Part III. — Internal Revenue Bulletin 2001-30

Amendment of Qualified Plans for the Economic Growth and Tax Relief Reconciliation Act of 2001

Notice 2001–42

I. Purpose

This notice provides guidance concerning amendments to plans qualified under §§ 401(a) and 403(a) of the Internal Revenue Code related to the Economic Growth and Tax Relief Reconciliation Act of 2001, Pub. L. 107–16 (“EGTRRA”). Changes made by EGTRRA to the Code provisions related to qualified plans include changes that require plan amendment to preserve qualification and changes that require plan amendment only if the plan sponsor chooses to change the plan.

The effects of this notice are to:

avoid further delays in amending plans for GUST ¹ ;
prevent disruption of the GUST determination letter process that has already been undertaken by thousands of plan sponsors;
facilitate timely adoption of EGTRRA plan amendments;
ensure that plan terms reflect the actual operation of the plan;
allow plan sponsors to minimize the cost and burden of adopting EGTRRA plan amendments;
provide plan sponsors with the opportunity to retroactively amend their “good faith” EGTRRA plan amendments, if necessary; and
facilitate the timely amendment of master and prototype (“M&P”) and

1 The term “GUST” refers to the following:

the Uruguay Round Agreements Act, Pub. L. 103-465;
the Uniformed Services Employment and Reemployment Rights Act of 1994, Pub. L. 103353;
the Small Business Job Protection Act of 1996, Pub. L. 104-188;
the Taxpayer Relief Act of 1997, Pub. L. 105-34 (“TRA ’97”);
the Internal Revenue Service Restructuring and Reform Act of 1998, Pub. L. 105-206; and
the Community Renewal Tax Relief Act of 2000, Pub. L. 106-554 (“CRA”).

amendment, is not consistent either with the provision of EGTRRA or with the operation of the plan in a manner consistent with EGTRRA, as applicable.

Before the end of August 2001, the Service will publish sample EGTRRA plan amendments that plan sponsors and sponsors of pre-approved plans can adopt or use in drafting individualized plan amendments. A sample EGTRRA plan amendment, or a plan amendment that is materially similar to a sample EGTRRA plan amendment, will be a “good faith” EGTRRA plan amendment.
Plan provisions that are amended by a timely “good faith” EGTRRA plan amendment or that automatically reflect a statutory EGTRRA change (for example, as a result of permitted incorporation by reference) have a remedial amendment period ending no earlier than the end of the 2005 plan year in which any needed retroactive

volume submitter plans (“pre-approved plans”) for GUST and EGTRRA.

Specifically, this notice provides the following:

The GUST remedial amendment period for individually designed plans, which ends on the last day of the 2001 plan year, is not being extended. However, a separate, later remedial amendment period is being provided for EGTRRA.
The GUST remedial amendment period provided to prior adopters of preapproved plans and employers that timely certify their intent to adopt a pre-approved plan that has been restated for GUST will be treated as not expiring earlier than December 31,

This change will simplify the determination of the GUST amendment deadline for these plans and facilitate timely amendment of the plans for GUST and EGTRRA.

A plan is required to have a “good faith” EGTRRA plan amendment in effect for a year if: (1) the plan is required to implement a

remedial EGTRRA plan amendments may be adopted.

“Good faith” EGTRRA plan amendments must be adopted no later than the later of (1) the end of the plan year in which the amendments are required to be, or are optionally, put into effect or (2) the end of the GUST remedial amendment period. In limited situations, earlier amendment may be required to avoid a decrease or elimination of benefits prohibited by § 411(d)(6).
Individually designed plans submitted for GUST determination letters may reflect the changes made by EGTRRA. Also, pre-approved plans submitted for GUST determination letters may include EGTRRA amendments in the form of a separate, clearly identified addendum to the plan (or basic plan document) and/or adoption agreement that is limited to the provisions of EGTRRA. However, until further notice, determination, opinion, and advisory letters will not consider the EGTRRA changes.

II. Background

Section 401(b) . Section 401(b) and the regulations thereunder provide a remedial amendment period during which an amendment to a disqualifying provision may be made retroactively effective, under certain circumstances, to comply with the requirements of § 401(a). Section 1.401(b)–1(b)(3) authorizes the Commissioner to designate as a disqualifying provision under § 401(b) a plan provision that either (1) results in the failure of the plan to satisfy the qualification requirements of the Code by reason of a change in those requirements, or (2) is integral to a qualification requirement that has been changed. Section 1.401(b)–1(c)(3) authorizes the Commissioner to impose limits and provide additional rules regarding the amendments that may be made within the remedial amendment period with respect to a plan provision designated as a disqualifying provision. Section 1.401(b)–1(f) grants the Commissioner the discretion to extend the remedial amendment period.

provision of EGTRRA for the year, or the plan sponsor chooses to implement an optional provision of EGTRRA for the year, and (2) the plan language, prior to the

July 23, 2001 70 2001–30 I.R.B.

The GUST Remedial Amendment Period and Determination Letter Program. The remedial amendment period for GUST disqualifying provisions for individually designed plans generally ends on the last day of the first plan year beginning on or after January 1, 2001 (“the 2001 plan year”). Many sponsors of individually designed plans have already amended or are in the process of amending plans for GUST.

Sponsors of pre-approved plans were required to submit these plans to the Service by December 31, 2000. The Service is currently reviewing and issuing opinion and advisory letters for pre-approved plans that have been amended for GUST. Section 19 of Rev. Proc. 2000–20, 2000–6 I.R.B. 553, as modified by Rev. Proc. 2000–27, 2000–26 I.R.B. 1272, provides an extension of the GUST remedial amendment period for employers that have adopted a preapproved plan, or certified their intent to adopt a pre-approved plan that has been restated for GUST, by the end of the 2001 plan year. If the requirements for the extension are satisfied, the GUST remedial amendment period for the employer’s plan will not end before the end of the 12th month beginning after the date on which the Service issues a GUST opinion or advisory letter for the pre-approved plan.

EGTRRA . EGTRRA, which was enacted on June 7, 2001, includes numerous changes to the qualified plan rules. Almost all of these changes are effective in years beginning after December 31, 2001. While many of the changes are not mandatory, a plan sponsor that chooses to implement an optional provision of EGTRRA will have to amend its plan to conform plan provisions to plan operation.

White Paper on Future Determination Letter Process . The Service is considering the design of the Employee Plans determination letter process and will publish in the near future a white paper that explores some options for long-term changes and alternatives to the current process. Some of the options in the white paper will deal with the timing of plan amendments to comply with law changes and the application of the remedial amendment provisions of § 401(b).

III. Remedial Amendment Period for EGTRRA

Designation as Disqualifying Provi- sions . A plan provision is hereby desig

nated as a disqualifying provision under § 1.401(b)–1(b) if:

(1) the plan provision either (i) causes

the plan to fail to satisfy the qualification requirements of the Code because of a change in those requirements made by EGTRRA or (ii) is integral to a qualification requirement that has been changed by EGTRRA; and (2) if a “good faith” EGTRRA plan

otherwise be permitted to be incorporated by reference is not a “good faith” EGTRRA plan amendment.

Section 411(d)(6). Section 411(d)(6) generally prohibits plan amendments that decrease accrued benefits or have the effect of eliminating or reducing an early retirement benefit or retirement-type subsidy, or eliminating an optional form of benefit, for benefits attributable to service before the amendment.

EGTRRA does not provide relief from the requirements of § 411(d)(6) for plan amendments adopted as a result of EGTRRA changes in the plan qualification requirements. Therefore, in order to have a provision effective for a plan year, a plan may have to be amended for provisions of EGTRRA before the time when “good faith” EGTRRA plan amendments would otherwise be required under this notice. However, a plan amendment that eliminates or decreases benefits that have not yet accrued does not violate § 411(d)(6).

amendment is required to be in effect with respect to the provision, the plan provision was added or changed by a “good faith” EGTRRA plan amendment adopted no later than the later of (i) the end of the plan year in which the EGTRRA change in the qualification requirements is required to be, or is optionally, put into effect under the plan or (ii) the end of the GUST remedial amendment period for the plan. Extension of the EGTRRA Remedial Amendment Period . The remedial amendment period under § 401(b) for a disqualifying provision described in the preceding paragraph shall not end prior to the last day of the first plan year beginning on or after January 1, 2005 (“the 2005 plan year”). Good Faith EGTRRA Plan Amend- ments. A plan is required to have a “good faith” EGTRRA plan amendment in effect for a year if:

(1) the plan is required to implement a

provision of EGTRRA for the year, or the plan sponsor chooses to implement an optional provision of EGTRRA for the year, and (2) the plan language, prior to the

For example, in a top-heavy defined contribution plan, only those non-key employees who are participants and have not separated from service by the end of the plan year must receive the top-heavy minimum benefit. (See § 1.416–1, Q&A M–10.) A benefit that is conditioned on employment at the end of the plan year does not accrue until the participant satisfies the end-of-the-plan-year employment requirement. Thus, the top-heavy minimum benefit in a defined contribution plan that provides minimum contributions only to non-key employees who have not separated from service by the end of the plan year does not accrue until the end of the plan year. A “good faith” amendment of such a plan that modifies the plan’s top-heavy rules in accordance with § 613 of EGTRRA will not result in an impermissible decrease of accrued minimum benefits provided the amendment is adopted before the end of the 2002 plan year.

In a top-heavy defined benefit plan, under §1.416–1, Q&A M–4, only those non-key employees who are participants and have at least one thousand hours of service for an accrual computation period must accrue the top-heavy minimum benefit for that accrual computation period. (In a top-heavy defined benefit plan that credits benefit accrual service using the

amendment, is not consistent either with the provision of EGTRRA or with the operation of the plan in a manner consistent with EGTRRA, as applicable. For purposes of this notice, a plan amendment is a “good faith” EGTRRA plan amendment if the amendment represents a reasonable effort to take into account all of the requirements of the applicable EGTRRA provision and does not reflect an unreasonable or inconsistent interpretation of the provision. A plan amendment that merely incorporates by reference an EGTRRA change in a qualification requirement that would not

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elapsed time method described in § 1.410(a)–7, minimum benefits must be credited for all periods of service required to be credited for benefit accrual.) A benefit that is conditioned on completion of one thousand hours of service does not accrue until the participant satisfies the service requirement. Thus, the top-heavy minimum benefit in a defined benefit plan that provides minimum benefits only to non-key employees who have at least one thousand hours of service in an accrual computation period does not accrue until the participant has one thousand hours of service in the period. A “good faith” amendment of a defined benefit plan that modifies the plan’s top-heavy rules in accordance with § 613 of EGTRRA will not be treated as impermissibly decreasing accrued minimum benefits provided the amendment is adopted on or before May 31, 2002, or, in the case of a plan that credits service using elapsed time, March 31, 2002. Effect of This Section . A plan amendment to a disqualifying provision described in this section III can be made retroactively effective within the EGTRRA remedial amendment period to the extent necessary either to satisfy the qualification requirements as amended by EGTRRA, as interpreted in published guidance, or to make the plan provisions consistent with plan operation. To the extent necessary, such a remedial amendment may be made retroactively effective as of the effective date of the “good faith” EGTRRA plan amendment or, where the plan provision automatically reflects the EGTRRA change, as of the effective date of the change.

No Extension of GUST Remedial Amendment Period . The EGTRRA remedial amendment period applies only to disqualifying provisions described in this section. It does not extend the GUST remedial amendment period.

IV. Sample EGTRRA Plan Amendments

Publication of Sample “Good Faith” EGTRRA Plan Amendments . Before the end of August 2001, the Service will publish sample EGTRRA plan amendments that can be adopted verbatim or used in drafting individualized plan amendments for individually designed and pre-approved plans. The sample EGTRRA plan amendments will be for both the required

and optional changes under EGTRRA. Additional guidance on amending pre-approved plans will be included with the sample EGTRRA amendments. A sample EGTRRA plan amendment, or a plan amendment that is materially similar to a sample EGTRRA plan amendment, will be a “good faith” EGTRRA plan amendment for purposes of this notice. However, plan amendments will not fail to be “good faith” plan amendments merely because they differ materially from the sample EGTRRA plan amendments.

Possible Subsequent Required Amend- ments . Plans amended by adoption of the sample EGTRRA amendments may have to be amended again within the EGTRRA remedial amendment period to continue to satisfy the plan qualification requirements as amended by EGTRRA.

V. Effect on Determination Letter Programs and Reliance

In General . Until further notice, determination, opinion and advisory letters will not consider and may not be relied on with respect to the EGTRRA changes. However, an employer’s ability to rely on a favorable determination, opinion, or advisory letter will not be adversely affected by the timely adoption of “good faith” EGTRRA plan amendments.

Individually Designed Plans . Individually designed plans submitted for GUST determination letters may incorporate the changes made by EGTRRA; however the GUST determination letter will not extend to amendments incorporating EGTRRA provisions.

Pre-Approved Plans . M&P sponsors and volume submitter practitioners may amend pre-approved plans for EGTRRA through the adoption of a separate, clearly identified addendum to the plan (or basic plan document) and/or adoption agreement that is limited to the provisions of EGTRRA. The sample EGTRRA plan amendments will provide additional guidance on the amendment of pre-approved plans. Until further notice, EGTRRA amendments of pre-approved plans should not be submitted to the Service.

Determination Letter Applications for Pre-Approved Plans . Until further notice, determination letter applications for preapproved plans that include EGTRRA amendments in a form other than a separate, clearly identified addendum to the

plan (or basic plan document) and/or adoption agreement that is limited to the provisions of EGTRRA will be treated as individually designed plans.

VI. Extension of 12-Month Period Under Rev. Proc. 2000–20

The extended GUST remedial amendment period available to certain adopters of pre-approved plans is determined by reference to the date on which the Service issues a favorable GUST opinion or advisory letter for the pre-approved plan. Pursuant to this notice, if the requirements of section 19 of Rev. Proc. 2000–20, as modified, and Announcement 2001–77, page 83, this bulletin, are satisfied, the extension of the GUST remedial amendment period thereunder will be treated as not expiring earlier than December 31, 2002. This change will simplify the determination of the GUST remedial amendment deadline for pre-approved plans and facilitate timely amendment of the plans for GUST and EGTRRA.

VII. Effect on Other Documents

Rev. Proc. 2000–20 and Rev. Proc. 2001–6, 2001–1 I.R.B. 194, are modified.

DRAFTING INFORMATION

The principal drafter of this notice is James Flannery of Employee Plans. For further information regarding this notice, please contact Employee Plans’ taxpayer assistance telephone service at (202) 2839516 or (202) 283-9517, between the hours of 1:30 p.m. and 3:30 p.m. Eastern Time, Monday through Thursday. Mr. Flannery may be reached at (202) 2839613. These telephone numbers are not toll-free.

Guidance on Implementation of Withholding and Reporting Regulations

Notice 2001–43

This notice provides guidance on the implementation of the withholding and reporting regulations (T.D. 8734, 1997–2 C.B. 109, and T.D. 8881, 2000–23 I.R.B. 1158). Specifically, this notice:

(1) provides a temporary alternative procedure for withholding and reporting on

July 23, 2001 72 2001–30 I.R.B.

payments made to certain nonqualified intermediaries (NQIs) and foreign trusts, which is available only for payments made to NQIs or foreign trusts on or after January 1, 2001, and before January 1, 2002;

(2) clarifies and corrects sections 1.1441–6(b)(1) and 301.6114–1 of the regulations, which require disclosure of certain treaty based return positions;

(3) adds a new alternative convention for converting payments in foreign currency into U.S. dollars to those listed in section 1.1441–3(e)(2);

(4) modifies section III. A. 1. of Notice 2001–4, 2001–2 I.R.B. 267, to permit an applicant for a qualified intermediary agreement that has been issued a QI-EIN to represent that it is a qualified intermediary (QI) until the IRS revokes its QIEIN and to permit an applicant that has been issued a QI-EIN before January 1, 2002, to apply all of the provisions of the QI agreement beginning January 1, 2001;

(5) clarifies section III. C. of Notice 2001–4, which provides documentation and reporting relief for simple and grantor trusts; and

(6) modifies Announcement 2000–48, 2000–23 I.R.B. 1243, to permit a branch of a QI to act as a qualified intermediary under the QI’s home country know-yourcustomer (KYC) rules if the branch is located in a country for which KYC rules have been submitted to IRS for approval.

Transitional relief for certain nonqualified intermediaries and foreign trusts.

In October 1997, Treasury and the IRS issued T.D. 8734, 1997–2 C.B. 109 (modified by T.D. 8881, 2000–23 I.R.B. 1158), which provided comprehensive regulations under chapter 3 (sections 1441–1445) and subpart G of subchapter A of chapter 61 (sections 6041–6050S) of the Internal Revenue Code. These regulations, which became effective on January 1, 2001, were developed after years of discussion with the U.S. and foreign financial services industry regarding how to improve compliance with the U.S. withholding rules without unduly impeding foreign investments in the United States or burdening financial institutions.

A key component of the new rules is the introduction of the qualified intermediary (QI) concept. In basic terms, a QI is a foreign financial institution that enters into an agreement with the IRS to verify the beneficial ownership of payments of U.S. source income for purposes of determining whether any reductions in the statutory 30 percent U.S. withholding tax rate under sections 871 and 881 are appropriate. To make this determination, a QI generally may rely on the documentation that it collects under the bank regulatory rules requiring it to establish the identity and residency of its account holders (“know your customer” (KYC) rules). The QI is required to transmit “pooled” information (but generally not the identity of its non-U.S. customers) to the U.S. withholding agent to enable the withholding agent to determine the correct amount of tax to withhold on payments made to the QI’s customers. The QI is also required to report certain pooled information to the IRS, as specified in the regulations. By allowing QIs to transmit information on a pooled basis, the regulations reduce the QI’s compliance burden (by minimizing the amount of information that is required to be reported to the IRS) and protect the QI’s customer base (by minimizing the amount of information that must be reported to the U.S. withholding agent, who will often be a competitor of the QI).

Sections 1.1441–1(e)(3)(iii) and (iv) of the regulations require a nonqualified intermediary (NQI) to supply the U.S. withholding agent or a QI with customer-specific documentation, rather than pooled information, to establish that its customers qualify for a reduction in the statutory 30 percent withholding rate.

The NQI does this by attaching appropriate documentation and a withholding statement identifying customers and allocating payments among them to an intermediary certificate that it forwards to the U.S. withholding agent or QI. To ensure the proper withholding and reporting of a payment, the U.S. withholding agent or QI must receive this intermediary certificate before it makes a payment of a reportable amount (as defined in section 1.1441–1(e)(3)(vi)) to the NQI. Finally, unless its withholding agent has done so, the NQI must report payment information to the IRS on Forms 1042 and 1042–S

and must send the foreign income recipient a corresponding Form 1042–S. In the same way, foreign simple trusts and foreign grantor trusts are required to forward to the U.S. withholding agent or QI a flow-through withholding certificate with attached documentation and a withholding statement identifying beneficiaries and grantors and to report payment information to the IRS.

Treasury and the IRS understand that, despite significant efforts by U.S. withholding agents and QIs to establish automated systems to process information received from NQIs and foreign trusts for withholding and reporting purposes, in some cases these systems are not yet fully operational. Treasury and the IRS have been advised, however, that the automated systems in those cases will be fully operational before the end of 2001. Accordingly, Treasury and the IRS believe that limited relief is warranted to ensure a smooth transition into the new withholding procedures. Treasury and the IRS emphasize, however, that the NQI and foreign trust documentation and reporting rules in the regulations are central to the appropriate administration of the U.S. withholding regulations, and U.S. withholding agents and QIs are expected to complete the development of automated systems that will ensure compliance with these rules.

To achieve a smoother transition period for withholding agents that make payments to NQIs and foreign trusts, the IRS will permit a withholding agent and NQI or foreign trust to apply the alternative procedures of section 1.1441–1(e) (3)(iv)(D) of the regulations as modified below for calendar year 2001, provided the withholding agent and NQI or foreign trust comply with all the conditions set forth below. This modified alternative procedure may not be used by flowthrough entities or U.S. branches described in section 1.1441–1(e)(3) (iv)(D)( 8 ) of the regulations. (See sections III. C. and IV. of Notice 2001–4, 2001–2 I.R.B. 267 for certain other relief provisions relating to trusts and partnerships.) A withholding agent may use this modified alternative procedure only for payments made to NQIs and to foreign simple or grantor trusts. This modified alternative procedure may not be used by a withholding agent if the withholding

2001–30 I.R.B. 73 July 23, 2001

agent would be responsible for filing fewer than 250 Forms 1042–S for calendar year 2001 without using this modified alternative procedure. This modified alternative procedure may not be used for payments to U.S. nonexempt recipients.

An NQI or foreign trust and its withholding agent that comply with the conditions set forth below may rely on this notice for payments made on or after January 1, 2001, and before January 1, 2002: (1) to permit pooled basis reporting on Form 1042–S instead of the payee specific reporting otherwise required under the alternative procedure of section 1.1441–1(e)(3)(iv)(D); and (2) to permit the NQI or foreign trust to provide the withholding agent with a withholding statement containing the beneficial owner information required under sections 1.1441–1(e)(3)(iv)(C)( 1 ) and (D)( 2 ) after a payment is made but no later than January 31, 2002.

In order to qualify for this transitional relief, the following conditions must be met:

(1) The withholding agent submits a notification no later than January 31, 2002, that it is using the temporary alternative procedure under this notice. Notifications should be sent to:

Internal Revenue Service Pre-Filing Services LM:PFT:PF New Mint Building, 3 ^rd Floor 1111 Constitution Avenue, NW Washington, DC 20224

(2) The withholding agent includes the following in its notification under penalties of perjury:

(a) a statement listing the NQIs and foreign trusts that are participating with the withholding agent in using the temporary alternative procedure under this notice;

(b) a statement (i) that during 2001 the withholding agent was engaged in the building and implementation of computerized information systems for transfer and processing of withholding statement information between the withholding agent and the NQI or foreign trust and for Form 1042–S reporting to the IRS, and (ii) that they were relying on completion of those systems for purposes of complying with section 1.1441–1(e)(3)(iii) and (iv) of the regulations;

(d) a statement that those systems are not capable of complying with the requirements of section 1.1441–1(e)(3)(iii) and (iv) regarding timely provision of withholding statement information by the NQI or foreign trust and Form 1042–S reporting by the withholding agent for calendar year 2001;

(e) a statement of the number of Forms 1042–S that the withholding agent would be responsible for filing for calendar year 2001 if it were not using this modified alternative procedure; and

(f) a representation that the systems will be capable of complying with those withholding statement and Form 1042–S reporting requirements for calendar year 2002. (3) The withholding agent and NQI or foreign trust comply with all applicable requirements of section 1.1441–1(e)(3) (iv)(D) of regulations, except as modified by conditions (4), (5) and (6).

(4) The NQI or foreign trust provides the withholding agent with withholding rate pool information prior to the payment of a reportable amount in accordance with section 1.1441–1(e)(3)(iv)(D)( 2 ) of the regulations. The NQI or foreign trust must also provide appropriate documentation with respect to its customers to the withholding agent prior to the payment being made. The NQI or foreign trust need not, however, provide the withholding statement information identifying and classifying foreign persons as required by sections 1.1441–1(e)(3)(iv)(C)( 1 ) and (D)( 2 ) and assigning each listed foreign person to a withholding rate pool as required by section 1.1441–1(e)(3) (iv)(D)( 2 ) prior to payment. The NQI or foreign trust is required to provide that withholding statement information to the withholding agent no later than January 31, 2002. The NQI or foreign trust must provide the withholding agent with withholding statement information allocating the income in each withholding rate pool to each payee within the pool no later than January 31, 2002, as required under sections 1.1441–1(e)(3)(iv)(C)( 2 ) and (D)( 3 ) of the regulations.

(5) The withholding agent withholds and timely files Forms 1042–S based on the withholding rate pool information provided by the NQI or foreign trust.

(6) The withholding agent submits a copy of the withholding statement that it

receives from the NQI or foreign trust (which must identify each beneficial owner of payments to the NQI or foreign trust and allocate payments among these beneficial owners) for calendar year 2001 to the IRS at the address stated in condition (1) on or before the due date for filing Forms 1042–S for calendar year 2001.

If the NQI or foreign trust fails to provide the withholding statement information required under condition (4) by January 31, 2002, for any withholding rate pool, then the withholding agent may apply the provisions of sections 1.1441–1(e)(3)(iv)(D)( 4 ), ( 5 ), ( 6 ), and ( 7 ). The NQI or foreign trust will be responsible for withholding, filing Form 1042 and filing Forms1042–S for each beneficial owner for which it has received payments.

The IRS will accept the pooled basis reporting and withholding statements filed under this temporary procedure in lieu of the payee specific reporting otherwise required of an NQI or foreign trust and its withholding agent only if the NQI or foreign trust and its withholding agent satisfy all of the conditions set forth above. The withholding agent and NQI or foreign trust must retain all records, documentation and other evidence relevant to the above conditions for the same retention period as would be required for information relevant to an audit of Form 1042–S for calendar year 2001. In determining on audit whether a withholding agent has exercised its best efforts to complete building and implementing their information systems, the IRS will take into account all the facts and circumstances including the efforts and performance of similarly situated withholding agents.

Disclosing treaty based return positions.

Section 1.1441–6(b)(1) of the regulations provides that withholding under sections 1441, 1442 and 1443 on a payment to a foreign person is eligible for reduction under the terms of an income tax treaty only to the extent that the payment is treated as derived by a resident of an applicable treaty jurisdiction, such resident is a beneficial owner, and all other requirements for benefits under the treaty are satisfied. It provides further that if the beneficial owner is a person related to the

July 23, 2001 74 2001–30 I.R.B.

withholding agent within the meaning of section 482, the beneficial owner’s withholding certificate must contain a representation that the beneficial owner will file the statement required under section 301.6114–1(d) if applicable. This requirement applies only to amounts of income subject to withholding received during the calendar year that exceed $500,000 in the aggregate.

Section 301.6114–1(a) of the regulations provides that if a taxpayer takes a return position that a tax treaty overrules or modifies any provision of the Internal Revenue Code and thereby effects a reduction of any tax at any time, the taxpayer shall disclose such return position on a statement attached to the return. If a tax return would not otherwise be required to be filed, a return must nevertheless be filed to make this disclosure. For this purpose, the taxpayer’s taxable year is deemed to be the calendar year, unless the taxpayer has established or timely chooses to establish a different taxable year. The taxpayer must make the disclosure statement on a fully completed Form 8833 ( Treaty-Based Return Position Dis- closure Under Section 6114 or 7701(b) ) attached to the return.

Section 301.6114–1(b) provides that reporting is required unless it is expressly waived, and it further provides a nonexclusive list of particular positions for which reporting is required. Among the positions listed are those described in section 301.6114–1(b)(4)(ii)(C) or (D).

Paragraph (b)(4)(ii)(C) requires a taxpayer to report a position taken under a treaty that contains a limitation on benefits provision if: (1) the treaty exempts from tax or reduces the rate of tax on income subject to withholding; (2) the income is received by a foreign person other than an individual or State that is the beneficial owner of the income and the foreign person is related to the person obligated to pay the income within the meaning of sections 267(b) and 707(b)(5); (3) the income exceeds $500,000; and (4) the foreign person meets the requirements of the limitation on benefits provision. Paragraph (b)(4)(ii)(D) requires reporting a position taken under a treaty that imposes any other conditions for the entitlement to treaty benefits if the position is that such conditions are met.

Section 301.6114–1(c) lists positions for which reporting is expressly waived. Paragraph (c)(1)(i) waives reporting for the position that a treaty has reduced the rate of withholding tax otherwise applicable to a particular type of income subject to withholding to the extent that the income is beneficially owned by an individual or a State. Paragraph (c)(2) waives reporting by an individual who receives payments or income items during the taxable year that do not exceed $10,000 in the aggregate.

Taxpayers have requested guidance on the scope of the reporting required under section 301.6114–1(b) in the case of treaty claims for exemption or reduced rates of tax on income subject to withholding made by foreign persons that are not individuals or States. Taxpayers have expressed concerns that:

(1) Because paragraph (c)(1)(i) of that section waives reporting only for individuals and States, it is unclear whether taxpayers that are not individuals or States and that are not required to report under paragraph (b)(4)(ii)(C) are required nevertheless to disclose treaty based return positions described in paragraph (b)(4)(ii) under the general rule of paragraph (b).

(2) Because paragraph (c)(2) waives reporting only for individuals who receive less than the threshold amount, taxpayers that are not individuals must report under paragraph (b)(4)(ii)(D) even when they have received de minimis amounts of income subject to withholding.

(3) Because the representation under section 1.1441–6(b)(1) is required when the beneficial owner is related to the withholding agent within the meaning of section 482 and the filing under section 301.6114–1(b)(4)(ii)(C) is required when the beneficial owner is related to the person obligated to pay the income within the meaning of sections 267(b) and 707(b), it is unclear how the representation requirement coordinates with the filing requirement.

(4) Because section 1.1441–6(b)(1) states that the filing requirement applies only to amounts received during the calendar year that exceed $500,000 in the aggregate and section 301.6114–1(b)(1) permits a taxpayer to adopt a taxable year for filing different from the calendar year, it

is unclear how a fiscal year taxpayer is to report those amounts.

To address these concerns, Treasury and the IRS intend to amend sections 1.1441–6(b)(1) and 301.6114–1 of the regulations, as described below, effective January 1, 2001.

(1) Treasury and the IRS intend to amend section 301.6114–1(c) to provide that reporting is waived for taxpayers that are taking a treaty based return position described in section 301.6114–1(b)(4)(ii), unless those taxpayers are described in paragraph (b)(4)(ii)(A) and (B), or (C) or (D).

(2) Treasury and the IRS intend to amend section 301.6114–1(c) to waive reporting under section 301.6114–(b)(4)(ii)(D) for taxpayers that are not individuals or States and that receive amounts of income subject to withholding that do not exceed $10,000 in the aggregate.

(3) Treasury and the IRS intend to amend section 1.1441–6(b)(1) to conform the representation requirement to the filing requirement of section 301.6114–1(b) (4)(ii)(C). Thus, section 1.1441–6(b)(1) will require a representation if the taxpayer takes the position under a treaty that contains a limitation on benefits provision that the treaty exempts from tax or reduces the rate of tax on income subject to withholding, the income is received by a foreign person other than an individual or State that is the beneficial owner of the income, the foreign person is related to the person obligated to pay the income within the meaning of sections 267(b) and 707(b), the income exceeds $500,000 in the aggregate, and the foreign person meets the requirements of the limitation on benefits provision.

(4) Treasury and the IRS intend to amend section 1.1441–6(b)(1) to conform to section 301.6114–1(b)(1) by changing the rule that the filing requirement applies only to amounts received during the calendar year that exceed $500,000 in the aggregate. The conformed rule will provide that the filing requirement applies only to income received during the taxpayer’s taxable year that exceeds $500,000 in the aggregate.

A taxpayer that is required to make the disclosure statement on Form 8833 under

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sections 301.6114–1 (b)(4)(ii)(A) and (B) or (C) or (D) taking into account the modifications described in the notice will be considered to have timely filed Form 8833 if, in the case of a calendar year taxpayer, the taxpayer files the Form 8833 with its return for its taxable year ending on December 31, 2001, or in the case of a fiscal year taxpayer, the taxpayer files Form 8833 with its return for its first taxable year ending after December 31, 2001.

Taxpayers may rely on the authority of this notice until the regulations are amended.

Converting payments in foreign currency to U.S. dollars.

Section 1.1441–3(e)(2) provides that if an amount subject to tax is paid in a currency other than the U.S. dollar, the amount of withholding under section 1441 shall be determined by applying the applicable rate of withholding to the foreign currency amount and converting the amount withheld into U.S. dollars at the spot rate on the date of payment. A withholding agent that makes regular or frequent payments in foreign currency is permitted to use a month end spot rate or a monthly average spot rate.

Certain withholding agents that make regular and frequent payments in foreign currency have expressed concern that the permitted conversion conventions can expose them to currency risks that would require management by means of hedging transactions. Also, they have expressed concern that permitted conventions can require multiple accounting adjustments when payment amounts in the base currency are adjusted or corrected in the course of processing and settlement. They have suggested that using the spot rate on the day of deposit of the amount of tax withheld would eliminate the currency risks and the need for those accounting adjustments.

In response to those concerns, Treasury and the IRS intend to amend section 1.1441–3(e)(2) to add the suggested alternative conversion convention to the conventions already permitted. Section 1.1441–3(e)(2) will permit a withholding agent that makes regular or frequent payments in foreign currency to convert the amount withheld into U.S. dollars at the

spot rate on the day the tax is deposited provided that the deposit is made within seven days of the date of payment. As is the case with the conversion conventions currently in the regulations, taxpayers using this alternative convention must do so consistently for all nondollar amounts withheld and from year to year. Such convention cannot be changed without the consent of the Commissioner. Taxpayers may rely on the authority of this notice until the regulations are amended.

Representing QI status and applying QI agreement beginning January 1, 2001.

Section III. A. 1. of Notice 2001–4 provides that an applicant that has submitted a QI application before January 1, 2001, may represent on Form W-8IMY that it is a QI without being in possession of a fully executed QI agreement until June 30, 2001. It further provides that an applicant that has submitted a QI application after December 31, 2000, may represent on Form W-8IMY that it is a QI until the end of the sixth full month after the month in which it submits its QI application. Applicants have been issued QI-EINs upon application to permit them to complete Forms W-8IMY. Finally, it provides that a potential QI may apply all of the provisions of the QI agreement beginning January 1, 2001, provided that it submits its application before July 1, 2001.

Taxpayers have requested extension of the time during which an applicant may represent that it is a QI without being in possession of a fully executed QI agreement and extension of the July 1, 2001, application deadline for application of the QI agreement beginning January 1, 2001, in order to allow adequate time for the process of review and execution by both the applicants and the IRS.

In response, this notice modifies those provisions of Notice 2001–4. An applicant to which IRS has issued a QI-EIN may represent on Form W–8IMY that it is a QI without being in possession of a fully executed QI agreement until the IRS revokes its QI-EIN. The IRS will revoke an applicant’s QI-EIN if the applicant does not execute and return its QI agreement to the IRS within a reasonable time after the IRS has sent the QI agreement to the applicant for signature. An applicant to which the IRS has issued a QI-EIN before January 1, 2002, may apply all of the pro

visions of the QI agreement beginning January 1, 2001.

Documentation and reporting relief for simple and grantor trusts.

The QI agreement generally requires a QI to obtain a Form W-8IMY from a foreign simple or grantor trust together with appropriate documentation from beneficiaries and grantors and requires the QI to file separate Forms 1042–S for each beneficiary or grantor.

Section III. C. of Notice 2001–4, 2001–2 I.R.B. 267, provides documentation and reporting relief for simple and grantor trusts. It permits a QI to treat the beneficiaries or grantors as direct account holders, and thus permits them to be incorporated into the pooled basis reporting permitted for direct account holders rather than requiring separate Forms 1042–S for each of them, provided three criteria are met. (1) The QI must be required, pursuant to the applicable KYC rules, to determine the identity of the beneficiaries or owners of foreign simple or grantor trusts. (2) The QI must obtain the type of documentation set forth in the appropriate KYC attachment to the agreement. (3) The QI must obtain a valid Form W–8BEN from the beneficiary or owner of the trust.

Some QIs have suggested that the scope of criterion (1) may be unclear, because local KYC rules in certain jurisdictions require the QI to determine the identity of the beneficiaries or owners of foreign simple or grantor trusts, but do not require the QI to obtain documentation confirming their identities. These QIs have expressed the concern that the reporting relief for trusts may be unavailable in such jurisdictions.

This notice clarifies that criterion (1) is satisfied if the local KYC rules require the QI to determine the identity of trust beneficiaries and grantors, even if those rules do not require the QI to obtain documentation confirming their identities. The QI must nevertheless obtain any documentation necessary to satisfy criterion (2), which is based on the applicable KYC documentation.

Branches permitted to apply QI’s home country KYC.

Announcement 2000–48, 2000–23 I.R.B. 1243, provides that the IRS gener

July 23, 2001 76 2001–30 I.R.B.

ally will not extend the QI system to any country that does not have KYC rules or that has unacceptable KYC rules. The IRS will, however, permit a branch of a financial institution (but not a separate juridical entity affiliated with the financial institution) located in such a country to act as a QI if the branch is part of an entity organized in a country that has acceptable KYC rules and the entity agrees to apply its home country KYC rules to the branch.

Taxpayers have requested that this rule be extended to include branches of QIs in countries for which KYC rules have been submitted to IRS for approval during the time those rules are pending approval.

In response, this notice modifies Announcement 2000–48. IRS will permit a branch of a financial institution (but not a separate juridical entity affiliated with the financial institution) to act as a QI if the branch is located in a country identified by the IRS as a jurisdiction awaiting approval of KYC rules on the IRS website at www.irs.ustreas.gov, if the branch is part of an entity organized in a country that has acceptable KYC rules and if the entity agrees to apply its home country KYC rules to the branch. The branch will be permitted to act as a QI under this rule only for the period of time during which the jurisdiction in which it is located is identified as awaiting approval. If the IRS approves the KYC rules of the jurisdiction, then the branch must apply the KYC rules of the jurisdiction beginning on the date that an attachment to the QI agreement for the jurisdiction is posted on the IRS website at www.irs.ustreas.gov .

Contact Information

For further information regarding this notice, contact Carl Cooper or Laurie HattenBoyd of the Office of the Associate Chief Counsel (International), Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, D.C. 20224. Mr. Cooper and Ms. Hatten-Boyd may be contacted by telephone at 202-622-3840 (not a toll-free call).

Notional Principal Contracts

Notice 2001–44

I. PURPOSE

The IRS and the Treasury Department are soliciting comments on the appropri

ate method for the inclusion into income or deduction of contingent nonperiodic payments made pursuant to a notional principal contract and the treatment of such inclusions or deductions.

II. BACKGROUND

A. In General

Section 1.446–3 of the Income Tax Regulations provides rules on the timing of inclusion of income and deductions for amounts paid or received pursuant to notional principal contracts. T.D. 8491, 1993–2 C.B. 215. The regulations define a notional principal contract (“a NPC”) as a “financial instrument that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount, in exchange for specified consideration or a promise to pay similar amounts.” Section 1.446– 3(c)(1)(i). Payments made pursuant to NPCs are divided into three categories (periodic, nonperiodic, and termination payments), and the regulations provide separate timing regimes for each. However, no guidance is provided in the regulations for the timing of inclusion or deduction of contingent nonperiodic payments made under NPCs. In addition, neither § 1.446–3 nor any other section provides specific rules governing the character of the various types of payments that could be made pursuant to a NPC.

The lack of comprehensive guidance in this area of the law has created significant uncertainty for taxpayers. For some, this uncertainty adds a considerable burden to the tax compliance process, and may discourage certain taxpayers from entering into NPCs. Other taxpayers welcome the ability to pick and choose among various tax law theories as to the character and timing of NPC payments, but this can lead to a whipsaw of the government. Both result in lack of confidence in the tax system, and inefficiencies in the capital markets.

The IRS and Treasury have reviewed several methods for including into income or deducting contingent nonperiodic payments made pursuant to NPCs. In evaluating each method, the IRS and Treasury have considered the extent to which it reflects certain fundamental tax policy principles. These policy principles include: whether the method provides sufficient

certainty as to the amount and timing of inclusions or deductions (certainty/clarity); whether the method is complex, and the compliance and administrability burden created by that complexity (administrability); whether the method creates or increases inconsistencies in the tax treatment of financial instruments with similar economic characteristics (neutrality); whether the method creates or increases inconsistencies in the tax treatment of different taxpayers entering into the same instruments (symmetry); whether the method accurately reflects the accretion or reduction in economic wealth in the period in which the taxpayer is measuring the tax consequence of being a party to the NPC (economic accuracy); and whether the method is flexible enough to readily accommodate new financial arrangements (flexibility). It is clear that these principles are frequently in conflict, and there is no method of accounting that would satisfy all the criteria. However, the examination of an accounting method in the light of these principles can highlight the strengths and weaknesses of the method and inform the rulemaking process.

The methods the IRS and Treasury are considering for the inclusion into income or deduction of contingent nonperiodic payments made pursuant to NPCs are described below under the following headings: the Noncontingent Swap Method; the Full Allocation Method; the Modified Full Allocation Method; and the Mark-toMarket Method. The IRS and Treasury are seeking comments on the relative merits of each of these methods, as well as suggestions as to other methods that may be superior to these methods with respect to the fundamental tax policy principles listed above. The IRS and Treasury are interested in what authority taxpayers believe exists for mandating any and each of these methods.

Although this notice is addressing the timing issues regarding NPCs with a contingent component, the IRS and Treasury are aware that there must be some coordination between the existing NPC rules and any new applicable rules. The IRS and Treasury are interested in comments on the need to revise the current rules for NPCs and related instruments if new rules for contingent NPCs are introduced. The IRS and Treasury are also interested in

2001–30 I.R.B. 77 July 23, 2001

broader group of contracts that serve similar purposes as NPCs. The IRS and Treasury also seek comments on the appropriate character of payments made pursuant to contracts similar to NPCs.

A. Methods for Determining the Timing of Payments under NPCs

The Noncontingent Swap Method

a. Timing . The noncontingent swap (“NCS”) method provides an approach to accruing contingent payments made pursuant to a NPC. The method provides techniques for taxpayers to convert the contingent nonperiodic payment provided for in the NPC into a noncontingent periodic amount. The method would provide rules for creating a payment schedule that spreads the recognition of income or deduction of this noncontingent amount over the life of the NPC on a constant yield basis.

b. Illustration . This method is illustrated using the following example of a simple equity swap contract, on a notional amount of 100 shares of XYZ stock, entered into on January 1, 2001, between A and B with the following terms:

A pays B:

Every six months until expiration – any dividend payments to the holder of one share of XYZ times 100. At expiration, December 31, 2002 – any appreciation in a share of XYZ since contract inception times 100.

whether taxpayers believe it is necessary to develop rules on a much wider range of instruments before any kind of rule is issued with respect to contingent NPCs, which are only one specific type of instrument, i.e ., whether the proliferation of individualized rules is more harmful than helpful in this area.

The IRS and Treasury are interested in comments from taxpayers as to the appropriateness of special, simplified rules for short-term or standardized contracts, and what form the simplified rules should take. If taxpayers suggest that a simplified rule should be provided for certain contracts, the IRS and Treasury are interested in what kind of test should be used to determine whether the simplified rule applies.

In addition to reviewing methods for the timing of income and expense with respect to contingent nonperiodic payments, the IRS and Treasury are considering what the character should be for all types of payments made pursuant to NPCs. In the current tax law, the distinction between capital gain and ordinary income is significant in two ways. First, taxpayers cannot offset capital losses against ordinary income (with a small exception for individuals). One policy reason for the rule against offsetting of capital losses against ordinary income is that taxpayers are able to choose the timing of their sales or exchanges of capital assets much more easily than the timing of their ordinary income or loss (“cherry picking”). They could, therefore, sell their loss assets at a time when they are expecting large amounts of ordinary income while deferring recognition on their gain assets. Second, for individuals, long-term capital gains are taxed at lower rates than ordinary income.

In determining whether particular payments made pursuant to a NPC should most appropriately be characterized as capital or as ordinary, attention should be given to the goals of minimizing cherry picking of character results and consistent application of the policy rationale for the current capital gains preference. In addition, in the financial products area, it is particularly important to pay attention to the neutrality principle, i.e ., consistent treatment of different instruments with similar economic characteristics. There is almost limitless flexibility in the design of

derivatives, and tax rules that provide for differences in tax treatment that do not reflect economic differences may produce inappropriate tax consequences. For example, some taxpayers are permitted to treat certain payments received pursuant to forward and option contracts as capital. If these taxpayers entered into NPCs with the same economic characteristics as the options or forwards contracts, but did not receive the same tax character treatment, tax-advantaged products might develop to arbitrage the tax differences between the various instruments. The particular problem the IRS and Treasury face with regard to neutrality is that the existing rules for various financial instruments are so inconsistent with each other, that it is difficult to decide, when developing rules for new instruments that can mimic many types of instruments, which set of existing rules should be followed. The IRS and Treasury are interested in comments on how the neutrality principle can best be given consistent effect for complex financial instruments.

The IRS and Treasury invite comments on the appropriate policy considerations for making character designations for NPC payments, as well as the application of those principles illustrated by the examples in the notice. The IRS and Treasury also seek comments on: the authority governing the character of NPC payments and whether and what legislative change may be necessary to rationalize the rules.

The IRS and Treasury are aware that the definition of NPC as provided in § 1.446–3 covers only one class of the possible notional principal contracts that are transacted in the marketplace. For example, a contract that provides for a single payment at maturity based on some notional amount and specified index may not be covered by the definition because there are no “payments” made at “specified intervals.” Such a contract is sometimes called a “bullet swap.” There may be little difference in economics between a NPC as defined in § 1.446–3 and a series of bullet swaps, yet the payments made under one are covered by the regulation, whereas the payments under the other may not. The IRS and Treasury seek comments on how the tax accounting methods described in this notice, or other methods, could be made applicable to a

B pays A:

Every six months until expiration – 7.00% (annual rate) of notional amount at inception.

At expiration, December 31, 2002 – any depreciation in a share of XYZ since contract inception times 100.

The contingent payment is equal to the appreciation or depreciation in the value of a share during the period between the inception and expiration of the contract, multiplied by 100 shares. The payments are netted, and only the net amounts are transferred. The net payments can flow from either A to B or from B to A.

Under the NCS method, the cost of hedging the exposure to the contingent NPC payment is used as a proxy for the contingent payment itself. The cost of hedging the contingent payment under the NPC is the current price of a portfolio of financial assets that, if liquidated on December 31, 2002, will exactly cover the cost of the contingent payment. This approach has been chosen because if a party

July 23, 2001 78 2001–30 I.R.B.

to a contingent NPC assumed the hedging cost, both counterparties would be in the same position as if the contingent future obligation were actually paid. This hedging cost is therefore deemed to be paid, for example, by A to B, in satisfaction of the contingent obligation (for purposes of making calculations under the NCS method). The NCS method then provides a mechanism for amortizing this deemed payment by A to B into B’s income throughout the life of the swap. It should be noted that the hedge transaction need not be entered into by either A or B. The deemed hedge merely provides a computational mechanism for converting the contingent payment into a fixed payment. Further details regarding this illustration, with computations of the hedging cost and the amounts of deductions and income inclusions, are provided in the Appendix.

c. Policy Considerations . The NCS method has the policy advantage of being certain and clear in many cases. It depends, however, on the ability to establish the cost of hedging the contingent payment exposures using forward pricing analysis. The methodology may be difficult to administer and apply in other cases because of the subjectivity in pricing forward contracts where there is no active market. This problem may be partially overcome by requiring appropriate record keeping and information reporting. The NCS method provides relative neutrality of tax treatment compared to contingent debt, but does not provide neutrality of tax treatment as compared to forwards and options, or as compared to ownership of the underlying equity (in the example of an equity NPC). Given that for many NPCs, at least one counterparty is on a mark-to-market method of accounting with respect to the NPC under § 475 of the Internal Revenue Code, in many cases there would be asymmetry of tax treatment between counterparties. The NCS method does not accurately reflect the change in economic position over time of either counterparty as a result of being a party to the NPC, because the schedule that determines inclusions and deductions is fixed at the outset and, in the simplest description of the method, does not change with market conditions. Finally, it is unclear how flexible the method is in accommodating variations in NPCs and related instruments.

d. Request for Comments .

(i) The IRS and Treasury request comments on a number of aspects of this method. The amount of inclusions and deductions under this method could significantly diverge from market prices as the swap runs its course. The ability of this method to meet the policy principles outlined above may be reduced unless the counterparties to the swap are required to revise their payment schedules with changes in market conditions. The IRS and Treasury invite comments on if and when it would be appropriate to require taxpayers to make such revisions to the payment schedule ( e.g ., every three years), or if the underlying index changes a certain percentage from its level at the inception of the contract, or both. Comments are also solicited on the treatment of adjustments resulting from updated projections. For example, should adjustments from updated projections be taken into account in the year of the updated projections or should they be spread over the remaining term of the NPC?

The IRS and Treasury are aware that the more frequently payment schedules are required to be updated, the more the method begins to resemble a mark-to-market method. We are seeking comments on the relative effectiveness of the NCS method, given the inaccuracies that are possible when only one market observation is required at the inception of the contract, and the fact that as the number of adjustments to that initial observation is increased, the benefits of using this technique ( e.g ., certainty of tax result) decline.

(ii) The IRS and Treasury also request comments on the treatment of contingent payments that are made prior to their expected payment date, and how this should be coordinated with the treatment of revised payment schedules.

(iii) The character of payments generated by the NCS method is unclear under current law. The IRS and Treasury are seeking comments on what the character of payments under the NCS method would be under current law, both originally projected payments and any periodic revisions (see (i), above). In addition, comments are solicited on whether it would be appropriate to change or clarify the character rules, either statutorily or through regulations, so that the various policy goals can be achieved

(iv) One commentator suggested an interpretation of § 1234A that would conform the character treatment of NPCs with the character of the underlying position or positions. Comments would be welcome on the desirability of this approach, including the authority for its adoption under current law, and the feasibility of administration.

(v) More generally, comments are invited on the problem of mismatching of the character of payments and receipts and on methods of avoiding or minimizing such mismatches.

The Full Allocation Method

a. Timing . Under the full allocation method, taxpayers would not include or deduct any payment that is required to be made under the NPC (periodic, nonperiodic, contingent, and noncontingent) until the taxable year in which all contingencies are resolved. When the final contingency is resolved, the parties would treat all payments as made or received in the year of the resolution of the contingency.

b. Policy Considerations . This method has the policy advantages of being certain, clear, and administrable. The method provides partial neutrality of tax treatment compared to options and forwards, and compared to ownership of the underlying equity, but does not provide neutrality of tax treatment compared to contingent debt. There would be asymmetry of tax treatment between the counterparties if only one party to the contingent NPC were on a mark-to-market method of accounting with respect to the NPC. The full allocation method does not reflect the change in economic position over time of either counterparty as a result of being a party to the NPC, because all tax consequences are postponed until the contract matures, is terminated, etc. This result is particularly open for manipulation to the extent taxpayers have the ability to terminate a contract if it has decreased in value but can retain the contract if it has increased in value. Finally, it would appear that the method is flexible enough to accommodate many financial instruments, although it is unclear whether the method would be appropriate for all forms of NPCs and related contracts.

c. Request for Comments . The IRS and Treasury request comments on a number of aspects of this method:

2001–30 I.R.B. 79 July 23, 2001

(i) The IRS and Treasury are aware that this method permits complete deferral for taxpayers entering into NPCs with contingent elements, in contrast to the accrual method required for NPCs without such contingent elements. However, even though the full allocation method would create discontinuities between different types of NPCs, it is somewhat consistent with the treatment of both straight equity and certain other derivatives, such as options and forward contracts, as noted above. The IRS and Treasury are soliciting comments on whether the inconsistency between contingent and noncontingent NPCs could be mitigated through the use of an anti-abuse rule (and on what the nature and scope of such an anti-abuse rule might be), or whether a more global change in the treatment of derivatives would be necessary to overcome this problem.

(ii) It is unclear how current law would characterize the various payments made pursuant to a contingent NPC under the full allocation method. Based on one interpretation of § 1234A, it is possible that taxpayers could elect the character of their NPC payments by terminating their NPC early or holding it until maturity. Comments are solicited on how taxpayers could be prevented from manipulating the character of payments made pursuant to a NPC under current law if the full allocation method is required. Comments are also solicited on whether and how a modification of current law could improve the character treatment of payments made pursuant to a contingent NPC under the full allocation method.

(iii) The IRS and Treasury seek comments on how the full allocation method should apply when contingencies under a NPC are resolved at a time other than at the maturity of the contract.

Modified Full Allocation Method

a. Timing . Under this method, each party to a NPC would offset any noncontingent payments made by that party in a taxable year against any payments received in that year with respect to the NPC, but would not be able to claim a deduction if the amount received were less than the amount paid out. Any net deductions with respect to the NPC would be deferred until all contingencies are resolved. In effect, this method accords with those tax principles that provide for

income to be recognized when received and deductions to be deferred until all contingencies with respect to that deduction are resolved. However, this method modifies the effects of these principles by first determining income on an annual net basis.

b. Policy Considerations . This method has the advantages of being certain and clear, and being relatively easy to administer. However, the method does not provide for neutrality of tax treatment with respect to any financial instrument or combination of instruments that have economic characteristics similar to a contingent NPC. The method does not accurately reflect the change in economic position over time of a counterparty subject to the method because of the differing treatment of net receipts and payments under the NPC. In addition, there would be asymmetry of tax treatment of the counterparties to the NPC if one of the parties were subject to the mark-to-market method of accounting with respect to the NPC. Finally, it is unclear how flexible the method would be in accommodating variations in NPCs and related instruments.

c. Request for Comments . The IRS and Treasury request comments on a number of aspects of this method:

(i) The IRS and Treasury are aware that the modified full allocation method may result in mismatching of income and deductions. This is because income from the NPC would be recognized when received while deductions would be deferred until all contingencies are resolved. The IRS and Treasury are seeking assistance in developing rules to ensure that the asymmetrical treatment of the income and deductions under this method does not lead to undesirable consequences for either taxpayers or the government.

(ii) It is unclear how the payments made pursuant to a NPC would be characterized under the modified full allocation method. It is possible that application of current law to the modified full allocation method could result in differences in character for current inclusions and for gains or losses on final settlement of the NPC. For example, a taxpayer may be taxable currently on net receipts as ordinary income but have an offsetting capital loss subject to loss limitations on the final settlement of the NPC. Mismatches of timing and char

acter could be reduced if deductions were permitted in years before the resolution of all contingencies, in a manner similar to the treatment of unreversed inclusions under § 1296(a)(2). The IRS and Treasury request comments on ways to avoid this mismatching of character, and whether a regime similar to that used under § 1296(a)(2) would be administratively burdensome to implement.

(iii) The IRS and Treasury seek comments on how the modified full allocation method should apply when contingencies under a NPC are resolved at a time other than at the maturity of the contract.

Mark-to-Market Method

a. Timing . Under this method, taxpayers would mark their NPCs to market and recognize gain or loss at year end, or when the contract is terminated, assigned, etc.

b. Policy Considerations . The mark-to-market method has the advantages of being certain and clear with respect to timing and character. It would likely, however, be difficult to administer for non-exchange traded instruments to the extent that there is no consensus on the fair market value of the NPC. This problem may be partially overcome by requiring appropriate record keeping and information reporting. The mark-to-market method does not provide neutrality of tax treatment compared to almost any financial instrument or combination of instruments or compared to the underlying property. It would, however, provide equitable tax treatment between counterparties. The mark-to-market method accurately reflects the change in economic position over time of both counterparties as a result of being a party to the NPC, to the extent that the mark is accurate. Finally, the mark-to-market method is the most flexible of the methods, as it is constrained only by the ability to provide a consistent system for measuring the market value of instruments.

c. Request for Comments . The IRS and Treasury request comments on a number of aspects of this method:

(i) The IRS and Treasury are interested in comments generally on the benefits and burdens of imposing a markto-market regime.

(ii) The IRS and Treasury are interested in what the character of a gain or

July 23, 2001 80 2001–30 I.R.B.

loss on a mark would be under current law, and how the law may be modified to ensure appropriate characterization of the mark, based on policy principles.

(iii) The IRS and Treasury are interested in comments on what authority taxpayers believe exists to mandate a mark-to-market regime for NPCs. We are also requesting comments on whether this regime should be made elective if another regime is used as the primary regime.

(iv) The IRS and Treasury seek comments on how to ensure that the values taxpayers use as market values are truly related to the market, and are not subject to consistently biased manipulation by taxpayers. It appears that substantial investment has been made by the financial community into technology that enables a regular mark-to-market of many types of derivatives. ¹ The IRS and Treasury are requesting comments on how a valuation regime could be developed to ensure some consistency by a single taxpayer with different NPCs, and between taxpayers.

C. Recordkeeping and Information Reporting

The IRS and Treasury are seeking comments on what kinds of record keeping and information reporting would be necessary for each and any of the methods of accounting for contingent NPCs that would enable the IRS to verify the inclusions and deductions of counterparties to contingent NPCs and minimize the compliance burdens for taxpayers. In particular, the IRS and Treasury are interested in the following:

Are there any special kinds of information necessary for the IRS to obtain

1 Much of the impetus for this has come from the Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended by Statement of Financial Accounting Standards No. 138, which requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. However, this is not the only source of interest in technology to enable a regular marking of derivatives. Treasury departments of many corporations require a tool to assess the impact of financial stress on their portfolios, and this requires a mechanism for marking their securities in various scenarios. In addition, in a different context entirely, mutual funds must have some mechanism for regularly assessing the value of their portfolios (including derivatives) as they have to report a daily net asset value.

from taxpayers in order to verify their tax return positions with respect to contingent NPCs?

If there are special kinds of information relating to tax return positions for contingent NPCs, how should that information be made available to the IRS? Is it sufficient for taxpayers to keep detailed books and records which an agent can request if necessary? Or should specific information be required to be reported with the tax return? If the information is reported with a tax return, what form should the reporting take?
Is there sufficient justification to require third party reporting with respect to any of the methods of accounting for NPCs, particularly for the NCS method and the mark-to-market method? Should counterparties who are dealers be required to report their marks to nondealer counterparties under the mark-to-market method?
If certain types of record keeping or information reporting are recommended in comments to the IRS and Treasury, what would be the appropriate penalties for failure to keep the required records or provide the information?

III. REQUEST FOR COMMENTS

Written comments are requested to be submitted no later than November 20, 2001, to CC:FIP (Notice 2001–44), room 4300, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. Comments may be hand delivered between the hours of 8 a.m. and 5 p.m. to CC:FIP (Notice 2001–44), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue NW, Washington, DC. Alternatively, taxpayers may submit comments electronically via the Internet by submitting comments directly to the IRS Internet site at http://www.irs.gov/tax_regs/regslist.html. All comments will be available for public inspection and copying.

DRAFTING INFORMATION

The principal authors of this notice are: Elizabeth Handler and Dale S. Collinson, Office of Associate Chief Counsel (Financial Institutions and Products), Internal Revenue Service; Viva Hammer, Office of the Tax Legislative Counsel, Office of Tax Policy, United States Department of the Treasury; and Matthew J. Eichner, Of

fice of Tax Analysis, Office of Tax Policy, United States Department of the Treasury. However, other personnel from the IRS and Treasury Department participated in its development. For further information regarding this notice contact Viva Hammer at (202) 622-0869 or Dale Collinson at (202) 622-3900 (not toll-free calls).

APPENDIX

The method described in Section II.B.1.b. is illustrated using the following example of a simple equity swap contract on a notional amount of 100 shares of XYZ stock, entered into on January 1, 2001, between A and B with the following terms:

A pays B:

2 The terms of the contract require B to make a payment to A if the XYZ stock decreases in value. Because forward pricing for investment property such as corporate stock always assumes an increase in price, the method would also assume at the outset that the contingent payment would be made by A to B.

B pays A:

Every six months until expiration – 7.00% (annual rate) of notional amount at inception.

At expiration, December 31, 2002 – any depreciation in a share of XYZ since contract inception times 100.

Assume that the market price of a share of XYZ was $975 at the inception of the contract, and the forward price for future delivery of a share of XYZ was $1,062. For computational purposes only, A is deemed under the NCS method to have hedged itself by entering into a forward contract at the inception of the NPC for the purchase of 100 shares of XYZ, in exchange for $106,200, on December 31, 2002. In order to make the $106,200 payment, A would need to set aside at the inception of the contract an amount that equals the present value of $106,200, i.e., $92,547 (based on a 7% annual interest rate compounded semiannually).

With this forward contract in place, A would be able to make the required payment to party B. ² However, the arrangement described thus far would involve A committing more funds to building the hedge than is absolutely necessary. A is required to pay B only the difference be

2001–30 I.R.B. 81 July 23, 2001

tween the price of the shares on December 31, 2002, and the price of the shares on January 1, 2001, and not the entire value of the shares on December 31, 2002. For example, suppose that the price of the 100 XYZ shares has risen to $110,000 by expiration of the NPC. If this happens, A would be obligated to pay B $12,500. A would purchase the shares pursuant to the forward contract for $106,200, sell them for $110,000, and pay party B the $12,500 required under the terms of the swap. The remaining $97,500 in proceeds would belong to A. This $97,500 (the market price of the shares on January 1, 2001) would always remain in A’s possession at maturity no matter how the value of XYZ stock changes through the life of the NPC. Therefore, simply entering into a forward contract for the purchase of the XYZ stock is not an exact hedge for A’s commitment

under the swap contract. To further refine the hedge, A could borrow the present value of $97,500, i.e., $84,966 on January 1, 2001. Borrowing this amount would mean that the cost of assembling the hedge would be ($92,547 - $84,966), or $7,582.

The net cash flow from these two transactions - purchasing the forward contract and borrowing the present value of the current price of the 100 shares - would always enable A to exactly make the payment due to B under the NPC on December 31, 2002, no less and no more. If the share price rises to $1,000 by December 31, 2002, A would sell the stock delivered in satisfaction of the forward contract for $100,000, pay $2,500 to B and repay the loan with the remaining $97,500. If, instead, the price were to fall to $935 by December 31, 2002, A would actually re

ceive $4,000 from B which, in combination with the proceeds from selling the stock delivered under the forward contract for $93,500, would allow A to repay the loan balance of $97,500.

Once the present value of A’s deemed hedge for the contingent payment is determined, this amount must be amortized into B’s income. This can be done by deeming A to provide to B a zero coupon bond with a present value of $7,582. Such a bond has a face value, payable at maturity, of $8,700 (assuming again an annual rate of 7.00% and compounded semiannually).

The original issue discount (OID) is found by multiplying the present value of the bond at the beginning of each six month period by the periodic rate, 7.00%/2 or 3.50%:

July 23, 2001 82 2001–30 I.R.B.