the amount of gain that E would have recognized (in the absence of section 1032) upon the sale by LTP of the E stock if both UTP and LTP had made section 754 elections for the taxable year in which E acquired the interest in UTP. If section 754 elections had been in effect for UTP and LTP for the year in which E acquired E’s interest in UTP, the following would occur. E would be entitled to a $225,000 positive basis adjustment under section 743(b) with respect to the property of UTP. The entire basis adjustment would be allocated to UTP’s only asset, its interest in LTP. In addition, the sale of C’s interest in UTP would be treated as a deemed sale of E’s share of UTP’s interest in LTP for purposes of sections 754 and 743. The deemed selling price of E’s share of UTP’s interest in LTP would be $250,000 (E’s share of UTP’s adjusted basis in LTP, $25,000, plus E’s basis adjustment under section 743(b) with respect to the assets of UTP, $225,000). The deemed sale of E’s share of UTP’s interest in LTP would trigger a basis adjustment under section 743(b) of $225,000 with respect to the assets of LTP (the excess of E’s share of UTP’s adjusted basis in LTP, including E’s basis adjustment ($225,000), $250,000, over E’s share of the adjusted basis of LTP’s property, $25,000). This $225,000 adjustment by LTP would be allocated to LTP’s only asset, the E stock, and would be segregated and allocated solely to E. The amount of LTP’s gain from the sale of the E stock (before considering section 743(b)) would be $1,900,000. E’s share of this gain, $475,000, would be offset in part by the $225,000 basis adjustment under section 743(b), so that E would recognize gain equal to $250,000 in the absence of section 1032.

(v) If the basis of E’s interest in UTP were increased by $250,000, the total basis of E’s interest would equal $500,000. This would conform to E’s share of UTP’s basis in the LTP interest ($1,500,000 x 1/3 = $500,000) as well as E’s indirect share of the cash held by LTP ((1/3 x 3/4) x $2,000,000 = $500,000). Such a basis adjustment does not create the opportunity for the recognition of an inappropriate loss by E on a subsequent disposition of E’s interest in UTP and is consistent with the purpose of this section. Accordingly, under paragraph (c) of this section, of the $475,000 gain allocated to E, only $250,000 will apply to increase the adjusted basis of E in UTP under section 705(a)(1). E’s adjusted basis in its UTP interest following the sale of the E stock is $500,000

Example 2 . Acquisition of lower-tier partnership interest by upper-tier partnership . (i) A, B, and C form an equal partnership (UTP), with each partner contributing $100,000. D, E, and F also form an equal partnership (LTP), with each partner contributing $30,000. LTP purchases stock in corporation B for $90,000, which appreciates in value to $900,000. LTP has no liabilities. UTP purchases D’s interest in LTP for $300,000. LTP does not have an election under section 754 in effect for the taxable year of UTP’s purchase. LTP later sells the B stock for $900,000. UTP’s share of the gain is $270,000, and B’s share of that gain is $90,000. Under section 1032, B does not recognize its share of the gain. (ii) With respect to the basis of UTP’s interest in LTP, if all of the gain from the sale of the B stock

(including B’s share) were to increase the basis of UTP’s interest in LTP, UTP’s basis in the LTP interest would be $570,000 ($300,000 + $270,000), and the fair market value of such interest would be $300,000, so that B would be allocated a loss of $90,000 (($570,000 - $300,000) x 1/3) if UTP sold its interest in LTP immediately after LTP’s disposition of the B stock. It would be inappropriate for B to recognize a taxable loss of $90,000 upon a disposition of UTP’s interest in LTP. B would not incur an economic loss in the transaction, and B was not allocated a taxable gain upon LTP’s disposition of the B stock that appropriately would be offset by a taxable loss on the disposition of UTP’s interest in LTP. Accordingly, increasing UTP’s basis in its LTP interest by the gain allocated to B from the sale of the B stock is not consistent with the purpose of this section. (Conversely, because E and F were allocated taxable gain on the disposition of the B stock, it would be appropriate to increase E’s and F’s bases in their respective interests in LTP by the full amount of such gain.)

(iii) The appropriate basis adjustment for UTP’s interest in LTP upon the disposition of the B stock by LTP can be determined as the amount of gain that UTP would have recognized (in the absence of section 1032) upon the sale by LTP of the B stock if the portion of the gain allocated to UTP that subsequently is allocated to B were determined as if LTP had made an election under section 754 for the taxable year in which UTP acquired its interest in LTP. If a section 754 election had been in effect for LTP for the year in which UTP acquired its interest in LTP, then with respect to B, the following would occur. UTP would be entitled to a $90,000 positive basis adjustment under section 743(b), allocable to B, in the property of LTP. The entire basis adjustment would be allocated to LTP’s only asset, its B stock. The amount of LTP’s gain from the sale of the B stock (before considering section 743(b)) would be $810,000. UTP’s share of this gain, $270,000, would be offset, in part, by the $90,000 basis adjustment under section 743(b), so that UTP would recognize gain equal to $180,000.

(iv) If the basis of UTP’s interest in LTP were increased by $180,000, the total basis of UTP’s partnership interest would equal $480,000. This would conform to the sum of UTP’s share of the cash held by LTP (1/3 x $900,000 = $300,000) and the taxable gain recognized by A and C on the disposition of the B stock that appropriately may be offset on the disposition of their interests in UTP ($90,000 + $90,000 = $180,000). Such a basis adjustment does not inappropriately create the opportunity for the allocation of a loss to B on a subsequent disposition of UTP’s interest in LTP and is consistent with the purpose of this section. Accordingly, of the $270,000 gain allocated to UTP, only $180,000 will apply to increase the adjusted basis of UTP in LTP under section 705(a)(1). UTP’s adjusted basis in its LTP interest following the sale of the B stock is $480,000.

(v) With respect to B’s interest in UTP, if B’s share of the gain allocated to UTP and then to B were to increase the basis of B’s interest in UTP, B would have a UTP partnership interest with an adjusted basis of $190,000 ($100,000 + $90,000) and a value of $100,000, so that B would recognize a loss of $90,000 if B sold its interest in UTP immediately after LTP’s disposition of the B

2001–4 I.R.B. 427 January 22, 2001

SUPPLEMENTARY INFORMATION

Background and Explanation of Provisions

This document contains proposed amendments to 26 CFR parts 1, 31, 35, 36, 40, 301, and 601 relating to Federal tax deposits under section 6302(c) of the Internal Revenue Code (Code). Section 6302(c) provides that the Secretary may authorize Federal Reserve banks, and incorporated banks, trust companies, domestic building and loan associations, or credit unions that are depositaries or financial agents of the United States, to receive any tax imposed under the internal revenue laws, in such manner, at such times, and under such conditions as the Secretary may prescribe. Pursuant to this authority, various regulations provide that Federal Reserve banks, as well as other authorized financial institutions, may receive certain Federal tax deposits.

In cooperation with the Treasury Department’s Financial Management Service (FMS), the Federal Reserve System has been streamlining its Treasury Tax and Loan (TT&L) Operation to respond to the fact that the overwhelming majority of Federal Tax Deposits (FTDs) are now received electronically. The widespread adoption of electronic deposits by taxpayers is an important aspect of improving the efficiency, reliability, and cost-effectiveness of the Treasury Department’s financial management. In general, compared to the universe of all tax deposits, the percentage of FTDs made with paper coupons has significantly declined. FTDs made with paper coupons at Federal Reserve banks now constitute only a tiny percentage of all tax deposits. For example, in Fiscal Year 1999, of the approximately 100 million Federal tax deposits, made by paper coupon and electronically, only about 270,000, or less than one half of one percent, were paper coupons presented at Federal Reserve banks. Additionally, the number of paper coupons presented at Federal Reserve banks has declined over twenty-five percent since 1997.

The Treasury Department has developed an array of other deposit options that are more convenient for taxpayers to use, and more economical to process, than deposits with Federal Reserve banks . For example, taxpayers may use their touch tone telephone or personal computer to make

stock. It would be inappropriate for B to recognize a taxable loss of $90,000 upon a disposition of its interest in UTP because B would not incur an economic loss in the transaction, and B did not recognize a taxable gain upon LTP’s disposition of the B stock that appropriately would be offset by a taxable loss on the disposition of its interest in UTP. Accordingly, increasing B’s basis in its UTP interest by the gain allocated to B from the sale of the B stock is not consistent with the purpose of this section. (Conversely, because A and C were allocated taxable gain on the disposition of the B stock that is a result of LTP not having a section 754 election in effect, it would be appropriate for A and C to recognize an offsetting taxable loss on the disposition of A’s and C’s interests in UTP. Accordingly, it would be appropriate to increase A’s and C’s bases in their respective interests in UTP by the amount of gain recognized by A and C.)

(vi) The appropriate basis adjustment for B’s interest in UTP upon the disposition of the B stock by LTP can be determined as the amount of gain that B would have recognized (in the absence of section 1032) upon the sale by LTP of the B stock if the portion of the gain allocated to UTP that is subsequently allocated to B were determined as if LTP had made an election under section 754 for the taxable year in which UTP acquired its interest in LTP. If a section 754 election had been in effect for LTP for the year in which UTP acquired its interest in LTP, then with respect to B, the following would occur. UTP would be entitled to a basis adjustment under section 743(b) in the property of LTP of $90,000. The entire basis adjustment would be allocated to LTP’s only asset, its B stock. The amount of UTP’s gain from the sale of the B stock (before considering section 743(b)) would be $810,000. UTP’s share of this gain, $270,000, would be offset, in part, by the $90,000 basis adjustment under section 743(b), so that UTP would recognize gain equal to $180,000. The $90,000 basis adjustment would completely offset the gain that otherwise would be allocated to B.

(vii) If no gain were allocated to B so that the basis of B’s interest in UTP was not increased, the total basis of B’s interest would equal $100,000. This would conform to B’s share of UTP’s basis in the LTP interest (($480,000 $180,000 (i.e., A’s and C’s share of the basis that should offset taxable gain recognized as a result of LTP’s failure to have a section 754 election)) x 1/3 = $100,000) as well as B’s indirect share of the cash held by LTP ((1/3 x 1/3) x $900,000 = $100,000). Such a basis adjustment does not create the opportunity for the recognition of an inappropriate loss by B on a subsequent disposition of B’s interest in UTP and is consistent with the purpose of this section. Accordingly, under paragraph (c) of this section, of the $90,000 gain allocated to B, none will apply to increase the adjusted basis of B in UTP under section 705(a)(1). B’s adjusted basis in its UTP interest following the sale of the B stock is $100,000.

(d) Effective date . This section applies to gain or loss allocated with respect to sales or exchanges of stock occurring after December 6, 1999.

Robert E. Wenzel, Deputy Commissioner

of Internal Revenue .

(Filed by the Office of the Federal Register on December 29, 2000, 8:45 a.m., and published in the issue of the Federal Register for January 3, 2001, 66 F.R. 315)

Notice of Proposed Rulemaking

Removal of Federal Reserve Banks as Federal Depositaries

REG–107176–00

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

SUMMARY: This document contains proposed regulations which remove the Federal Reserve banks as authorized depositaries for Federal tax deposits. The regulations affect taxpayers who make Federal tax deposits using paper Federal Tax Deposit (FTD) coupons (Form 8109) at Federal Reserve banks.

DATES: Written or electronically generated comments and requests for a public hearing must be received by March 26, 2001 .

ADDRESSES: Send submissions to: CC (REG–107176–00), 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 (REG–107176–00), 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.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, Brinton T. Warren, (202) 6224940; concerning submissions of comments and requests for a public hearing, Treena Garrett of the Regulations Unit at (202) 622-7180 (not toll-free numbers).

January 22, 2001 428 2001–4 I.R.B.

deposits 24 hours a day through the Electronic Federal Tax Payment System (EFTPS). For those taxpayers who still prefer paper coupons over electronic deposits, there are now more than 10,000 financial institutions nationwide that are designated as TT&L depositaries where taxpayers may make FTD deposits using paper coupons.

In response to the declining number of deposits being made with paper coupons at Federal Reserve banks, the Federal Reserve Bank of St. Louis was selected, effective May 1, 2000, to serve as the only Federal Reserve bank accepting FTDs. Even after this consolidation, however, it is no longer cost-effective for the Federal Reserve bank in St. Louis to process the small number of paper coupons it receives annually. Accordingly, these proposed regulations remove all Federal Reserve banks as depositaries for Federal taxes. To mitigate any difficulties for those taxpayers who still do not wish to use the deposit alternatives discussed above, the Treasury Department has authorized a financial agent to receive and process FTD payments through the mail, thereby maintaining a mail-in alternative for taxpayers who do not have an account with an authorized financial institution and who do not wish to use EFTPS. The address for this mail-in alternative is Financial Agent, Federal Tax Deposit Processing, P.O. Box 970030, St. Louis, Missouri, 63197.

Proposed Effective Date

The regulations, as proposed, apply to any deposits of Federal taxes made after the date of publication of a Treasury decision adopting these rules as final regulations in the Federal Register .

Special Analyses

It has been determined that this notice of proposed rulemaking is not a signifi

cant 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 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, these 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 (a signed original and 8 copies) and electronic comments that are submitted timely to the IRS. The IRS and Treasury Department request comments on the clarity of the proposed rules and how they can be made easier to understand. All comments will be available for public inspection and copying. A public hearing will be scheduled if requested in writing by any person that timely submits comments. If a public hearing is scheduled, notice of the date, time, and place for the public hearing will be published in the Federal Register .

Drafting Information

The principal author of these regulations is Brinton T. Warren of the Office of Associate Chief Counsel, Procedure and Administration (Administrative Provisions and Judicial Practice Division). However, other personnel from the IRS and Treasury Department participated in their development.

Proposed Amendments to the Regulations

Accordingly, and under the authority of 26 U.S.C. 7805 and 5 U.S.C. 301, 26 CFR parts 1, 31, 35, 36, 40, 301 and 601 are proposed to be amended as follows:

PART 1—INCOME TAXES

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

Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.6302–1 is amended by removing the fifth sentence in paragraph (b)(1).

Par. 3. Section 1.6302–2 is amended by removing the third sentence in paragraph (b)(1).

PART 31—EMPLOYMENT TAXES AND COLLECTION OF INCOME TAX AT SOURCE

Par. 4. The authority citation for part 31 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * * Par. 5. Section 31.6302–1 is amended by removing the fourth sentence in paragraph (i)(3).

Par. 6. Section 31.6302(c)–3 is amended by removing the third sentence in paragraph (b)(2).

PARTS 1, 31, 35, 36, 40, 301, 601–[AMENDED]

Par. 7. In the list below, for each section indicated in the left column, remove the language in the middle column and add, if any, the language in the right column:

Section Remove Add

1.1461–1(a), a Federal reserve bank or an effective January 1, 2001

1.1502–5(a)(1) commercial dispositary or financial institution Federal Reserve Bank

1.6151–1(d)(1) Federal Reserve Banks or - - - - - - - - - - - 1.6302–1(b)(1) 214 or, at the election of the 203 fourth sentence corporation, to a Federal Reserve bank

2001–4 I.R.B. 429 January 22, 2001

Section Remove Add

1.6302–1(b)(1)(as the Federal Reserve bank or - - - - - - - - - - - amended by paragraph 2) fifth sentence

1.6302–2(a)(1)(i) a Federal Reserve bank or an

1.6302–2(a)(1)(ii) a Federal Reserve bank or an

1.6302–2(a)(1)(iv) a Federal Reserve bank or an

1.6302–2(b)(1) 214 or, at the election of the 203 second sentence withholding agent, to a Federal Reserve bank

1.6302–2(b)(1)(as the Federal Reserve bank or - - - - - - - - - - - amended by paragraph 3) third sentence

1.6302–3(a) or with a Federal Reserve Bank - - - - - - - - - - - 31.6071(a)–1(a)(1) or by a Federal Reserve bank - - - - - - - - - - - 31.6071(a)–1(c) a Federal Reserve bank or by - - - - - - - - - - - 31.6151–1(b) Federal Reserve banks and - - - - - - - - - - - 31.6302–1(c)(1) a Federal Reserve bank or an

31.6302–1(c)(2)(i) a Federal Reserve bank or an

31.6302–1(c)(3) a Federal Reserve bank or an

31.6302–1(i)(3) 214 or, at the election of the 203 employer, to a Federal Reserve bank

31.6302–1(i)(5) the Federal Reserve bank or - - - - - - - - - - - 31.6302(c)–2A(b)(1)(i) with a Federal Reserve bank or - - - - - - - - - - - 31.6302(c)–2A(b)(3) with a Federal Reserve bank or - - - - - - - - - - - 31.6302(c)–3(a)(1)(i) with a Federal Reserve bank or - - - - - - - - - - - 31.6302(c)–3(a)(1)(ii) with a Federal Reserve bank or - - - - - - - - - - - 31.6302(c)–3(a)(3) with a Federal Reserve bank or - - - - - - - - - - - 31.6302(c)–3(b)(2) 214 or, at the election of the 203 second sentence employer, to a Federal Reserve bank

31.6302(c)–3(b)(2) the Federal Reserve bank or - - - - - - - - - - - (as amended by paragraph 6) third sentence

35.3405–1T(e–10) a Federal Reserve Bank or - - - - - - - - - - - 36.3121(l)(10)–4 a Federal Reserve bank or an

40.6302(c)–1(d)(1) 214) or to a Federal Reserve bank 203)

301.6302–1(a) Federal Reserve banks and authorized authorized financial commercial banks institutions

301.6302–1(b)(1) Federal Reserve banks or authorized authorized financial commercial banks institutions

January 22, 2001 430 2001–4 I.R.B.

Section Remove Add

301.6302–1(b)(2) Federal Reserve banks or authorized authorized financial commercial banks institutions

301.9100–5T(c)(3) Federal Reserve banks and - - - - - - - - - - - 601.401(a)(5) Federal Reserve banks and - - - - - - - - - - - heading

601.401(a)(5)(iii) a Federal Reserve bank or an first sentence

601.401(a)(5)(iii) a Federal Reserve bank or an second sentence

601.401(a)(5)(iv) a Federal Reserve bank or a an authorized financial institution authorized financial institution in accordance with Treasury Department Circular No. 1079, revised, to accept remittances of these taxes for transmission to a Federal Reserve bank

Robert E. Wenzel, Deputy Commissioner

of Internal Revenue .

(Filed by the Office of the Federal Register on December 22, 2000, 8:45 a.m., and published in the issue of the Federal Register for December 26, 2000, 65 F.R. 81453)

Information Reporting for Payments of Qualified Tuition and Payments of Interest on Qualified Education Loans; Magnetic Media Filing Requirements for Information Returns; Public Hearing

Announcement 2001–10

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of public hearing on proposed rulemaking.

SUMMARY: This document contains a notice of public hearing on proposed regulations relating to reporting for payments of qualified tuition and payments of interest on qualified education loans and magnetic filing requirements for information returns.

DATES: The public hearing is being held on Tuesday, February 13, 2001, at 10 a.m.

The IRS must receive outlines of the topics to be discussed at the hearing by January 23, 2001.

ADDRESSES: The public hearing is being held in the auditorium, Room 7218, 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.

Mail outlines to: Regulations Unit CC (REG–105316–98), Room 5226, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. Hand deliver outlines Monday through Friday between the hours of 8 a.m. and 5 p.m. to: Regulations Unit CC (REG–105316–98), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue NW., Washington, DC. Submit electronic outlines of oral comments directly to the IRS Internet site at:

http://www.irs.gov/tax_regs/regslist.html.

FOR FURTHER INFORMATION CONTACT: Concerning submissions of comments, the hearing, and/or to be placed on the building access list to attend the hearing, Guy Traynor, (202) 622-7180 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

The subject of the public hearing is proposed regulations (REG–105316–98, 2000–27 I.R.B. 98) that were published in the Federal Register on Friday, June 16, 2000 (65 F.R. 37728). The rules of §601.601(a)(3) apply to the hearing.

Persons who have submitted written comments and wish to present oral comments at the hearing, must submit an outline of the topics to be discussed and the amount of time to be devoted to each topic (signed original and eight (8) copies) by January 23, 2001.

A period of 10 minutes is allotted to each person for presenting oral comments.

After the deadline for receiving outlines has passed, the IRS will prepare an agenda containing the schedule of speakers. Copies of the agenda will be made available, free of charge, at the hearing.

Because of access restrictions, the IRS will not admit visitors 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 document.

2001–4 I.R.B. 431 January 22, 2001

Cynthia E. Grigsby, Chief, Regulations Unit, Office of Special Counsel (Modernization & Strategic Planning) .

(Filed by the Office of the Federal Register on December 19, 2000, 8:45 a.m., and published in the issue of the Federal Register for December 20, 2000, 65 F.R. 79788)

Guidance Under Section 355(e); Recognition of Gain on Certain Distributions of Stock or Securities in Connection With an Acquisition; Withdrawal of Proposed Rulemaking

Announcement 2001–11

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Withdrawal of notice of proposed rulemaking.

SUMMARY: This document withdraws the notice of proposed rulemaking relat

ing to recognition of gain on certain distributions of stock or securities of a controlled corporation in connection with an acquisition that was published in the Federal Register on August 24, 1999. The withdrawal is in response to written comments received and oral comments presented at a public hearing.

EFFECTIVE DATE: These regulations are effective January 2, 2001.

FOR FURTHER INFORMATION CONTACT: Brendan O’Hara, (202) 622-7530 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

On August 24, 1999, the IRS issued proposed regulations (REG–116733–98, 1999–2 C.B. 392) in the Federal Register (64 F.R. 46155) under section 355(e), relating to the recognition of gain on certain distributions of stock or securities in connection with an acquisition of stock of the distributing corporation or of stock of the

corporation whose stock is distributed. In response to written comments received and comments presented at a public hearing, these proposed regulations are being withdrawn. New proposed regulations (REG– 107566–00) covering the same matters as the withdrawn proposed regulations were being issued in 2001–3 I.R.B. 346.

Withdrawal of Notice of Proposed Rulemaking

Accordingly, under the authority of 26 U.S.C. 7805 and 26 U.S.C. 355(e)(5), the notice of proposed rulemaking (REG–116733–98) that was published in the Federal Register on August 24, 1999 (64 F.R. 46155) is withdrawn.

Robert E. Wenzel, Deputy Commissioner

of Internal Revenue .

(Filed by the Office of the Federal Register on December 29, 2000, 8:45 a.m., and published in the issue of the Federal Register for January 2, 2001, 66 F.R. 76)

January 22, 2001 432 2001–4 I.R.B.