Part IV. Items — Internal Revenue Bulletin 2002-22

mented that the regulations inappropriately characterize as foreign personal holding company income any gain arising from hedging transactions entered into by a manufacturer to protect itself from fluctuations in the prices of commodities associated with the products that it manufactures. Because the manufacturer would not be considered to be selling the commodities in the active conduct of a commodities business, transactions entered into by the manufacturer could not qualify for the “qualified hedging transaction” exception under the regulations.

The regulations also address the treatment of currency gain or loss for purposes of subpart F. Although the regulations provide that foreign personal holding company income generally includes the excess of foreign currency gains over foreign currency losses, an exception is provided for foreign currency gain or loss “directly related to the business needs of the controlled foreign corporation.” § 1.954–2(g)(2)(ii). Notwithstanding this “business needs” exception, the regulations provide that currency gain or loss arising from an interestbearing liability must be allocated and apportioned between subpart F and nonsubpart F income in the same manner that interest expense associated with the liability is allocated and apportioned between subpart F and non-subpart F income under §§ 1.861–9T and 1.861– 12T. § 1.954–2(g)(2)(iii). Some taxpayers have commented that the final regulations inappropriately characterize a portion of foreign currency gain on certain interest-bearing liabilities as foreign personal holding company income. In particular, these taxpayers have noted that securities dealers commonly utilize a technique known as “match funding” to manage currency exposures associated with their dealer assets. Rather than borrowing in their functional currency to meet their business needs, dealers who utilize this technique attempt to manage their exposure to foreign currencies on their dealer assets by borrowing the funds needed for their business in the currency in which the dealer assets are denominated. As a result, the foreign currency exposure on the dealer assets is offset economically by the

Notice of Proposed Rulemaking and Notice of Public Hearing

Guidance Regarding the Definition of Foreign Personal Holding Company Income

REG–154920–01

AGENCY: Internal Revenue Service (IRS), Treasury.

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

SUMMARY: This document contains proposed regulations that provide that gain or loss arising from certain commodities hedging transactions and currency gain or loss arising from certain interest-bearing liabilities do not constitute (or are not netted against) foreign personal holding company income. This treatment is proposed because the applicable commodities hedging transactions and interest-bearing liabilities typically offset transactions that do not generate foreign personal holding company income. This document also provides notice of a public hearing on these proposed regulations.

DATES: Written or electronic comments must be received by August 21, 2002. Requests to speak (with outlines of oral comments to be discussed) at the public hearing scheduled for September 11, 2002, at 10 a.m. must be submitted by August 21, 2002.

ADDRESSES: Send submissions to: CC:ITA:RU (REG–154920–01), 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:ITA:RU, REG–154920–01, Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC. Alternatively, taxpayers may submit comments electronically directly to the IRS Internet site at: www.irs.gov/regs . The public hearing will be held in room

4718, Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, Kenneth Christman or Ted Setzer at (202) 622–3870; concerning submission and delivery of comments and the public hearing, Treena Garrett, (202) 622–7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

Section 954(c)(1)(C) of the Internal Revenue Code provides that foreign per- sonal holding company income of a con- trolled foreign corporation (a CFC) generally includes the excess of gains over losses from transactions in commodities. An exception to this treatment is provided, however, for gains and losses that arise out of “ bona fide hedging transactions” entered into by a producer, processor, merchant or handler of commodities. Section 954(c)(1)(C)(i). On September 7, 1995, final regulations (T.D. 8618, 1995-2 C.B. 89) were published in the Federal Register (60 FR 46500, as corrected at 60 FR 62024) under section 954 governing the definition of a CFC and the definitions of foreign base company income and foreign personal holding company income of a CFC. These regulations address, among other matters, the circumstances in which income from transactions in commodities will be treated as foreign personal holding company income. In particular, the regulations provide that income from a “qualified hedging transaction” is excluded from the definition of foreign personal holding company income. § 1.954– 2(f)(1)(ii). A qualified hedging transaction is defined in the regulations generally as a bona fide hedging transaction with respect to a sale of commodities in the active conduct of a commodities business by a CFC if substantially all of the CFC’s business is as an active producer, processor, merchant or handler of commodities. §§ 1.954–2(f)(2)(iii) and (iv).

Following the publication of the final regulations, some taxpayers have com

June 3, 2002 1060 2002–22 I.R.B.

foreign currency exposure on the interestbearing liabilities incurred by the dealer. Under the regulations, foreign currency gain on the dealer assets would qualify for the “business needs” exception and therefore would not be classified as foreign personal holding company income. If the foreign currency gain arose on the offsetting interest-bearing liabilities, however, a portion of the foreign currency gain likely would be treated as subpart F income under the regulations.

Explanation of Provisions

The proposed regulations address each of these issues by refining the relevant exceptions to foreign personal holding company income.

Commodities Hedging Transactions

Section 1.954–2(f)(2)(v), as proposed, would provide that a hedging transaction entered into by a CFC with respect to its business as a producer, processor, merchant or handler of commodities may be a qualified hedging transaction although the hedging transaction is not a hedge with respect to a sale of commodities in the active conduct of a commodities business by a CFC substantially all of whose business is as an active producer, processor, merchant or handler of commodities. The proposed regulation also provides that, for purposes of satisfying the qualified hedging transaction requirements, a producer, processor, merchant or handler of commodities includes (but is not limited to) a CFC that regularly uses commodities in a manufacturing, construction, utilities, or transportation business. Similar to the regulations currently in effect, the proposed regulations provide that a corporation is not a producer, processor, merchant or handler of commodities (and therefore cannot satisfy the qualified hedging transaction requirements) if its business is primarily financial.

Foreign Currency Gain or Loss on Interest-bearing Liabilities

Section 1.954–2(g)(2)(ii)(C)( 2 ), as proposed, would provide that interestbearing liabilities of a CFC will be treated as dealer property if the liabilities are denominated in a currency so as to man

age the CFC’s currency risk with respect to dealer property held by the CFC. This provision would apply only to interestbearing liabilities identified on the date the liability is incurred. The result of the proposed rule would be to exclude currency gain or loss on interest-bearing liabilities that manage the CFC’s currency risk with respect to dealer property from the computation of foreign personal holding company income.

Proposed Effective Dates

Section 1.954–2(f)(2)(v) is proposed to apply to gain or loss realized by a CFC with respect to a qualified hedging transaction entered into on or after the date proposed § 1.954–2(f)(2)(v) is published as a final regulation in the Federal Reg- ister . Section 1.954–2(g)(2)(ii)(C)( 2 ) is proposed to apply to gain or loss from an interest-bearing liability entered into by a CFC on or after the date proposed § 1.954–2(g)(2)(ii)(C)( 2 ) is published as a final regulation in the Federal Register .

Special Analysis

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 has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations and, because these regulations do not impose on small entities a collection of information requirement, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the 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 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) or electronic comments that are submitted timely to the IRS. The IRS and Treasury Department specifically request com

ments 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 September 11, 2002, at 10 a.m. in room 4718, Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC. Due to building security procedures, visitors must enter at the Constitution Avenue entrance. 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 30 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 August 21, 2002. 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 Kenneth Christman and Ted Setzer of the Office of the Associate Chief Counsel (International). 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 1—INCOME TAXES

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

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

2002–22 I.R.B. 1061 June 3, 2002

contracts for the delivery of aluminum. These futures purchase contracts are bona fide hedging transactions. As CFC1 purchases aluminum and component parts containing significant amounts of aluminum in the spot market for use in its business, it closes out an equivalent amount of aluminum futures purchase contracts by entering into offsetting aluminum futures sales contracts. The aluminum futures purchase contracts are qualified hedging transactions as defined in paragraph (f)(2)(v)(A) of this section. Accordingly, any gain or loss on such aluminum futures purchase contracts is excluded from the computation of foreign personal holding company income.

Example 2 . CFC2 is a controlled foreign corporation located in country B. CFC2 operates an airline business within country B in a manner in which such business is customarily and usually conducted by others. To protect itself against increases in the price of aviation fuel, CFC2 enters into forward contracts for the purchase of aviation fuel. These forward purchase contracts are bona fide hedging transactions. As CFC2 purchases aviation fuel in the spot market for use in its business, it closes out an equivalent amount of its forward purchase contracts for cash pursuant to a contractual provision that permits CFC2 to terminate the contract and make or receive a one-time payment representing the contract’s fair market value. The aviation fuel forward purchase contracts are qualified hedging transactions as defined in paragraph (f)(2)(v)(A) of this section. Accordingly, any gain or loss on such aviation fuel forward purchase contracts is excluded from the computation of foreign personal holding company income.

(D) Effective date . This paragraph (f)(2)(v) applies to gain or loss realized by a controlled foreign corporation with respect to a qualified hedging transaction entered into on or after the date § 1.954– 2(f)(2)(v) is published as a final regulation in the Federal Register .

(vi) Financial institutions not a pro- ducer, etc . For purposes of this paragraph (f), a corporation is not a producer, processor, merchant or handler of commodities if its business is primarily financial. For example, the business of a controlled foreign corporation is primarily financial if its principal business is making a market in notional principal contracts based on a commodities index.

- - - (g) - - (2) - - (ii) - - (C) Regular dealers —(1) General rule . Transactions in dealer property (as defined in paragraph (a)(4)(v) of this section) described in section 988(c)(1)(B) or (C) that are entered into by a controlled foreign corporation that is a regular dealer (as defined in paragraph (a)(4)(iv) of this section) in such property in its capacity as

Par. 2. In § 1.954–0, paragraph (b) is amended by:

Removing the entry for § 1.954– 2(f)(2)(iii)(E).
Revising the entry for § 1.954– 2(f)(2)(iv).
Adding entries for § 1.954– 2(f)(2)(iv)(C), (f)(2)(v) and (f)(2)(vi).
Revising the entry for § 1.954– 2(g)(2)(ii)(C). The additions and revisions read as follows::

§ 1.954–0 Introduction .

- - - (b) - -

§ 1.954–2 Foreign personal holding company income .

- - - (f) - - (2) - - (iv) Qualified hedging transaction entered into prior to the date § 1.954–2(f)(2)(v) is published as a final regulation in the Federal Register .
- - - (C) Effective date. (v) Qualified hedging transaction entered into on or after the date § 1.954– 2(f)(2)(v) is published as a final regulation in the Federal Register . (A) In general. (B) Exception. (C) Examples. (D) Effective date.

(vi) Financial institutions not a producer, etc. (g) - - (2) - - (ii) - - (C) Regular dealers. ( 1 ) General rule. ( 2 ) Certain interest-bearing liabilities treated as dealer property. (i) In general. (ii) Failure to identify certain liabilities. (iii) Effective date.

- - - Par. 3. Section 1.954–2 is amended by:

Removing paragraph (f)(2)(iii)(E).
Revising the heading of paragraph (f)(2)(iv).
Adding paragraphs (f)(2)(iv)(C), (f)(2)(v), and (f)(2)(vi).
Revising paragraphs (g)(2)(C) and (g)(2)(iii).

The revisions and additions read as follows:

§ 1.954–2 Foreign personal holding company income .

- - - (f) - - (2) - - (iv) Qualified hedging transaction entered into prior to the date § 1.954– 2(f)(2)(v) is published as a final regulation in the Federal Register .
- - - (C) Effective date . This paragraph (f)(2)(iv) applies to gain or loss realized by a controlled foreign corporation with respect to a qualified hedging transaction entered into prior to the date § 1.954– 2(f)(2)(v) is published as a final regulation in the Federal Register .

(v) Qualified hedging transaction entered into on or after the date § 1.954– 2(f)(2)(v) is published as a final regula- tion in the Federal Register —(A) In gen- eral . The term qualified hedging transaction means a bona fide hedging transaction, as defined in paragraph (a)(4)(ii) of this section, with respect to one or more commodities transactions reasonably necessary to the conduct of any business by a producer, processor, merchant or handler of commodities in a manner in which such business is customarily and usually conducted by others. For purposes of this paragraph (f)(2)(v), a producer, processor, merchant or handler of commodities includes a controlled foreign corporation that regularly uses commodities in a manufacturing, construction, utilities, or transportation business.

(B) Exception . The term qualified hedging transaction does not include a transaction described in section 988(c)(1) (without regard to section 988(c)(1)(D)(i)). (C) Examples . The following examples illustrate the provisions of this paragraph (f)(2)(v):

Example 1 . CFC1 is a controlled foreign corporation located in country A. CFC1 manufactures and sells machinery in country B using aluminum and component parts purchased from third parties that contain significant amounts of aluminum. CFC1 conducts its manufacturing business in a manner in which such business is customarily and usually conducted by others. To protect itself against increases in the price of aluminum used in the machinery it manufactures, CFC1 enters into futures purchase

June 3, 2002 1062 2002–22 I.R.B.

the acts or omissions of the organization that were the basis for revocation.

Crisis at Home Intervention Center

San Bruno, CA

Changes in Annual Accounting Period

Announcement 2002–53

PURPOSE

This announcement discusses some of the more significant issues raised in connection with finalizing Notice 2001–34, 2001–23 I.R.B. 1302, and Notice 2001– 35, 2001–23 I.R.B. 1314, which proposed procedures for obtaining the Commissioner’s approval to adopt, change, or retain an annual accounting period under §§ 441 and 442 of the Internal Revenue Code and the regulations thereunder.

BACKGROUND

Notice 2001–34 proposed procedures for obtaining the Commissioner’s prior approval to adopt, change, or retain an annual accounting period, applicable to a taxpayer that is not within the scope of any automatic approval procedure. Notice 2001–35 proposed new automatic approval procedures for partnerships, S corporations, electing S corporations, and personal service corporations (PSCs). Both notices requested comments from the public in connection with the proposed procedures. At the same time that the Service published these notices, it also issued new proposed regulations (REG–106917–99, 2001–27 I.R.B. 4) under §§ 441, 442, 706, and 1378, relating to annual accounting periods, which also requested public comments.

Rev. Proc. 2002–39, finalizing Notice 2001–34, and Rev. Proc 2002–38, finalizing Notice 2001–35, appear elsewhere in this Bulletin, along with Rev. Proc. 2002– 37, which provides updated automatic approval procedures for corporations. These revenue procedures, together with final regulations (T.D. 8996, published in the May 17, 2002, Federal Register (67 FR 35009)) under §§ 441, 442, 706, and 1378, issued concurrently, are intended to provide comprehensive guidance on the adoption, change, and retention of an

a dealer will be treated as directly related to the business needs of the controlled foreign corporation under paragraph (g)(2)(ii)(A) of this section.

(2) Certain interest-bearing liabilities treated as dealer property —( i ) In gen- eral . For purposes of this paragraph (g)(2)(ii)(C), an interest-bearing liability incurred by a controlled foreign corporation that is denominated in (or determined by reference to) a non-functional currency shall be treated as dealer property if the liability, by being denominated in such currency, reduces the controlled foreign corporation’s currency risk with respect to dealer property, and the liability is identified on the controlled foreign corporation’s records as a liability treated as dealer property before the close of the day on which the liability is incurred.

( ii ) Failure to identify certain liabili- ties . If a controlled foreign corporation identifies certain interest-bearing liabilities as liabilities treated as dealer property under the previous paragraph but fails to so identify other interest-bearing liabilities that manage its currency risk with respect to assets held that constitute dealer property, the Commissioner may treat such other liabilities as dealer property if the Commissioner determines that the failure to identify such other liabilities had as one of its principal purposes the avoidance of federal income tax.

( iii ) Effective date . This paragraph (g)(2)(ii)(C)( 2 ) applies only to gain or loss from an interest-bearing liability entered into by a controlled foreign corporation on or after the date § 1.954– 2(g)(2)(ii)(C)(2) is published as a final regulation in the Federal Register .

- - - (iii) Special rule for foreign currency gain or loss from an interest-bearing liability . Except as provided in paragraph (g)(2)(ii)(C)( 2 ) or (g)(5)(iv) of this section, foreign currency gain or loss arising from an interest-bearing liability is characterized as subpart F income and nonsubpart F income in the same manner that interest expense associated with the liability would be allocated and apportioned between subpart F income and non-subpart F income under §§ 1.861– 9T and 1.861–12T.

(Filed by the Office of the Federal Register on May 10, 2002, 8:45 a.m., and published in the issue of the Federal Register for May 13, 2002, 67 F.R. 31995)

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

Announcement 2002–51

The name of an organization that no longer qualifies as an organization described in section 170(c)(2) of the Internal Revenue Code of 1986 is listed below.

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

If on the other hand a suit for declaratory judgment has been timely filed, contributions from individuals and organizations described in section 170(c)(2) that are otherwise allowable will continue to be deductible. Protection under section 7428(c) would begin on March 18, 2002, and would end on the date the court first determines that the organization is not described in section 170(c)(2) as more particularly set forth in section 7428 (c)(1). For individual contributors, the maximum deduction protected is $1,000, with a husband and wife treated as one contributor. This benefit is not extended to any individual, in whole or in part, for

Robert E. Wenzel, Deputy Commissioner of

Internal Revenue .

2002–22 I.R.B. 1063 June 3, 2002

fore accepted by the Service as a sufficient business purpose in cases where substantial distortion is present, and can be based on criteria, such as gross receipts, that are also the focus of the natural business year tests. For example, such a business purpose could include having significant gross receipts in the last months of the requested taxable year, albeit less than 25 percent of the taxpayer’s annual gross receipts.

C. Changes Within 48 Months

Some taxpayers have expressed concern that the Service will deny most, or even all, applications to change or retain an annual accounting period under the final prior approval procedures if the taxpayer made a change within the previous 48 months (“prior change”). Although a prior change may disqualify a taxpayer for automatic approval of a change or retention, the Service expects that, for the vast majority of applications under Rev. Proc. 2002–39, approval will not be denied because of a prior change. However, in certain cases, approval may be denied because of the taxpayer’s accounting period history (for example, where there exists a pattern of prior changes). See generally section 7.01 of Rev. Proc. 2002–39.

D. Director Consent/Audit Protection

Notice 2001–34 proposed to offer audit protection to all taxpayers that received prior approval under the final revenue procedure to retain or change an annual accounting period. Consistent with procedures of the Service in the accounting method area, taxpayers under examination were required to secure the consent of the Director to the change or retention. One commentator argued that the requirement to obtain the Director’s consent was burdensome, particularly for corporate taxpayers for whom an annual accounting period ordinarily would not be an issue under consideration. The commentator suggested either that all taxpayers under examination be permitted to provide a representation (under penalties of perjury) that their annual accounting period is not an issue under consideration, in lieu of a letter of consent from the Director, or that audit protection be limited to taxpayers that provide the letter of consent.

annual accounting period. The most significant comments received in connection with Notice 2001–34 and Notice 2001– 35, along with certain other changes to the proposed procedures, are discussed below. Comments specific to the proposed regulations are discussed in the preamble to the final regulations.

CHANGES TO NOTICE 2001–34 (PRIOR APPROVAL PROCEDURES)

A. Natural Business Year

One commentator suggested that the final revenue procedure clarify the terms “peak and nonpeak periods,” “at or soon after,” and “insignificant gross receipts,” in connection with the annual business cycle and seasonal business tests. Rev. Proc. 2002–39 provides clarification by including safe harbor rules for administrative convenience, as well as examples. One safe harbor provides that 1 month will be deemed to be “soon after” the end of a peak period (in the case of the annual business cycle test) or the close of operations (in the case of the seasonal business test). Under a second safe harbor, gross receipts will be deemed to be “insignificant” for purposes of the seasonal business test if they are less than 10 percent of the taxpayer’s total gross receipts for the year. The examples illustrate the application of these safe harbor rules. Taxpayers that do not meet the safe harbor rules nevertheless may establish that their requested taxable year meets the annual business cycle test or seasonal business test using all of the facts and circumstances.

Notice 2001–34 provided that a taxpayer seeking to establish a natural business year under section 5.03 must provide information about its gross receipts for the three taxable years immediately preceding the first effective year. Although Rev. Proc. 2002–39 continues to require this information, and to require that the annual business cycle, seasonal business, or 25-percent gross receipts test be met for each of the three preceding years for taxpayers that have been in existence for that length of time, the Service and Treasury realize that newly formed taxpayers may be uncertain about whether and how they can establish a natural business year under these tests. Accordingly, Rev. Proc. 2002–39 clarifies that a taxpayer that has

not been in existence for 3 taxable years may satisfy the annual business cycle or seasonal business test by providing information other than prior years’ gross receipts, such as a description of its business and reasonable estimates of its gross receipts. However, the Service and Treasury believe that the more objective 25-percent gross receipts test should continue to apply only to established taxpayers that can produce actual gross receipts information for the required 3-year period.

B. Additional Acceptable Business Purposes

Section 5.02(1)(b) of Notice 2001–34 provides that a taxpayer, including a partnership, S corporation, electing S corporation, or PSC, may establish a business purpose for a requested taxable year for purposes of section 5.02(1) (to which only general terms and conditions apply) based on all of the facts and circumstances. A commentator requested that the Service provide examples of the kinds of facts and circumstances that would be sufficient for a taxpayer to demonstrate a sufficient business purpose. The commentator further suggested that the final revenue procedure explain whether and how facts such as a taxpayer’s gross receipts would be evaluated to determine whether the taxpayer has demonstrated a sufficient business purpose under the facts and circumstances test of section 5.02(1)(b). The Service and Treasury intend for the facts and circumstances test of section 5.02(1)(b) to apply only in rare and unusual circumstances. Rev. Proc. 2002–39 has been clarified to that effect. Accordingly, examples such as those suggested by the commentator have not been included in Rev. Proc. 2002–39.

It should be noted that, if a taxpayer (other than a taxpayer with a required taxable year) fails to satisfy one of the three alternative tests for showing a natural business year (annual business cycle, seasonal business, or 25-percent gross receipts), then the taxpayer still may obtain approval for the change if it demonstrates some nontax reason for the change and accepts additional terms and conditions that are necessary to eliminate substantial distortion created by the change. Under Rev. Proc. 2002–39, this nontax reason can be a reason not hereto

June 3, 2002 1064 2002–22 I.R.B.

CHANGES TO NOTICE 2001–35 (AUTOMATIC APPROVAL PROCEDURES FOR PASS-THROUGH ENTITIES)

A. Natural Business Year

One commentator suggested that the final procedures for obtaining automatic approval by a pass-through entity clarify whether a taxpayer changing to or from a 52–53-week taxable year ending with reference to its existing natural business year is required to recompute the 25-percent gross receipts test. Section 7.02(6) of Rev. Proc. 2002–38 requires only a taxpayer changing to a natural business year using the 25-percent gross receipts test to provide the gross receipts information with its application, in compliance with the instructions for Form 1128, Applica- tion to Adopt, Change, or Retain a Tax Year . A taxpayer changing to or from a 52–53-week taxable year ending with reference to its existing natural business year is not required to provide this information. However, as discussed above, for a taxpayer with a required year to continue to use a fiscal year, that year must continue to be a permitted year.

B. Ownership Taxable Year

Notice 2001–35 provided that, for purposes of determining the ownership tax year of an S corporation or electing S corporation, a shareholder that is tax-exempt under § 501(a) is disregarded if such shareholder is not subject to tax on any income attributable to the S corporation. One commentator suggested that taxexempt shareholders should not be disregarded if the S corporation is wholly owned by such shareholders. This suggestion has been adopted in Rev. Proc. 2002– 38.

C. Certain Minor Changes in Ownership of Partnerships

To alleviate taxpayer burden associated with temporary and minor changes in ownership of a partnership that result in a new required year under § 706(b), a new rule has been added to Rev. Proc. 2002– 38. The rule provides that a partnership required under § 706(b) to change its taxable year due to a change of less than 10 percent of the aggregate interests of all

After carefully weighing the benefits of audit protection against the burden of obtaining the requisite Director consent, the Service and Treasury Department have determined that it is appropriate to extend audit protection only to certain taxpayers with required taxable years, namely, partnerships, S corporations, electing S corporations, and PSCs. Accordingly, other corporate taxpayers, and taxpayers with required taxable years other than those identified above, that are under examination or before an area office or a federal court will not be required to obtain Director consent as a prerequisite to applying for a change under Rev. Proc. 2002–39, and will not be offered audit protection. Similarly, no consent letter is required, and no audit protection is offered, by Rev. Proc. 2002– 37, which provides automatic consent procedures for corporations.

E. Failure to Satisfy Natural Business Year Test in Future Years

Notice 2001–34 provides that if a partnership, S corporation, electing S corporation, or PSC changes to a natural business year, and that year later fails to qualify as a permitted year, the taxpayer must then change to a permitted year. One commentator objected to this condition, arguing that it effectively mandates annual monitoring of the taxpayer’s continued compliance with the natural business year requirement, and as such is overly burdensome. The commentator suggested that the final procedures instead adopt a 3-year testing period.

The Service and Treasury Department believe that a 3-year testing period is inconsistent with the statutory framework imposing required years on such taxpayers, and that the taxpayer’s year must continue to be a permitted year in order for the taxpayer to retain it. It should be noted, however, that even if the requested taxable year fails in some later year to qualify as a permitted year under the original test for which approval was granted (for example, the 25-percent gross receipts test), the taxpayer need not change its existing taxable year if the taxpayer can demonstrate that the year is a permitted year under some other test (for example, the annual business cycle test). The same would be true for a taxpayer that changed to or retained a natural busi

ness year under one of the automatic approval revenue procedures.

F. Substantial Distortion of Income

Notice 2001–34 provides that, for purposes of determining whether the additional terms and conditions of section 5.05 apply, distortion of income resulting from the requested taxable year change will not be considered substantial if the amount of the distortion is less than both: (1) 5 percent of the taxpayer’s estimated gross receipts for its current taxable year; and (2) $500,000. The amount of the distortion or deferral is the taxpayer’s allocable share of income from a passthrough entity, including ordinary income or loss, rents, royalties, interest, dividends, and deduction equivalents of credits. A similar de minimis rule is provided in Rev. Proc. 2000–11 (applied to each of the 3 prior taxable years) for determining whether a corporation with an interest in a pass-through entity is within the scope of that automatic approval revenue procedure.

One commentator suggested that the final prior approval procedures eliminate the $500,000 floor. The commentator believes that, in the case of prior approval applications processed by the national office, it is more appropriate for the Service to determine on a case-by-case basis whether an estimated amount of distortion is de minimis .

The Service and Treasury Department believe that the $500,000 floor is appropriate in order to promote consistency of results and facilitate the administration of prior approval applications. Thus, the $500,000 floor is retained in Rev. Proc. 2002–39. Similarly, the $500,000 floor contained in Rev. Proc. 2000–11 is retained in Rev. Proc. 2002–37.

The commentator also recommended that, regardless of the de minimis distortion test, the additional terms and conditions of section 5.05 of Notice 2001–34 not apply if the taxpayer’s interest in the pass-through entity is less than 5 percent of the entity’s profits and capital. The Service and Treasury do not believe that such a rule would be appropriate, as even a 1 percent interest in profits and capital can potentially result in a significant amount of distortion.

2002–22 I.R.B. 1065 June 3, 2002

and certain scope limitations are waived for changes to (or from) certain 52–53week taxable years that reference the same calendar month. In addition, Rev. Proc. 2002–37 has been modified to provide that a de minimis interest in a controlled foreign corporation, foreign personal holding company, or passive foreign investment company may be disregarded under section 4 of that revenue procedure for purposes of determining whether a corporation is within the scope of Rev. Proc. 2002–37, similar to the treatment of de minimis interests in partnerships.

FURTHER INFORMATION

For further information regarding this announcement, contact Martin Scully, Jr. or Michael F. Schmit of the Office of the Associate Chief Counsel (Income Tax and Accounting) at (202) 622–4960 (not a toll-free call).

partners in the partnership’s profits and capital may continue to use its current taxable year for one taxable year if it is foreseeable that the change in ownership will be reversed after one taxable year.

CHANGES TO REV. PROC. 2000–11

A. Automatic Changes to Natural Business Year

Rev. Proc. 2000–11 did not allow corporations with disqualifying interests in pass-through entities to change automatically to a natural business year under the 25-percent gross receipts test. Under the final prior approval procedures of Rev. Proc. 2002–39, a corporation qualifying to change to a natural business year based on the 25-percent gross receipts test generally would receive approval to do so (subject only to general terms and conditions) notwithstanding any resulting deferral or distortion attributable to an

interest in a pass-through entity. Accordingly, the Service and Treasury Department believe that it is appropriate to provide automatic approval for corporations to change to a natural business year, based on the 25-percent gross receipts test, notwithstanding their interest in a pass-through entity. Rev. Proc. 2002–37 reflects this change.

B. Conforming Changes

Certain conforming changes have been made to Rev. Proc. 2002–37, consistent with the rules set forth in the final regulations, Rev. Proc. 2002–38, and Rev. Proc. 2002–39. For example, the limitation on changes within 6 years has been reduced to the most recent 48 months, corporations that are shareholders of a closely-held real estate investment trust are considered to have an interest in a pass-through entity for purposes of the scope limitations of Rev. Proc. 2002–37,

June 3, 2002 1066 2002–22 I.R.B.