Part I. Rulings — Internal Revenue Bulletin 2002-28

and $2,000 for an employee who has family coverage under the major medical plan, increased by the unused amount from the previous year. If an employee retires or otherwise terminates employment, any unused reimbursement amount remaining in the HRA is unavailable thereafter.

Under the terms of the plans, a qualified beneficiary who chooses to elect COBRA continuation coverage may only elect the HRA in conjunction with the major medical plan. However, a qualified beneficiary may choose to elect COBRA continuation coverage for only the major medical plan. The COBRA applicable premium for continuation of the major medical plan is $1,800 for employee-only coverage and $4,500 for family coverage.

Situation 2 : The facts are the same as Situation 1, except that any portion of the maximum reimbursement amount under the HRA that is not applied to reimburse medical care expenses before an employee retires or otherwise terminates employment continues to be available after retirement or termination for any medical care expense under § 213(d)(1) (A), (B), and (D) incurred by the former employee or the former employee’s spouse and dependents. However, after the employee retires or otherwise terminates employment, the maximum reimbursement amount is not increased unless COBRA continuation coverage is elected.

LAW AND ANALYSIS

Section 61(a)(1) and § 1.61–21(a)(3) of the Income Tax Regulations provide that, except as otherwise provided in subtitle A, gross income includes compensation for services, including fees, commissions, fringe benefits, and similar items.

Section 106 provides that “gross income of an employee does not include employer-provided coverage under an accident or health plan.”

Section 1.106–1 provides that the gross income of an employee does not include contributions which the employee’s employer makes to an accident or health plan for compensation (through insurance or otherwise) to the employee

Section 105.—Amounts Received Under Accident and Health Plans

(Also §§ 106, 125.)

Health Reimbursement Arrange- ments (HRAs) . This ruling describes an employer-provided medical care expense reimbursement plan called a health reimbursement arrangement (HRA), in which reimbursements for medical care expenses made from the plan are excludable from employee gross income. Among other things, the HRA described retains favorable tax treatment because it only reimburses employees or former employees for medical care expenses of the employee or former employee and their spouses and dependents; is solely employer-funded and not paid for directly or indirectly from salary reduction; and although it allows participants to carry forward unused amounts for use in later coverage periods, these amounts may never be used for anything but reimbursements for qualified medical expenses.

Rev. Rul. 2002–41

ISSUE

Whether employer-provided coverage and medical care expense reimbursements made under a reimbursement arrangement that allows unused amounts to be carried forward, as described in Situations 1 and 2 below, are excludable from gross income under §§ 106 and 105 of the Internal Revenue Code, respectively.

FACTS

Situation 1 : An employer sponsors a major medical plan for all employees that provides coverage under a policy of accident and health insurance for certain medical care expenses described in § 213(d)(1)(A) and (B). The major medical plan has a $2,000 annual deductible for employee-only coverage and a $4,000 annual deductible for family coverage. However, certain preventive care benefits ( e.g., annual physicals and well-baby visits) are covered without regard to the

plan’s deductible. The major medical plan is paid for in part pursuant to salary reduction elections under the employer’s cafeteria plan. The election form provides that salary reduction elections are used only to pay for the major medical plan. To participate in the major medical plan, an employee must make a $1,000 annual salary reduction election for employeeonly coverage or a $3,500 annual salary reduction election for family coverage.

In addition to the major medical plan, the employer also sponsors a health reimbursement arrangement (HRA) that reimburses the medical care expenses of all participating employees and their spouses and dependents up to an annual maximum reimbursement amount that is fixed on January 1 of each year. The HRA is available only to employees who participate in the major medical plan. The HRA meets the nondiscrimination requirements of § 105(h).

The HRA is paid for by the employer and employees do not make any salary reduction election to pay for the HRA. The HRA operates on a calendar year basis. Employees have no right to receive cash or any benefit other than reimbursement for medical care expenses under the HRA.

The expenses reimbursable under the HRA are any medical care expenses that would be covered by the major medical plan but for the major medical plan’s deductible, limitation to expenses that are “usual, customary and reasonable,” or any other similar dollar limitation imposed by the major medical plan. Only expenses that are substantiated are reimbursed.

The maximum reimbursement amount for the first year in which an employee participates in the HRA is $1,000 for an employee who has employee-only coverage under the major medical plan and $2,000 for an employee who has family coverage under the major medical plan. Unused reimbursement amounts from one year are carried forward for use in later years. Therefore, in each year after the first year, the maximum reimbursement amount under the HRA equals $1,000 for an employee who has employee-only coverage under the major medical plan

2002–28 I.R.B. 75 July 15, 2002

for personal injuries or sickness incurred by the employee or the employee’s spouse or dependents (as defined in § 152).

Section 105(a) provides that, except as otherwise provided in § 105, “amounts received by an employee through accident or health insurance for personal injuries or sickness shall be included in gross income to the extent such amounts (1) are attributable to contributions by the employer which were not includible in the gross income of the employee, or (2) are paid by the employer.”

Section 105(e) states that amounts received under an accident or health plan for employees are treated as amounts received through accident or health insurance for purposes of § 105 (and § 104 relating to compensation for injuries and sickness). Section 1.105–5(a) provides that an accident or health plan is an arrangement for the payment of amounts to employees in the event of personal injuries or sickness.

Section 105(b) states that except in the case of amounts attributable to (and not in excess of) deductions allowed under § 213 (relating to medical expenses) for any prior taxable year, gross income does not include amounts referred to in subsection (a) if such amounts are paid, directly or indirectly, to the taxpayer to reimburse the taxpayer for expenses incurred by the taxpayer for the medical care (as defined in § 213(d)) of the taxpayer or the taxpayer’s spouse or dependents (as defined in § 152).

Section 1.105–2 provides that only amounts that are paid specifically to reimburse the taxpayer for expenses incurred by the taxpayer for the prescribed medical care are excludable from gross income. Thus, § 105(b) does not apply to amounts that the taxpayer would be entitled to receive irrespective of whether or not the taxpayer incurs expenses for medical care.

Section 105(h)(1) provides that, unless the plan satisfies the nondiscrimination requirements of § 105(h)(2), amounts paid under a self-insured medical expense reimbursement plan to a highly compensated individual will not be excludable from that individual’s gross income under § 105(b) to the extent they constitute excess reimbursements.

Coverage provided under an accident and health plan to former employees and their spouses and dependents are excludable from gross income under § 106. See, Rev. Rul. 82–196, 1982–2 C.B. 53; Rev. Rul. 85–121, 1985–2 C.B. 57.

Under the facts described above, the HRA is an employer-provided accident and health plan used exclusively to reimburse expenses incurred for medical care as defined under § 213(d). Under the HRA, no benefits other than reimbursements for medical care expenses are available either in the form of cash or other non-taxable or taxable benefits at any time.

For purposes of determining whether any part of the salary reduction for the major medical plan is attributable to the HRA, under the facts and circumstances, the applicable premium for COBRA continuation coverage may be used as the actual cost of the major medical plan. Under the facts described above, the actual cost of the major medical plan for one year is $1,800 for employee-only coverage and $4,500 for family coverage. The amount of salary reduction election for employee-only coverage ($1,000) is less than $1,800 and the amount of salary reduction election for family coverage ($3,500) is less than $4,500. Also, the cafeteria plan election form states that salary reduction elections are used only to pay for the major medical plan. Under these facts and circumstances, the HRA reimbursement amounts are not attributable to the salary reduction contributions made to pay for the major medical plan.

In Situation 2, the employer provides accident and health coverage under the HRA for former employees. This coverage is provided based on the former employee’s prior employment relationship with the employer. The HRA is used to reimburse the former employee only for medical care expenses of the former employee or the former employee’s spouse or dependents. Neither the former employee nor the former employee’s spouse or dependents receive any other benefits from the HRA at any time.

HOLDING

Employer-provided coverage and medical care expense reimbursements made under the reimbursement arrange

ment that allows unused amounts to be carried forward, as described in Situations 1 and 2, are excludable from gross income under §§ 106 and 105, respectively.

See Notice 2002–45 published elsewhere in this Internal Revenue Bulletin for further information and guidance concerning HRAs.

DRAFTING INFORMATION

The principal author of this revenue ruling is Lorianne D. Masano of the Office of Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities). For further information regarding this revenue ruling, contact Lorianne D. Masano (202) 622–6080 (not a toll-free call).

Section 401.—Qualified Pension, Profit-Sharing, and Stock Bonus Plans

(Also, §§ 411, 4980F; 26 CFR 1.411(d)–2.)

Rev. Rul. 2002–42

Merger or conversion; partial termi- nation; notice . This ruling describes a situation where a merger or conversion of a money purchase pension plan into a profit-sharing plan is not a partial termination of the money purchase pension plan and also describes the type of notice that must be given to affected plan participants.

ISSUES

Whether, in the absence of other facts indicating a partial termination, the merger or conversion of a money purchase pension plan into a profit-sharing plan results in a partial termination of the money purchase pension plan under § 411(d)(3) of the Internal Revenue Code (the Code).
Whether the notice required by § 4980F of the Code and section 204(h) of the Employee Retirement Income Security Act of 1974, as amended (ERISA) must be provided to affected individuals in a money purchase pension plan that is merged or converted into a profit-sharing plan.

July 15, 2002 76 2002–28 I.R.B.

FACTS

Situation 1. Employer J maintains a money purchase pension plan qualifying under § 401(a) of the Code. The plan provides that upon a termination or partial termination of the plan, all affected participants will vest 100% in their account balances. Employer J converts the money purchase pension plan into a profitsharing plan that covers the same employees as the money purchase pension plan and contains the same vesting schedule. It also provides that assets and liabilities in the profit-sharing plan that originated in the money purchase pension plan retain their money purchase pension plan attributes, in accordance with Rev. Rul. 94–76, 1994–2 C.B. 46. Situation 2. Employer L maintains a money purchase pension plan qualifying under § 401(a). This plan provides that upon a termination or partial termination of the plan all affected participants will vest 100% in their account balances. Employer L also maintains a profitsharing plan qualifying under § 401(a). L amends the money purchase pension plan to cease future employer contributions and to merge it into the profit-sharing plan in a transaction that satisfies the requirements of § 414( l ). Following the merger, the profit-sharing plan covers the same employees and contains the same vesting schedule as the money purchase pension plan. Simultaneously, L amends the profit-sharing plan to provide that assets and liabilities transferred from the money purchase pension plan to the profit-sharing plan retain their money purchase pension plan attributes, in accordance with Rev. Rul. 94–76.

LAW AND ANALYSIS

Section 411(d)(3)

Section 411(d)(3) requires that a plan provide that upon its termination or partial termination the rights of all affected parties accrued to the date of such termination or partial termination, to the extent funded as of such date, or the amounts credited to the employees’ accounts, are nonforfeitable.

Section 1.411(d)–2(b)(1) of the Income Tax Regulations provides that whether or not a partial termination of a defined contribution or defined benefit plan has occurred is dependent on the facts and circumstances in a particular case. Such facts and circumstances include: the exclusion, by reason of a plan amendment or severance by the employer, of a group of employees who have previously been covered by the plan; and plan amendments which adversely affect the rights of employees to vest in benefits under the plan. Section 1.411(d)– 2(b)(2) contains a special rule providing that if a defined benefit plan ceases or decreases future benefit accruals under the plan, a partial termination shall be deemed to occur if, as a result of such cessation or decrease, a potential reversion to the employer maintaining the plan (determined as of the date such cessation or decrease is adopted) is created or increased.

Section 1.401(a)–2(b) provides that a plan may provide that upon the plan’s termination assets held in a § 415 suspense account may revert to the employer.

Section 1.415–6(b)(6) describes how amounts in a § 415 suspense account must be allocated to participants before any amount in the § 415 suspense account may revert to the employer on plan termination.

Rev. Rul. 85–6, 1985–1 C.B. 133, provides that a defined benefit plan that has surplus resulting from actuarial error may allow that surplus to revert to the employer upon termination of the plan.

Rev. Rul. 80–155, 1980–1 C.B. 84, provides that a profit-sharing, stock bonus, or money purchase pension plan ( i.e., a defined contribution plan) will not satisfy plan qualification requirements unless all funds are allocated to participants’ accounts under the plan in accordance with a definite formula (although certain exceptions are allowed, such as the use of a suspense account in accordance with the requirements of § 415 of the Code).

Rev. Rul. 94–76 provides that, under § 414( l ), the transfer of assets and liabilities from a money purchase pension plan to a profit-sharing plan is considered a spinoff of those assets and liabilities from

the money purchase pension plan and a merger of those assets and liabilities with the assets and liabilities of the profitsharing plan. The merger does not divest the assets and liabilities of the money purchase pension plan of their attributes as money purchase pension plan assets and liabilities. The holding in Rev. Rul. 94–76 is applicable when an employer converts a money purchase pension plan into a profit-sharing plan.

The special rule provided in § 1.411(d)–2(b)(2) for determining whether a partial termination has occurred is limited to defined benefit plans. The listed facts and circumstances in § 1.411(d)–2(b)(1) do not include the creation of a potential reversion as a factor to be considered in determining whether there has been a partial termination of a defined contribution plan. Unlike a defined benefit plan, in a defined contribution plan all assets must be allocated to participants’ accounts with the exception of amounts held in a § 415 suspense account. Therefore, on the termination of a defined contribution plan, the only amounts that may revert to the employer are amounts in a § 415 suspense account and then only to the extent amounts in the § 415 suspense account are not required to be allocated as provided under § 1.415–6(b)(6). In a defined contribution plan, the cessation or reduction of benefit accruals does not create or increase the potential for reversion. Accordingly, the creation or increase of a potential reversion is not a relevant fact or circumstance in determining whether there has been a partial termination in a defined contribution plan as a result of the cessation or reduction of benefit accruals.

In Situations 1 and 2, all of the employees who are covered by the converted or merged money purchase plan remain covered under the continuing profit-sharing plan, the money purchase plan assets and liabilities retain their characterization under the profit-sharing plan, and the employees vest in the continuing profit-sharing plan under the same vesting schedule that existed under the money purchase plan. Under these facts and circumstances, no partial termination has occurred.

2002–28 I.R.B. 77 July 15, 2002

Treaty Guidance Regarding Payments With Respect to Domestic Reverse Hybrid Entities

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations under section 894 relating to the eligibility for treaty benefits of items of income paid by domestic entities that are not fiscally transparent under U.S. law but are fiscally transparent under the laws of the jurisdiction of the person claiming treaty benefits (domestic reverse hybrid entities). The regulations affect the determination of tax treaty benefits with respect to U.S. source income of foreign persons.

DATES: Effective Date : These regulations are effective June 12, 2002.

Applicability Date : These regulations are applicable to items of income paid by a domestic reverse hybrid entity on or after June 12, 2002, with respect to amounts received by the domestic reverse hybrid entity on or after June 12, 2002.

FOR FURTHER INFORMATION CONTACT: Elizabeth U. Karzon at (202) 622– 3880 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

On February 27, 2001, the IRS and Treasury published a notice of proposed rulemaking (REG–107101–00, 2001–1 C.B 1083) in the Federal Register (66 FR 12445) under section 894 relating to whether payments made by domestic reverse hybrid entities to their interest holders are eligible for benefits under income tax treaties. A limited number of comments responding to the notice of proposed rulemaking were received. After consideration of these comments, the proposed regulations are adopted as final regulations as revised by this Treasury decision.

Section 4980F of the Code and § 204(h) of ERISA

ERISA § 204(h), as amended by § 659(b) of the Economic Growth and Tax Relief Reconciliation Act of 2001, Public Law 107–16 (EGTRRA), provides that a defined benefit pension plan or an individual account plan subject to the funding standards of § 412 of the Code not be amended to provide a significant reduction in the rate of future benefit accrual unless the plan administrator provides a notice describing the reduction to each affected individual whose benefit is adversely affected by the reduction and to each employee organization representing these individuals.

Section 4980F, as added by § 659(a) of EGTRRA, provides for an excise tax if a defined benefit pension plan or an individual account plan subject to the funding standards of § 412 is amended to provide a significant reduction in the rate of future benefit accrual and the plan administrator does not provide a notice describing the reduction to each affected individual whose benefit is adversely affected by the reduction and to each employee organization representing these individuals.

If a money purchase plan is converted or merged into a profit-sharing plan, there is necessarily a significant reduction in the rate of future benefit accrual under the money purchase plan requiring notice under § 4980F of the Code and § 204(h) of ERISA. Allocations under the profitsharing plan are not benefit accruals under the money purchase plan for purposes of determining if there is a reduction in the rate of future benefit accrual for purposes of § 4980F of the Code and § 204(h) of ERISA. A profit-sharing plan is neither subject to § 4980F of the Code or § 204(h) of ERISA. Consequently, a notice is required to be given to affected individuals under § 4980F of the Code and § 204(h) of ERISA.

HOLDINGS

Issue 1. In the absence of other facts, the merger or conversion of a money purchase pension plan into a profit-sharing plan does not result in a partial termination of the money purchase pension plan under § 411(d)(3) of the Code. Under

either the facts in Situation 1 or 2 there is no partial termination.

Issue 2. The notice required by § 4980F of the Code and § 204(h) of ERISA must be provided to affected individuals in a money purchase pension plan that is merged or converted into a profitsharing plan. Under the facts in either Situation 1 or 2, the notice must be given to affected individuals.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 94–76 is amplified.

DRAFTING INFORMATION

The principal author of this revenue ruling is Andrew Zuckerman of the Employee Plans, Tax Exempt and Government Entities Division. For further information regarding this revenue ruling, please contact the Employee Plans’ taxpayer assistance telephone service at 1–877–829–5500 (a toll-free number), between the hours of 8:00 a.m. and 6:30 p.m. Eastern time, Monday through Friday. Mr. Zuckerman may be reached at 1–202–283–9655 (not a toll-free number).

Section 411.—Minimum Vesting Standards

26 CFR 1.411(d)–2: Termination or partial termina- tion; discontinuance of contributions.

Whether, in the absence of other facts, the merger or conversion of a money purchase pension plan into a profit-sharing plan creates or increases a potential for reversion that results in a partial termination of the money purchase pension plan. See Rev. Rul. 2002–42, page 76.

Section 894.—Income Affected by Treaty

26 CFR 1.894–1: Income affected by treaty.

T.D. 8999

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

July 15, 2002 78 2002–28 I.R.B.

of DRH structures to obtain inappropriate treaty benefits.

In this regard, the commentator misconstrues the concern of the IRS and Treasury with respect to the issues associated with the use of DRH structures. Treasury and the IRS are concerned that DRH structures are being established by related parties to manipulate differences in U.S. and foreign entity classification rules to reduce, through inappropriate use of an income tax treaty, the amount of tax imposed on items of income paid by domestic corporations to related foreign companies. The overall effect of these transactions, if respected, would be (1) a deduction under U.S. law for the “outbound” payment of an item of income, (2) the reduction or elimination of U.S. withholding tax on that item of income under an applicable treaty, and (3) the imposition of little or no tax by the treaty partner on the item of income. This result is inconsistent with the expectation of the United States and its treaty partners that treaties should be used to reduce or eliminate double taxation of income. The legislative history of section 894(c) supports this analysis. Congress specifically expressed its concern about the use of income tax treaties to manipulate the inconsistencies between U.S. and foreign tax laws to obtain similar benefits. See H.R. Conf. Rep. No 220, 105th Cong., 1st Sess. 573 (1997); Joint Committee on Taxation, 105th Cong., 1st Sess., General Explanation of Tax Legislation Enacted in 1997 (JCS–23–97), at 249 (December 17, 1997). The approach adopted by these regulations also is consistent with the U.S. view that contracting states to an income tax treaty may adopt provisions in their domestic laws to prevent inappropriate use of the treaty. See, e.g., the Treasury Department Technical Explanation to Article 22 ( Limitation on Benefits) of the 1996 United States Model Income Tax Convention. See also Commentaries to Article 1 of the 2000 OECD Model Tax Convention on Income and Capital; S. Rep. No. 445, 100th Cong. 2d Sess. 322–23 (1988). Another commentator questioned Treasury’s authority for issuing the regulations, arguing that the recharacterization of an interest payment as a dividend payment may contravene the definition of interest contained in various U.S. treaties.

Explanation of Provisions

I. General

These final section 894 regulations clarify the availability of treaty benefits on payments made by a domestic reverse hybrid entity (DRH) to its interest holders. A DRH is a U.S. entity that the United States treats as non-fiscally transparent ( e.g., as a corporation), but the interest holder’s country treats as fiscally transparent ( e.g., as a partnership or branch). These regulations are the final piece of guidance associated with section 894 regulations finalized on July 3, 2000 (T.D. 8889, 2000–2 C.B. 124 [65 FR 40993]) (the “2000 regulations”), that generally address the availability of treaty benefits on items of U.S. source income paid to hybrid entities ( i.e., entities treated as fiscally transparent by one jurisdiction but non-fiscally transparent by another).

The preamble to the 2000 regulations noted that the IRS and Treasury had learned that non-U.S. multinationals were establishing DRH structures in the United States to manipulate the U.S. tax treaty network to obtain tax-advantaged financing. The IRS and Treasury notified the public in that preamble that they intended to issue regulations to address this situation.

Proposed regulations were issued on February 27, 2001. The proposed regulations provided guidance with respect to two distinct issues involving domestic reverse hybrid entities. First, to resolve a technical question raised by commentators regarding the application of the 2000 regulations, the proposed regulations clarified that a payment by a domestic reverse hybrid entity to a foreign interest holder may be eligible for treaty benefits. No comments were received on this portion of the proposed regulations, and the rule in the proposed regulations is accordingly adopted without change in these final regulations.

The proposed regulations also addressed certain structures involving domestic reverse hybrid entities that Treasury and the IRS believed represented the use of such entities to obtain inappropriate treaty benefits. The comments received in response to this portion of the proposed regulations generally confirmed the need for regulations to address the use

of DRH structures by non-U.S. companies. One commentator wrote in its comment that “regulations addressing the DRH structure are appropriate.” The commentator noted that DRH structures are “relatively uncommon” with the exception of their use by highly sophisticated non-U.S. multinational groups to procure acquisition financing at a taxadvantaged rate vis-a-vis their U.S. competitors.

Several commentators expressed concern that the approach taken in the proposed DRH regulations might erode the simplicity achieved by the section 7701 entity classification rules, known as the Check-the-Box (CTB) regulations. The IRS and Treasury have carefully considered this comment, but continue to believe that the approach in these final regulations is appropriate. The regulations only apply to a DRH structure established by a group of taxpayers related to each other by 80% common ownership. This high ownership requirement minimizes the possibility that a taxpayer might inadvertently establish such a structure. In addition, the comments confirm that DRH structures remain “relatively uncommon.” Thus, any loss of the simplification benefits of the CTB regulations also will be relatively uncommon.

One commentator suggested that, rather than adopt the approach in the regulations, the IRS and Treasury should pursue an approach under section 1503(d) to directly address structures similar to, and potentially including, the DRH that rely on hybrid entity structures to deduct the same interest expense in two jurisdictions (commonly called a “double dip” of interest deductions) to achieve taxadvantaged financing. The commentator expressed the view that the real concern of the IRS and Treasury should be this double dip on deductions, rather than the tax treaty manipulation present in DRH structures.

Treasury and the IRS agree that a re-examination of the rules of section 1503(d) and the policies underlying those rules may be appropriate. Such a re-examination will require substantial and careful analysis with respect to the interaction of U.S. and foreign law in a variety of contexts and is therefore beyond the scope of these regulations, which, as noted above, focus on the use

2002–28 I.R.B. 79 July 15, 2002

whether a domestic reverse hybrid entity made a payment to a related foreign interest holder. The ownership requirements set forth in section 267(b) or 707(b)(1), the constructive ownership rules of sections 318, and attribution rules of section 267(c) were used solely to determine whether an entity was “related” for purposes of paragraph (d)(2)(ii)(B); and not to determine if the entity was an interest holder.

Commentators consequently have questioned whether corporations that do not own any stock directly in the domestic reverse hybrid entity, but are related to the domestic reverse hybrid entity within the meaning of paragraph (d)(2)(ii)(B)( 3 ), can be interest holders, and, therefore, related foreign interest holders for purposes of paragraph (d)(2)(ii)(B). For example, commentators questioned whether the regulations apply if a domestic reverse hybrid entity, which has received a dividend payment from a related domestic entity, makes an interest payment to a foreign sister corporation of the domestic reverse hybrid entity which is not itself a shareholder in the domestic reverse hybrid entity. Commentators believe that the application of the regulations to a foreign sister corporation should depend on whether that corporation is part of a “consolidated group” under the laws of the jurisdiction of the foreign parent.

The IRS and Treasury generally agree with this position. Paragraph (d)(2)(ii) (B)( ii ) of the final regulations provides that a payment to a person, wherever organized, the income and losses of which are available, under the laws of the jurisdiction of the related foreign interest holder, to offset the income and losses of a related foreign interest holder, will be treated as a payment to a related foreign interest holder, and the regulations will apply. Examples have been added to the final regulations illustrating these principles.

Paragraph (d)(2)(ii)(B)( 3 ) of the proposed regulations also contained a special rule that would treat certain accommodation parties as related foreign interest holders. Pursuant to the rule in the proposed regulations, if a person entered into a transaction with a domestic reverse hybrid entity, its related interest holder, or

The IRS and Treasury have concluded that the regulations are consistent with U.S. law, including U.S. treaties. These final regulations are issued under the authority of sections 894(a), 894(c), 7805 and 7701(l). Further, as noted above, contracting states to an income tax treaty may adopt provisions in their domestic laws to counter inappropriate uses of the treaty. Id .

II. Comments and Changes to § 1.894– 1(d)(2)(ii)(B)(1): Payment Made to Related Foreign Interest Holder

Section 1.894–1(d)(2)(ii)(B)( 1 ) of the proposed regulations provided a special rule that was generally targeted at payments made by a domestic reverse hybrid entity to a foreign parent of the domestic reverse hybrid entity. This rule would apply if: (1) a domestic subsidiary made a payment to a domestic reverse hybrid entity, the payment was considered to be a dividend either under the laws of the United States or under the laws of the jurisdiction of the foreign parent of the domestic reverse hybrid entity, and the domestic reverse hybrid entity was treated as a fiscally transparent, or “passthrough,” entity under the foreign parent’s laws; and (2) the domestic reverse hybrid entity made a deductible payment to the foreign parent that otherwise would qualify for a treaty-based reduction in U.S. withholding tax. Under these circumstances, the proposed regulations provided that the payment by the domestic reverse hybrid entity would be treated as a dividend for all purposes of the Internal Revenue Code and the applicable income tax treaty, but only to the extent of the foreign parent’s proportionate share of the prior dividend payments made to the domestic reverse hybrid entity by the domestic subsidiary.

Commentators recommended the inclusion of a tax avoidance purpose test in the final regulations. As part of this approach, commentators suggested consideration of several factors, including the ability of the domestic reverse hybrid entity to satisfy the debt independent of dividends or payments from the domestic entity, and the amount of time between the time the related foreign interest holder, the domestic reverse hybrid entity, and the domestic entity became related persons and the incurrence of the inter

company debt. This recommendation was not adopted. These regulations are intended to provide objective rules regarding eligibility for treaty benefits on certain items of U.S. source income paid by domestic reverse hybrid entities.

Commentators requested clarification that paragraph (d)(2)(ii)(B) does not apply to payments made by a domestic reverse hybrid entity that would not be subject to withholding tax without regard to a treaty. Commentators are correct in reading the regulations to provide that paragraph (d)(2)(ii)(B) will not apply if the payment made by the domestic reverse hybrid entity is exempt from withholding tax under the Internal Revenue Code. Commentators also requested clarification that the regulations apply only to payments received by the domestic reverse hybrid entity while it is related to both the domestic entity and the related foreign interest holder, and to payments made by the domestic reverse hybrid entity while it is related to the related foreign interest holder. The text of these regulations also confirms this result. Accordingly, no changes to the regulations were considered necessary on either of these points.

As a general matter, commentators questioned whether paragraph (d)(2)(ii) (B)( 1 ) of the regulations applies to a situation in which the dividend withholding rate under the applicable income tax treaty is lower than the withholding rate for interest under the treaty. The regulations do not make the recharacterization of the deductible payment dependent on the withholding rates in the applicable income tax treaty. Therefore, if the requirements of the regulations are met, the regulations will apply regardless of whether the dividend withholding rate is higher than the withholding rate for interest or other deductible payments in the applicable income tax treaty. An example to this effect has been added to the final regulations.

III. Comments and Changes to § 1.894– 1(d)(2)(ii)(B)(3): Definition of Related

Paragraph (d)(2)(ii)(B)( 3 ) of the proposed regulations defined the term related for purposes of determining whether a domestic entity made a dividend payment to a related domestic reverse hybrid entity, and for purposes of determining

July 15, 2002 80 2002–28 I.R.B.

not impose a collection of information requirement on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking preceding these regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Drafting Information

The principal author of these regulations is Karen A. Rennie-Quarrie 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 amended as follows:

PART 1—INCOME TAXES

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

Authority: 26 U.S.C. 7805 - - Par. 2. In § 1.894–1, paragraphs (d)(2)(ii) and (d)(2)(iii) are added and paragraph (d)(6) is revised to read as follows:

§ 1.894–1 Income affected by treaty.

- - - (d) - - (2) - - (ii) Payments by domestic reverse hybrid entities —(A) General rule . Except as otherwise provided in paragraph (d)(2)(ii)(B) of this section, an item of income paid by a domestic reverse hybrid entity to an interest holder in such entity shall have the character of such item of income under U.S. law and shall be considered to be derived by the interest holder, provided the interest holder is not fiscally transparent in its jurisdiction, as defined in paragraph (d)(3)(iii) of this section, with respect to the item of income. In determining whether the interest holder is fiscally transparent with

other related entity, and the effect of the transaction was to avoid the principles of these regulations, then that person would be treated as related to the domestic reverse hybrid entity for purposes of this section. Commentators expressed concern that this language could encompass legitimate dealings with unrelated third parties. For example, an unrelated foreign bank that makes a loan to a domestic reverse hybrid entity and receives interest payments under the loan could be treated as related to the domestic reverse hybrid entity under paragraph (d)(2)(ii)(B)( 3 ). In recognition of the fact that the special rule in paragraph (d)(2)(ii)(B)( 3 ) was potentially overbroad and created uncertainty as to its application, the rule was deleted.

IV. Comments and Changes to §1.894– 1(d)(2)(ii)(C): Commissioner’s discretion.

Paragraph (d)(2)(ii)(C) of the proposed regulations provided the Commissioner with the authority to recharacterize, for all purposes of the Internal Revenue Code, all or part of any transaction (or series of transactions) between related parties if the effect of the transaction was to avoid the principles of paragraph (d)(2)(ii)(B). Commentators also questioned the scope of this provision and requested the inclusion of examples of situations in which the Commissioner would not exercise his discretion and situations in which the Commissioner may exercise his discretion. Commentators were concerned that this provision would allow the Commissioner to apply the regulations to legitimate, non-abusive transactions involving domestic reverse hybrid entities.

In response to these comments, and in recognition of the potentially overbroad reach of the proposed provision, paragraph (d)(2)(ii)(C) has been modified in the final regulations to narrow its scope and clarify the circumstances under which the provision will apply. Thus, under paragraph (d)(2)(ii)(C)( 1 ) of the final regulations (which applies to transactions involving related parties), the Commissioner has authority to recharacterize a transaction only if the following conditions are met: (1) A deductible payment is made to a person who is related, as that term is defined in paragraph

(d)(2)(ii)(B)( 3 ), to the domestic reverse hybrid entity (but is not otherwise described in paragraph (d)(2)(ii)(B) ( 1 )( ii )); and (2) that payment is made in connection with one or more transactions the effect of which is to avoid the application of paragraph (d)(2)(ii)(B). If paragraph (d)(2)(ii)(C)( 1 ) applies, the Commissioner is authorized to treat the deductible payment as if it were received directly by the related foreign interest holder in the domestic reverse hybrid entity.

In addition, paragraph (d)(2)(ii)(C)( 2 ) of the final regulations (which applies to transactions involving an unrelated “middleman”) provides that the Commissioner may treat a deductible payment made by a domestic reverse hybrid entity to an unrelated person as being made directly to a related foreign interest holder if: (1) the unrelated person (or other person (whether related or not) which receives a payment in a series of transactions that includes a transaction involving such unrelated person) makes a payment to the related foreign interest holder (or other person described in paragraph (d)(2)(ii)(B)( 1 )( ii )); (2) the payment to the unrelated person and the payment to the related foreign interest holder are made in connection with a series of transactions which constitute a financing arrangement, as defined in § 1.881– 3(a)(2)(i); and (3) the transactions have the effect of avoiding the application of paragraph (d)(2)(ii)(B) of this section. An example has been added to illustrate the principles contained in this revised paragraph (d)(2)(ii)(C)( 2 ).

To the extent the Commissioner recharacterizes a deductible payment as a distribution within the meaning of section 301(a) under this paragraph (d)(2)(ii)(C), the payment will be treated as such for all purposes of the Internal Revenue Code and the applicable income tax treaty.

Special Analysis

2002–28 I.R.B. 81 July 15, 2002

respect to the item of income under this paragraph (d)(2)(ii)(A), the determination under paragraph (d)(3)(ii) of this section shall be made based on the treatment that would have resulted had the item of income been paid by an entity that is not fiscally transparent under the laws of the interest holder’s jurisdiction with respect to any item of income.

(B) Payment made to related foreign interest holder —(1) General rule . If—

( i ) A domestic entity makes a payment to a related domestic reverse hybrid entity that is treated as a dividend under either the laws of the United States or the laws of the jurisdiction of a related foreign interest holder in the domestic reverse hybrid entity, and under the laws of the jurisdiction of the related foreign interest holder in the domestic reverse hybrid entity, the related foreign interest holder is treated as deriving its proportionate share of the payment under the principles of paragraph (d)(1) of this section; and

( ii ) The domestic reverse hybrid entity makes a payment of a type that is deductible for U.S. tax purposes to the related foreign interest holder or to a person, wherever organized, the income and losses of which are available, under the laws of the jurisdiction of the related foreign interest holder, to offset the income and losses of the related foreign interest holder, and for which a reduction in U.S. withholding tax would be allowed under an applicable income tax treaty; then

( iii ) To the extent the amount of the payment described in paragraph (d)(2)(ii) (B)( 1 )( ii ) of this section does not exceed the sum of the portion of the payment described in paragraph (d)(2)(ii) (B)( 1 )( i ) of this section treated as derived by the related foreign interest holder and the portion of any other prior payments described in paragraph (d)(2)(ii)(B)( 1 )( i ) of this section treated as derived by the related foreign interest holder, the amount of the payment described in (d)(2)(ii) (B)( 1 )( ii ) of this section will be treated for all purposes of the Internal Revenue Code and any applicable income tax treaty as a distribution within the meaning of section 301(a) of the Internal Revenue Code, and the tax to be withheld from the payment described in paragraph (d)(2)(ii) (B)( 1 )( ii ) of this section (assuming the payment is a dividend under section 301(c)(1) of the Internal Revenue Code)

shall be determined based on the appropriate rate of withholding that would be applicable to dividends paid from the domestic reverse hybrid entity to the related foreign interest holder in accordance with the principles of paragraph (d)(2)(ii)(A) of this section.

(2) Determining amount to be rechar- acterized under paragraph (d)(2)(ii)(B) (1)(iii) . For purposes of determining the amount to be recharacterized under paragraph (d)(2)(ii)(B)( 1 )( iii ) of this section, the portion of the payment described in paragraph (d)(2)(ii)(B)( 1 )( i ) of this section treated as derived by the related foreign interest holder shall be increased by the portion of the payment derived by any other person described in paragraph (d)(2)(ii)(B)( 1 )( ii ), and shall be reduced by the amount of any prior section 301(c) distributions made by the domestic reverse hybrid entity to the related foreign interest holder or any other person described in paragraph (d)(2)(ii)(B)( 1 )( ii ) and by the amount of any payments from the domestic reverse hybrid entity previously recharacterized under paragraph (d)(2)(ii)(B)( 1 )( iii ) of this section.

(3) Tiered entities . The principles of this paragraph (d)(2)(ii)(B) also shall apply to payments referred to in this paragraph (d)(2)(ii)(B) made among related entities when there is more than one domestic reverse hybrid entity or other fiscally transparent entity involved.

(4) Definition of related . For purposes of this section, a person shall be treated as related to a domestic reverse hybrid entity if it is related by reason of the ownership requirements of section 267(b) or 707(b)(1), except that the language “at least 80 percent” applies instead of “more than 50 percent,” where applicable. For purposes of determining whether a person is related by reason of the ownership requirements of section 267(b) or 707(b)(1), the constructive ownership rules of section 318 shall apply, and the attribution rules of section 267(c) also shall apply to the extent they attribute ownership to persons to whom section 318 does not attribute ownership. (C) Payments to persons not described in paragraph (d)(2)(ii)(B)(1)(ii) —( 1 ) Related persons. The Commissioner may treat a payment by a domestic reverse hybrid entity to a related person (who is neither the related foreign interest holder

nor otherwise described in paragraph (d)(2)(ii)(B)( 1 )( ii ) of this section), in whole or in part, as being made to a related foreign interest holder for purposes of applying paragraph (d)(2)(ii)(B) of this section, if ( i ) The payment to the related person is of a type that is deductible by the domestic reverse hybrid entity; and

( ii ) The payment is made in connection with one or more transactions the effect of which is to avoid the application of paragraph (d)(2)(ii)(B) of this section.

( 2 ) Unrelated persons . The Commissioner may treat a payment by a domestic reverse hybrid entity to an unrelated person, in whole or in part, as being made to a related foreign interest holder for purposes of applying paragraph (d)(2)(ii)(B) of this section, if ( i ) The payment to the unrelated person is of a type that is deductible by the domestic reverse hybrid entity;

( ii ) The unrelated person (or other person (whether related or not) which receives a payment in a series of transactions that includes a transaction involving such unrelated person) makes a payment to the related foreign interest holder (or other person described in paragraph (d)(2)(ii)(B)( 1 )( ii ));

( iii ) The foregoing payments are made in connection with a series of transactions which constitute a financing arrangement, as defined in § 1.881–3(a)(2)(i); and

( iv ) The transactions have the effect of avoiding the application of paragraph (d)(2)(ii)(B) of this section.

(iii) Examples . The rules of this paragraph (d)(2) are illustrated by the following examples:

Example 1 . Dividend paid by unrelated entity to domestic reverse hybrid entity . (i) Facts . Entity A is a domestic reverse hybrid entity, as defined in paragraph (d)(2)(i) of this section, with respect to the U.S. source dividends it receives from B, a domestic corporation to which A is not related within the meaning of paragraph (d)(2)(ii)(B)( 4 ) of this section. A’s 85-percent shareholder, FC, is a corporation organized under the laws of Country X, which has an income tax treaty in effect with the United States. A’s remaining 15-percent shareholder is an unrelated domestic corporation. Under Country X law, FC is not fiscally transparent with respect to the dividend, as defined in paragraph (d)(3)(ii) of this section. In year 1, A receives $100 of dividend income from B. Under Country X law, FC is treated as deriving $85 of the $100 dividend payment received by A. The applicable rate of tax on dividends under the U.S.-Country X income tax treaty is 5 percent with respect to a 10-percent or more corporate shareholder.

July 15, 2002 82 2002–28 I.R.B.

Facts . The facts are the same as Example 3, except that in year 2, A makes the interest payment of $25 to FS, a subsidiary of FC also organized in Country X. Under the laws of Country X, FS is not fiscally transparent with respect to the interest payment, and the income and losses of FS may be used to offset the income and losses of FC.

(ii) Analysis . The analysis is the same as in Example 1 with respect to the $100 dividend payment from S to A. With respect to the $25 interest payment from A to FS in year 2, FS is a person described in paragraph (d)(2)(ii)(B)( 1 )( ii ) of this section because the income and losses of FS may be used under the laws of Country X to offset the income and losses of FC, the related foreign interest holder that derived its proportionate share of the payment from S to A. Therefore, paragraph (d)(2)(ii)(B) of this section applies, and the $25 interest payment in year 2 by A to FS is treated as a dividend for all purposes of the Internal Revenue Code and the U.S.-Country X income tax treaty because the $25 payment does not exceed FC’s share of the $100 dividend payment made by S to A ($85). Since FS is not fiscally transparent with respect to the payment as determined under paragraph (d)(2)(ii)(A) of this section, FS is entitled to obtain the rate applicable to dividends under the U.S.-Country X income tax treaty with respect to the $25 payment. Because the $25 payment in year 2 is recharacterized as a dividend for all purposes of the Internal Revenue Code and the U.S.-Country X income tax treaty, A is not entitled to an interest deduction with respect to the payment and FS is not entitled to claim the reduced rate of withholding applicable to interest under the U.S.-Country X income tax treaty.

Example 7 . Interest paid by domestic reverse hybrid entity to unrelated foreign bank . (i) Facts . The facts are the same as in Example 3, except that in year 2, A makes the interest payment of $25 to FB, a Country Y unrelated foreign bank, on a loan from FB to A.

(ii) Analysis . The analysis is the same as in Example 1 with respect to the $100 dividend payment from S to A. With respect to the payment from A to FB, paragraph (d)(2)(ii)(B) of this section will not apply because, although A is related to S, the payor of the dividend income it received, A is not related to FB under paragraph (d)(2)(ii)(B)( 4 ) of this section. Under paragraph (d)(2)(ii)(A) of this section, the $25 interest payment made from A to FB in year 2 is characterized as interest under the Internal Revenue Code.

Example 8 . Interest paid by domestic reverse hybrid to an unrelated entity pursuant to a financing arrangement . (i) Facts . The facts are the same as in Example 7, except that in year 3, FB makes an interest payment of $25 to FC on a deposit made by FC with FB.

(ii) Analysis . The analysis is the same as in Example 1 with respect to the $100 dividend payment from S to A. With respect to the $25 payment from A to FB in year 2, because the payment is made in connection with a transaction that consititutes a financing arrangement within the meaning of paragraph (d)(2)(ii)(C)( 2 ) of this section, the payment may be treated by the Commissioner as being made directly to FC. If the Commissioner disregards

(ii) Analysis . Under paragraph (d)(2)(i) of this section, the U.S.-Country X income tax treaty does not apply to the dividend income received by A because the payment is made by B, a domestic corporation, to A, another domestic corporation. A remains fully taxable under the U.S. tax laws as a domestic corporation with regard to that item of income. Further, pursuant to paragraph (d)(2)(i) of this section, notwithstanding the fact that A is treated as fiscally transparent with respect to the dividend income under the laws of Country X, FC may not claim a reduced rate of taxation on its share of the U.S. source dividend income received by A.

Example 2 . Interest paid by domestic reverse hybrid entity to related foreign interest holder where dividend is paid by unrelated entity . (i) Facts . The facts are the same as in Example 1 . Both the United States and Country X characterize the payment by B in year 1 as a dividend. In addition, in year 2, A makes a payment of $25 to FC that is characterized under the Internal Revenue Code as interest on a loan from FC to A. Under the U.S.-Country X income tax treaty, the rate of tax on interest is zero. Under Country X laws, had the interest been paid by an entity that is not fiscally transparent under Country X’s laws with respect to any item of income, FC would not be fiscally transparent as defined in paragraph (d)(2)(ii) of this section with respect to the interest.

(ii) Analysis . The analysis is the same as in Example 1 with respect to the $100 payment from B to A. With respect to the $25 payment from A to FC, paragraph (d)(2)(ii)(B) of this section will not apply because, although FC is a related foreign interest holder in A, A is not related to B, the payor of the dividend income it received. Under paragraph (d)(2)(ii)(A) of this section, the $25 of interest paid by A to FC in year 2 is characterized under U.S. law as interest. Accordingly, in year 2, A is entitled to an interest deduction with respect to the $25 interest payment from A to FC, and FC is entitled to the reduced rate of withholding applicable to interest under the U.S.-Country X income tax treaty, assuming all other requirements for claiming treaty benefits are met.

Example 3 . Interest paid by domestic reverse hybrid entity to related foreign interest holder where dividend is paid by a related entity . (i) Facts . The facts are the same as in Example 2, except the $100 dividend income received by A in year 1 is from A’s wholly-owned subsidiary, S.

(ii) Analysis . The analysis is the same as in Example 1 with respect to the $100 dividend payment from S to A. However, the $25 interest payment in year 2 by A to FC will be treated as a dividend for all purposes of the Internal Revenue Code and the U.S.-Country X income tax treaty because $25 does not exceed FC’s share of the $100 dividend payment made by S to A ($85). Since FC is not fiscally transparent with respect to the payment as determined under paragraph (d)(2)(ii)(A) of this section, FC is entitled to the reduced rate applicable to dividends under the U.S.-Country X income tax treaty with respect to the $25 payment. Because the $25 payment in year 2 is recharacterized as a dividend for all purposes of the Internal Revenue Code and the U.S.-Country X income tax treaty, A is not entitled to an interest deduction with respect to that payment and FC is not entitled to claim the reduced rate of withholding applicable to interest.

Example 4 . Definition of related foreign interest holder . (i) Facts . The facts are the same as in Example 3, except that A has two 50-percent shareholders, FC1 and FC2. In year 2, A makes an interest payment of $25 to both FC1 and FC2. FC1 is a corporation organized under the laws of Country X, which has an income tax treaty in effect with the United States. FC2 is a corporation organized under the laws of Country Y, which also has an income tax treaty in effect with the United States. FP owns 100percent of both FC1 and FC2, and is organized under the laws of Country X. Under Country X law, FC1 is not fiscally transparent with respect to the dividend, as defined in paragraph (d)(3)(ii) of this section. Under Country X law, FC1 is treated as deriving $50 of the $100 dividend payment received by A because A is fiscally transparent under the laws of Country X, as determined under paragraph (d)(3)(iii) of this section. The applicable rate of tax on dividends under the U.S.-Country X income tax treaty is 5-percent with respect to a 10-percent or more corporate shareholder. Under Country Y law, FC2 is not treated as deriving any of the $100 dividend payment received by A because, under the laws of Country Y, A is not a fiscally transparent entity.

(ii) Analysis . The analysis is the same as in Example 1 with respect to the $100 dividend payment from S to A. With respect to the $25 payment in year 2 by A to FC1, the payment will be treated as a dividend for all purposes of the Internal Revenue Code and the U.S.-Country X income tax treaty because FC1 is a related foreign interest holder as determined under paragraph (d)(2)(ii)(B)( 4 ) of this section, and because $25 does not exceed FC1’s share of the dividend payment made by S to A ($50). FC1 is a related foreign interest holder because FC1 is treated as owning the stock of A owned by FC2 under section 267(b)(3). Since FC1 is not fiscally transparent with respect to the payment as determined under paragraph (d)(2)(ii)(A) of this section, FC1 is entitled to the 5-percent reduced rate applicable to dividends under the U.S.-Country X income tax treaty with respect to the $25 payment. Because the $25 payment in year 2 is recharacterized as a dividend for all purposes of the Internal Revenue Code and the U.S.Country X income tax treaty, A is not entitled to an interest deduction with respect to that payment. Even though FC2 is also a related foreign interest holder, the $25 interest payment by A to FC2 in year 2 is not recharacterized because A is not fiscally transparent under the laws of Country Y, and FC2 is not treated as deriving any of the $100 dividend payment received by A. Thus, the U.S.-Country Y income tax treaty is not implicated.

Example 5 . Higher treaty withholding rate on dividends . (i) Facts . The facts are the same as in Example 3, except that under the U.S.-Country X income tax treaty, the rate of tax on interest is 10-percent and the rate of tax on dividends is 5-percent. (ii) Analysis . The analysis is the same as in Example 1 with respect to the $100 dividend payment from S to A. The analysis is the same as in Example 3 with respect to the $25 interest payment in year 2 from A to FC.

Example 6 . Foreign sister corporation the income and losses of which may offset the income and losses of related foreign interest holder . (i)

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FB, then the analysis is the same as in Example 3 with respect to the $25 interest payment in year 2 from A to FC.

Example 9 . Royalty paid by related entity to domestic reverse hybrid entity . (i) Facts . The facts are the same as in Example 3, except the $100 income received by A from S in year 1 is a royalty payment under both the laws of the United States and the laws of Country X. The royalty rate under the treaty is 10 percent and the interest rate is 0 percent.

(ii) Analysis . The analysis as to the royalty payment from S to A is the same as in Example 1 with respect to the $100 dividend payment from S to A. With respect to the $25 payment from A to FC, paragraph (d)(2)(ii)(B) of this section will not apply because the payment from S to A is not treated as a dividend under the Internal Revenue Code or the laws of Country X. Under paragraph (d)(2)(ii)(A) of this section, the $25 of interest paid by A to FC in year 2 is characterized as interest under the Internal Revenue Code. Accordingly, in year 2, FC may obtain the reduced rate of withholding applicable to interest under the U.S.-Country X income tax treaty, assuming all other requirements for claiming treaty benefits are met.

(6) Effective dates . This paragraph (d) applies to items of income paid on or after June 30, 2000, except paragraphs (d)(2)(ii) and (d)(2)(iii) of this section apply to items of income paid by a domestic reverse hybrid entity on or after June 12, 2002, with respect to amounts received by the domestic reverse hybrid entity on or after June 12, 2002.

Robert E. Wenzel, Deputy Commissioner of

Internal Revenue.

Approved June 3, 2002.

Pamela F. Olsen, Acting Assistant Secretary of the Treasury (Tax Policy).

(Filed by the Office of the Federal Register on June 11, 2002, 8:45 a.m., and published in the issue of the Federal Register for June 12, 2002, 67 F.R. 40157)

Section 1233.—Gains and Losses From Short Sales

26 CFR 1.1233–1: Gains and losses from short sales.

The revenue ruling provides guidance on the recognition of gain or loss on a short sale when stock is purchased to close the short sale using a regular-way sale. See Rev. Rul. 2002–44, on this page.

Section 1259.—Constructive Sales Treatment for Appreciated Financial Positions

(Also § 1233; 26 CFR 1.1233–1.)

Short sale of stock . This ruling provides guidance on the timing of recognition of gain or loss on a short sale when stock is purchased to close the short sale using a regular-way sale.

Rev. Rul. 2002–44

ISSUE

If a taxpayer enters into a short sale of stock and directs its broker to purchase the stock sold short and close out the short sale, when is a gain or a loss on the short sale realized?

FACTS

Situation 1

In January of Year 1, Taxpayer T directs its broker to borrow 100 shares of XYZ stock and sell the 100 shares of XYZ stock in the market (the Short Sale). XYZ stock is traded on a registered securities exchange. T does not own any shares of XYZ stock. On December 31 of Year 1, when the value of XYZ stock has increased (and the value of T ’s short position has depreciated) T directs its broker to purchase 100 shares of XYZ stock to close the Short Sale. The purchased XYZ shares are delivered to the lender of the XYZ stock on January 4 of Year 2. The purchase of the XYZ stock on December 31 of Year 1 is a regular-way sale as described in Rev. Rul. 93–84, 1993–2 C.B. 225, with December 31 of Year 1 as

the trade date and January 4 of Year 2 as the settlement date.

Situation 2

The facts are the same as in Situation 1 except that the XYZ stock has depreciated in value and the Short Sale is closed out at a gain.

LAW

Section 1.1233–1(a)(1) of the Income Tax Regulations provides that, for income tax purposes, a short sale is not deemed to be consummated until delivery of property to close the short sale. Under § 1.1233–1(a)(4), if the short sale is made through a broker and the broker borrows property to make a delivery, the short sale is not deemed to be consummated until the obligation of the seller created by the short sale is finally discharged by delivery of property to the broker to replace the property borrowed by the broker.

In the context of determining holding period, Rev. Rul. 66–97, 1966–1 C.B. 190, states that both stocks and bonds “are considered acquired or sold on the respective ‘trade dates.’”

Analogously, Rev. Rul. 93–84 holds that the year of disposition for a regularway sale of stock traded on an established securities market is the year that includes the trade date. In Rev. Rul. 93–84, the taxpayer placed a regular-way sale order on stock with his broker on December 31, 1992, but the taxpayer did not deliver the stock certificates or receive the proceeds from the sale until January 8, 1993. The revenue ruling holds that the year of disposition and realization is 1992.

Section 1259(a)(1) provides that if there is a constructive sale of an appreciated financial position, the taxpayer shall recognize gain as if such position were sold, assigned, or otherwise terminated at its fair market value on the date of such constructive sale. The term “appreciated financial position” is defined in § 1259(b)(1) to include any position with respect to stock if there would be gain were such position sold, assigned, or otherwise terminated at its fair market value. The term “position” is defined in § 1259(b)(3) to include a short sale. Pursuant to § 1259(c)(1)(D), in the case of an appreciated financial position that is a short sale, a taxpayer is treated as having

July 15, 2002 84 2002–28 I.R.B.

The loan was secured solely by B’s account balance in Plan Y. At the time of the loan, B’s account balance was $12,000. According to the terms of the loan, B was to make substantially equal payments of principal and interest to Plan Y’s trust on the first business day of every calendar quarter. The interest rate of the loan was 11%, compounded annually, which was equal to or greater than a fair market rate of interest for such a loan at that time. B made no payments on the loan until December 31, 1999, at which time B repaid the loan, including principal and accrued interest. The repayment constituted a “correction” within the meaning of § 4975(f)(5) of the Code. None of the Forms 5500 that were filed for Plan Y for 1997, 1998, or 1999 reflected a loan to B.

LAW AND ANALYSIS

Section 4975(a) of the Internal Revenue Code provides that an excise tax is imposed as a result of each prohibited transaction on any disqualified person who participates in the prohibited transaction (other than a fiduciary acting only as such). Section 4975(c)(1)(B) of the Code defines the term “prohibited transaction” as including any direct or indirect lending of money or other extension of credit between a plan and a disqualified person.

Section 4975(d)(1) provides a statutory exemption for a loan made to a disqualified person who is a participant or beneficiary of the plan if such loan (1) is available to all such participants or beneficiaries on a reasonably equivalent basis; (2) is not made available to highly compensated employees (within the meaning of § 414(q)) in an amount greater than the amount made available to other employees; (3) is made in accordance with specific provisions regarding such loans set forth in the plan; (4) bears a reasonable rate of interest; and (5) is adequately secured.

Under section 102(a) of Reorganization Plan No. 4 of 1978 (43 F. R. 47713, October 17, 1978, 1979–1 C.B. 480), the Secretary of Labor has the authority to issue regulations interpreting § 4975 (d)(1) of the Code and the parallel provision in section 408(b)(1) of the Employee Retirement Income Security Act of 1974 (“ERISA”). Under 29 C.F.R. 2550.408b– 1(f)(2) of the Department of Labor’s

made a constructive sale of the appreciated financial position if the taxpayer acquires the same or substantially identical property.

ANALYSIS

Situation 1

Pursuant to § 1.1233–1(a)(1), the Short Sale is not consummated until the XYZ stock is delivered to close the Short Sale. Although T is treated as having acquired the XYZ stock on the trade date ( see Rev. Rul. 66–97; see also Rev. Rul. 93–84), the XYZ stock will not be delivered to close the Short Sale until January 4 of Year 2. Therefore, T does not realize the loss on the Short Sale until January 4 of Year 2.

Situation 2

As in Situation 1, T is treated as having acquired the XYZ stock on the trade date, December 31 of Year 1. See Rev. Rul. 66–97; see also Rev. Rul. 93–84. At that time, unlike in Situation 1, the price of XYZ stock has decreased. Therefore, the value of T ’s Short Sale has increased, and T holds an appreciated financial position within the meaning of § 1259(b)(1), that is, the short position. Section 1259(b)(3). Section 1259(c)(1)(D) provides that if a taxpayer holds an appreciated financial position that is a short sale, the acquisition of the same or substantially identical stock is a constructive sale transaction. Therefore, T has entered into a constructive sale transaction by acquiring the same or substantially identical stock as the stock underlying the Short Sale. Pursuant to § 1259(a)(1), T realizes gain on the Short Sale on December 31 of Year 1.

HOLDING

(1) In Situation 1, T realizes the loss on the Short Sale on January 4 of Year 2, the date the Short Sale is closed by delivery of the stock.

(2) In Situation 2, T has constructively sold the Short Sale on December 31 of Year 1. T realizes gain in Year 1 as if T had sold, assigned, or otherwise terminated the Short Sale at its fair market value on December 31 of Year 1.

DRAFTING INFORMATION

The principal author of this revenue ruling is Kate Sleeth of the Office of Associate Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling, contact Ms. Sleeth at (202) 622–3920 (not a toll-free call).

Section 1502.—Regulations (Consolidated Returns).

26 CFR 1.1502–77.—Agent for the group.

26 CFR 1.1502–77A.—Common parent agent for subsidiaries applicable for consolidated return years beginning before June 28, 2002.

The revenue procedure provides instructions relating to the determination of a substitute agent to act on behalf of a consolidated group, pursuant to section 1.1502–77(d) or section 1.1502–77A(d). Procedures are provided for automatic approval of requests by a terminating common parent to designate its qualifying successor as substitute agent. See §§ 1.1502–77(d) and 1.1502–77A(d), and Rev. Proc. 2002–43, page 99.

Section 4975:—Tax On Prohibited Transactions

26 CFR 54.4975–1: General rules relating to excise tax on prohibited transactions.

Rev. Rul. 2002–43

ISSUE

FACTS

X, Inc., is a Subchapter C corporation that sponsors Plan Y, a calendar year profit sharing plan qualified under § 401(a) of the Internal Revenue Code. Plan Y’s plan year is the calendar year. On April 1, 1997, individual B, a disqualified person with respect to Plan Y, obtained a two-year loan in the amount of $10,000 from Plan Y’s tax-exempt trust.

2002–28 I.R.B. 85 July 15, 2002

in § 4941(e) and § 4975(f). The term “amount involved” appears in both § 4941(e) and § 4975(f).

Section 53.4941(e)–1(b)(2)(ii) of the Foundation Excise Tax Regulations provides that, where the transaction involves the use of money, the amount involved is the greater of the amount paid for such use or the fair market value of such use for the period for which the money or other property is used and the amount involved is determined for the entire period that the money is used. In addition, § 53.4941(e)–1(e)(1) provides that, in the instance of a prohibited transaction that is a loan, an additional prohibited transaction is deemed to occur on the first day of each taxable year in the taxable period after the taxable year in which the loan occurred.

The interest amount for each year under the facts described above is computed as follows:

regulations, a loan secured solely by more than 50 percent of the present value of a participant’s vested accrued benefit is not adequately secured for purposes of determining whether the loan is exempt from the prohibited transaction excise tax.

Section 1453(a) of the Small Business Job Protection Act of 1996 increased the first tier excise tax rate of § 4975(a) of the Code from 5% to 10% of the amount involved for each year in the taxable period for prohibited transactions occurring after August 20, 1996. Section 1074(a) of the Taxpayer Relief Act of 1997 increased the first tier excise tax rate to 15% of the amount involved for each year in the taxable period for prohibited transactions occurring after August 5, 1997. Section 4975(f)(2) of the Code defines the term “taxable period” as the period beginning with the date on which the prohibited transaction occurs and ending on the earliest of (1) the date of the

mailing of a statutory notice of deficiency, (2) the date on which the first tier excise tax is assessed, or (3) the date on which correction of the prohibited transaction is completed. Section 4975(f)(4) defines the term “amount involved,” with respect to a prohibited transaction, as the greater of (1) the amount of money and the fair market value of the other property given or (2) the amount of money and the fair market value of the other property received in such transaction. For purposes of the first tier excise tax, the fair market value is determined as of the date on which the prohibited transaction occurs.

Section 141.4975–13 of the Temporary Pension Excise Tax Regulations provides that until superseded by permanent regulations under paragraphs (4) and (5) of § 4975(f) of the Code, § 53.4941(e)–1 of the Foundation Excise Tax Regulations will be controlling to the extent those regulations describe terms appearing both

Year Principal Rate Time

Interest

Amount

1997 (4/1–12/31) $10,000.00 11.00% 275/365 year $ 828.77

1998 $10,828.77 11.00% 1 year 1,191.16

1999 12,019.93 11.00% 1 year 1,322.19

Under the facts described above, and applying the rule in § 53.4941(e)–1(e)(1), there are three prohibited transactions that result from this loan. The first prohibited transaction occurs on the date of the loan (April 1, 1997), the second prohibited transaction occurs on January 1,1998 (the first day of the next taxable year) and the third prohibited transaction occurs on January 1, 1999. The taxable period for each of these prohibited transactions begins on the date that the prohibited transaction occurs (April 1, 1997, for the first prohibited transaction, January 1, 1998, for the second prohibited transaction, and January 1, 1999, for the third prohibited transaction). The taxable periods for all three prohibited transactions end on the date on which the prohibited transactions were corrected (December 31, 1999). The amount involved for each prohibited transaction is the interest amount, as computed in the preceding table, for the first taxable year in the taxable period for that prohibited transaction. Therefore, the first-tier prohibited transaction excise tax for each prohibited transaction is computed as follows:

2nd Prohibited Transaction

Excise Tax

3rd Prohibited Transaction

Excise Tax

Year

1st Prohibited Transaction

Excise Tax

1997 $ 828.77 x .10 = $ 82.88 --------------------------------- -------------------------------1998 828.77 x .10 = 82.88 $1,191.16 x .15 = $178.67 ------------------------------- 1999 828.77 x .10 = 82.88 1,191.16 x .15 = 178.67 $1,322.19 x .15 = $198.33 1st tier tax $248.64 $357.34 $198.33

Total for All Prohibited Transactions = $804.31.

July 15, 2002 86 2002–28 I.R.B.

HOLDING

When a loan from a qualified plan that is a prohibited transaction spans successive taxable years, and thus constitutes multiple prohibited transactions, and during those years the first tier prohibited transaction excise tax rate changes, the first tier excise tax liability for each prohibited transaction is the sum of the products resulting from multiplying the amount involved for each year in the taxable period for that prohibited transaction by the excise tax rate in effect at the beginning of that taxable period.

Drafting Information

The principal author of this revenue ruling is Michael Rubin of the Employee Plans, Tax Exempt and Government Entities Division. For further information regarding this revenue ruling, please contact the Employee Plans’ taxpayer assistance telephone service at 1–877–829– 5500 (a toll-free number), between the hours of 8:00 a.m. and 6:30 p.m. Eastern Time, Monday through Friday. Mr. Rubin can be reached at 1–202–283–9888 (not a toll-free number).

Section 4980F.—Failure of Applicable Plans Reducing Benefit Accruals to Satisfy Notice Requirements

Whether the notice required by section 4980F of the Code and section 204(h) ERISA, as amended, must be provided to the affected individuals in a money purchase pension plan that is merged or converted into a profit-sharing plan. See Rev. Rul. 2002–42, page 76.

Section 6011.—General Requirement of Return, Statement, or List

26 CFR 1.6011–4T: Requirement of statement dis- closing participation in certain transactions by tax- payers (Temporary).

T.D. 9000

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

Modification of Tax Shelter Rules III

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

SUMMARY: These regulations modify the rules relating to the filing by certain taxpayers of a statement with their Federal income tax returns under section 6011(a) and the registration of confidential corporate tax shelters under section 6111(d). These rules also affect the list maintenance requirement under section 6112. These regulations affect taxpayers participating in certain reportable transactions, persons responsible for registering confidential corporate tax shelters, and persons responsible for maintaining lists of investors in potentially abusive tax shelters. The text of these regulations also serves as the text of the proposed regulations set forth in the notice of proposed rulemaking (REG–103735–00; REG– 110311–98) on this subject on page 109 of this issue of the Bulletin.

DATES: Effective Date : These regulations are effective June 14, 2002.

Applicability Date : For dates of applicability, see § 1.6011–4T(g) and § 301.6111–2T(h).

FOR FURTHER INFORMATION CONTACT: Danielle M. Grimm or Tara P. Volungis, 202–622–3080 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained in these regulations have been previously reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduc

tion Act of 1995 (44 U.S.C. 3507(d)) under control number 1545–1685.

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

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

Background

This document amends 26 CFR parts 1 and 301 to provide modified rules relating to the disclosure of reportable transactions by certain individuals, trusts, partnerships, S corporations, and other corporations on their Federal income tax returns under section 6011 and the registration of confidential corporate tax shelters under section 6111.

On February 28, 2000, the IRS issued temporary and proposed regulations regarding section 6011 (T.D. 8877, 2000–1 C.B. 747; REG–103735–00, 2000–1 C.B. 770), section 6111 (T.D. 8876, 2000–1 C.B. 753; REG–110311– 98, 2000–1 C.B. 767), and section 6112 (T.D. 8875, 2000–1 C.B. 761; REG– 103736–00, 2000–1 C.B. 768) (collectively, the February regulations). The February regulations were published in the Federal Register (65 FR 11205, 65 FR 11215, 65 FR 11211) on March 2, 2000. On August 11, 2000, the IRS issued temporary and proposed regulations regarding sections 6011, 6111, and 6112 (T.D. 8896, 2000–2 C.B. 249; REG– 103735–00, REG–110311–98, REG– 103736–00, 2000–2 C.B. 258) (collectively, the August 2000 regulations). The August 2000 regulations were published in the Federal Register (65 FR 49909) on August 16, 2000, modifying the February regulations. On August 2, 2001, the IRS issued temporary and proposed regulations regarding sections 6011, 6111, and 6112 (T.D. 8961, 2001–35 I.R.B. 194; REG–103735–00, REG–110311–98, REG–103736–00, 2001–35 I.R.B. 204) (collectively, the August 2001 regulations). The August 2001 regulations were published in the Federal Register (66 FR

2002–28 I.R.B. 87 July 15, 2002

manner of the taxpayer’s indirect participation in the reportable transaction under the provisions of § 1.6011–4T.

Substantially Similar Transactions

Sections 1.6011–4T and 301.6111–2T make reference to substantially similar transactions. Some taxpayers and promoters have applied the substantially similar standard in an overly narrow manner to avoid disclosure. For instance, some taxpayers and promoters have made subtle and insignificant changes to a listed transaction in order to claim that their transactions are not subject to disclosure. Others have taken the position that their transaction is not substantially similar to a listed transaction because they have an opinion concluding that their transaction is proper. The IRS and Treasury believe that these interpretations are improper. Accordingly, the regulations are modified in § 1.6011–4T and § 301.6111–2T to clarify that the term substantially similar includes any transaction that is expected to obtain the same or similar types of tax benefits and that is either factually similar or based on the same or similar tax strategy. Further, the term substantially simi- lar must be broadly construed in favor of disclosure. This modification does not imply that a transaction was not otherwise the same as or substantially similar to a listed transaction prior to this modification.

For example, Notice 2000–44, 2000–2 C.B. 255, sets forth a listed transaction involving offsetting options transferred to a partnership where the taxpayer claims basis in the partnership for the cost of the purchased options but does not reduce basis under section 752 as a result of the partnership’s assumption of the taxpayer’s obligation with respect to the options. Transactions using short sales, futures, derivatives or any other type of offsetting obligations to inflate basis in a partnership interest would be the same as or substantially similar to the transaction described in Notice 2000–44. Moreover, use of the inflated basis in the partnership interest to diminish gain that would otherwise be recognized on the transfer of a partnership asset would also be the same as or substantially similar to the transaction described in Notice 2000–44.

on August 7, 2001, further modifying the February 2000 regulations.

The rules under sections 6011, 6111, and 6112 are designed to provide the IRS and Treasury with information needed to evaluate potentially abusive transactions. The IRS and Treasury have considered and evaluated compliance with the disclosure, registration, and list maintenance requirements under sections 6011, 6111, and 6112 and have determined that certain additional changes to the temporary and proposed regulations are necessary to improve compliance with the regulations and to carry out the purposes of sections 6011, 6111, and 6112. The IRS and Treasury continue to evaluate all the comments and recommendations received. Moreover, the IRS and Treasury intend to make substantial additional changes to the rules under sections 6011, 6111, and 6112 in order to establish a more effective disclosure regime and to improve compliance as announced in Treasury’s Plan to Combat Abusive Tax Avoidance Transactions (PO–2018), released on March 20, 2002. See http://www.treas.gov/press/ releases/po2018.htm.

Explanation of Provisions

Application of § 1.6011–4T to Individuals, Trusts, Partnerships, and S Corporations

Section 1.6011–4T generally provides that certain corporate taxpayers must disclose their participation in listed and other reportable transactions that meet the projected tax effect test by attaching a written statement to their Federal income tax returns. It has been determined that a number of these transactions are entered into by noncorporate taxpayers. Accordingly, in order to obtain information regarding potentially abusive transactions entered into by noncorporate taxpayers, the requirement to disclose under § 1.6011–4T is extended to individuals, trusts, partnerships, and S corporations that participate, directly or indirectly, in listed transactions. Thus, if a partnership or an S corporation participates in a listed transaction, that partnership or S corporation must disclose its participation under § 1.6011–4T and the partners and shareholders of the partnership or S corporation, respectively, also must disclose their participation under § 1.6011–4T. The IRS

and Treasury plan to extend in future guidance the requirement to disclose under § 1.6011–4T to other reportable transactions entered into by individuals, trusts, partnerships, and S corporations.

Indirect Participants

Section 1.6011–4T makes reference to taxpayers who participate directly or indirectly in reportable transactions. In order to obtain information about potentially abusive transactions entered into by taxpayers, the IRS and Treasury have provided clarification regarding indirect participation in a reportable transaction. A taxpayer will have indirectly participated in a reportable transaction if the taxpayer knows or has reason to know that the tax benefits claimed from the taxpayer’s transaction are derived from a reportable transaction. However, this clarification does not imply that a taxpayer’s participation in a transaction did not otherwise qualify as indirect participation in a reportable transaction for purposes of § 1.6011–4T, as in effect prior to June 14, 2002. For example, Notice 95–53 (1995–2 C.B. 334), describes a lease stripping transaction in which one party (the transferor) assigns the right to receive future payments under a lease of tangible property and receives consideration which the transferor treats as current income. The transferor later transfers the property subject to the lease in a transaction intended to qualify as a substituted basis transaction, for example, a transaction described in section 351. In return, the transferor receives stock (with low value and high basis) from the transferee corporation. The transferee corporation claims the deductions associated with the high basis property subject to the lease. The transferor and transferee corporation have directly participated in the listed transaction. If the transferor subsequently transfers the high basis/low value stock to a taxpayer in another transaction intended to qualify as a substituted basis transaction and the taxpayer uses the stock to generate a loss, and if the taxpayer knows or has reason to know that the tax loss claimed was derived from the lease stripping transaction, then the taxpayer is indirectly participating in a reportable transaction. Accordingly, the taxpayer must disclose the reportable transaction and the

July 15, 2002 88 2002–28 I.R.B.

Notwithstanding the effective date of these regulations, a corporate taxpayer was required to disclose a transaction in the time and manner provided for in § 1.6011–4T in effect prior to June 14, 2002, regardless of whether the taxpayer planned to disclose the transaction under other published guidance.

Effective Dates

The regulations are applicable June 14, 2002.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. It is hereby certified that the collection of information in these regulations will not have a significant economic impact on a substantial number of small entities. This certification is based upon the fact that the time required to prepare or retain the disclosure is minimal and will not have a significant impact on those small entities that are required to provide disclosure. Therefore, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of the Internal Revenue Code, these regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Drafting Information

The principal authors of these regulations are Danielle M. Grimm and Tara P. Volungis, Office of the Associate Chief Counsel (Passthroughs and Special Industries). However, other personnel from the IRS and Treasury Department participated in their development.

- - - - Adoption of Amendments to the

Regulations

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

As another example, Notice 2001–16, 2001–1 C.B. 730, sets forth a listed transaction involving a seller (X) who desires to sell stock of a corporation (T), an intermediary corporation (M), and a buyer (Y) who desires to purchase the assets (and not the stock) of T. M agrees to facilitate the sale to prevent the recognition of the gain that T would otherwise report. Notice 2001–16 describes M as a member of a consolidated group that has a loss within the group or as a party not subject to tax. Transactions utilizing different intermediaries to prevent the recognition of gain would be the same as or substantially similar to the transaction described in Notice 2001–16. An example is a transaction in which M is a corporation that does not file a consolidated return but which buys T stock, liquidates T, sells assets of T to Y, and offsets the gain recognized on the sale of those assets with currently generated losses.

Projected Tax Effect Test for Listed Transactions

Section 1.6011–4T provides that a reportable transaction is a transaction that meets the projected tax effect test and is either a listed transaction or a transaction that has at least two of five specified characteristics. Under § 1.6011–4T, the projected tax effect test for listed transactions is met if the taxpayer reasonably estimates that the transaction will reduce the taxpayer’s Federal income tax liability by more than $1 million in any single taxable year or by a total of more than $2 million for any combination of taxable years in which the transaction is expected to have the effect of reducing the taxpayer’s Federal income tax liability. The IRS and Treasury have determined that the projected tax effect test for listed transactions results in inadequate disclosure. Accordingly, the projected tax effect test will no longer apply to listed transactions. Thus, any individual, trust, partnership, S corporation, or other corporation that participates in a listed transaction must report it under the provisions of § 1.6011–4T.

Time of Providing Disclosure

In general, the disclosure statement for a reportable transaction must be attached to the taxpayer’s Federal income tax

return for each taxable year for which the taxpayer’s Federal income tax liability is affected by the taxpayer’s participation in the transaction. In the case of a taxpayer that is a partnership or an S corporation, the disclosure statement for a listed transaction must be attached to the taxpayer’s Federal income tax return for each taxable year ending with or within the taxable year of any partner or shareholder whose income tax liability is affected or is reasonably expected to be affected by the partnership’s or the S corporation’s participation in the transaction. In addition, at the same time that the disclosure statement is first attached to the taxpayer’s Federal income tax return, the taxpayer must file a copy of that disclosure statement with the Office of Tax Shelter Analysis.

If a transaction becomes a reportable transaction ( e.g., the transaction subsequently becomes one identified in published guidance as a listed transaction described in § 1.6011–4T(b)(2), or there is a change in facts affecting the expected Federal income tax effect of the transaction) on or after the date the taxpayer has filed the return for the first taxable year for which the transaction affected the taxpayer’s or a partner’s or a shareholder’s Federal income tax liability, the disclosure statement must be filed as an attachment to the taxpayer’s Federal income tax return next filed after the date the transaction becomes a reportable transaction (whether or not the transaction affects the taxpayer’s or any partner’s or shareholder’s Federal income tax liability for that year) and at that time a copy of that disclosure statement must be filed with the Office of Tax Shelter Analysis. Notwithstanding the effective date of these regulations, for purposes of § 1.6011–4T, as in effect prior to June 14, 2002, a corporate taxpayer was required to disclose a transaction that later became reportable on the corporation’s next filed Federal income tax return even if the transaction did not affect the corporation’s Federal income tax liability for that year.

Regardless of whether the taxpayer plans to disclose the transaction under other published guidance, for example, Rev. Proc. 94–69, 1994–2 C.B. 804, the taxpayer also must disclose the transaction in the time and manner provided for under the provisions of this regulation.

2002–28 I.R.B. 89 July 15, 2002

PART 1—INCOME TAXES

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

Authority: 26 U.S.C. 7805 - - Par. 2. Section 1.6011–4T is amended as follows:

The heading of § 1.6011–4T is amended by removing the language “corporate”.
The heading of paragraph (a) is revised.
Paragraph (a) is amended by adding “(1) In general. ” after the heading.
Newly designated paragraph (a)(1) is amended by adding the language “corporate” before “taxpayer” in the first sentence, and by removing the second sentence and adding three new sentences in its place.
Paragraphs (a)(2) and (a)(3) are added.
Paragraph (b)(1) is amended by revising the first sentence.
Paragraphs (b)(1)(i) and (b)(1)(ii) are added.
Paragraph (b)(4)(i) is amended by removing the first sentence.
Paragraph (b)(5) Example 3 is amended by revising the seventh sentence.
Paragraphs(c)(1)(iii) and (c)(1)(v) are revised.
Paragraph (c)(2) Example is amended by adding the language “ Example. ” after “of this section:” in the first sentence and by adding “as in effect at that time.” to the end of the third sentence.
Paragraph (d)(1) is revised.
Paragraph (e) is amended by removing the language “corporation’s” in the first sentence and adding “taxpayer’s” in its place.
Paragraph (g) is revised. The revisions and additions read as follows:

§ 1.6011–4T Requirement of statement disclosing participation in certain transactions by taxpayers (Temporary).

(a) Disclosure requirement —(1) In general . - - - Every individual, trust, partnership, and S corporation that has participated, directly or indirectly, in a reportable transaction within the meaning of paragraph (b)(2) of this section must attach to its return for the taxable year

described in paragraph (d) of this section a disclosure statement in the form prescribed by paragraph (c) of this section. For this purpose, a taxpayer will have indirectly participated in a reportable transaction if the taxpayer’s Federal income tax liability is affected (or in the case of a partnership or an S corporation, if a partner’s or shareholder’s Federal income tax liability is reasonably expected to be affected) by the transaction even if the taxpayer is not a direct party to the transaction ( e.g., the taxpayer participates as a partner in a partnership, as a shareholder in an S corporation, or through a controlled entity). Moreover, a taxpayer will have indirectly participated in a reportable transaction if the taxpayer knows or has reason to know that the tax benefits claimed from the taxpayer’s transaction are derived from a reportable transaction. - - (2) Example of indirect participation . Notice 95–53, 1995–2 C.B. 334, (see § 601.601(d)(2) of this chapter), describes a lease stripping transaction in which one party (the transferor) assigns the right to receive future payments under a lease of tangible property and receives consideration which the transferor treats as current income. The transferor later transfers the property subject to the lease in a transaction intended to qualify as a substituted basis transaction, for example, a transaction described in section 351. In return, the transferor receives stock (with low value and high basis) from the transferee corporation. The transferee corporation claims the deductions associated with the high basis property subject to the lease. The transferor and transferee corporation have directly participated in the listed transaction. If the transferor subsequently transfers the high basis/low value stock to a taxpayer in another transaction intended to qualify as a substituted basis transaction and the taxpayer uses the stock to generate a loss, and if the taxpayer knows or has reason to know that the tax loss claimed was derived from the lease stripping transaction, then the taxpayer is indirectly participating in a reportable transaction. Accordingly, the taxpayer must disclose the reportable transaction and the manner of the taxpayer’s indirect participation in the reportable transaction under the rules of this section.

(3) Definition of taxpayer . For purposes of paragraphs (b)(3) and (4) of this section, the term taxpayer means a corporation required to file a return under section 11, 594, 801, or 831. For all other purposes of this section, the term tax- payer also includes an individual, trust, partnership, or S corporation.

(b) Definition of reportable trans- action —(1) In general . A reportable transaction is either a transaction that is described in paragraph (b)(2) of this section, or is a transaction that is described in paragraph (b)(3) of this section and that meets the projected tax effect test in paragraph (b)(4) of this Section. - - (i) Definition of substantially similar . For purposes of this section, the term sub- stantially similar includes any transaction that is expected to obtain the same or similar types of tax benefits and that is either factually similar or based on the same or similar tax strategy. Receipt of an opinion concluding that the tax benefits from the taxpayer’s transaction are allowable is not relevant to the determination of whether the taxpayer’s transaction is the same as or substantially similar to a listed transaction. Further, the term sub- stantially similar must be broadly construed in favor of disclosure.

(ii) Examples . The following examples illustrate situations where a transaction is the same as or substantially similar to a listed transaction:

Example 1 . Notice 2000–44, 2000–2 C.B. 255, (see § 601.601(d)(2) of this chapter), sets forth a listed transaction involving offsetting options transferred to a partnership where the taxpayer claims basis in the partnership for the cost of the purchased options but does not reduce basis under section 752 as a result of the partnership’s assumption of the taxpayer’s obligation with respect to the options. Transactions using short sales, futures, derivatives or any other type of offsetting obligations to inflate basis in a partnership interest would be the same as or substantially similar to the transaction described in Notice 2000–44. Moreover, use of the inflated basis in the partnership interest to diminish gain that would otherwise be recognized on the transfer of a partnership asset would also be the same as or substantially similar to the transaction described in Notice 2000–44.

Example 2 . Notice 2001–16, 2001–1 C.B. 730, (see § 601.601(d)(2) of this chapter), sets forth a listed transaction involving a seller (X) who desires to sell stock of a corporation (T), an intermediary corporation (M), and a buyer (Y) who desires to purchase the assets (and not the stock) of T. M agrees to facilitate the sale to prevent the recognition of the gain that T would otherwise report. Notice 2001–16 describes M as a member of a consolidated group that has a loss within the group or

July 15, 2002 90 2002–28 I.R.B.

June 14, 2002. Taxpayers may rely on the rules in paragraphs (a)(1), (a)(2), (a)(3), (b)(1), (b)(4)(i), (b)(5) Example 3, (c)(1)(iii), (c)(1)(v), (c)(2) Example, (d)(1), and (e) of this section for Federal income tax returns filed after February 28, 2000. Otherwise, the rules that apply with respect to transactions entered into before January 1, 2001, and with respect to any transaction entered into on or after January 1, 2001, and reported on a tax return of the taxpayer that is filed on or before June 14, 2002, are contained in § 1.6011–4T in effect prior to June 14, 2002, (see 26 CFR part 1 revised as of April 1, 2002).

Par. 3. In § 1.6031(a)–1, paragraph(a)(1) is amended by adding a sentence to the end of the paragraph to read as follows:

§ 1.6031(a)–1 Return of partnership income.

(a) - - (1) - - - For the rules requiring the disclosure of certain transactions, see § 1.6011–4T.

- - - Par. 4. In § 1.6037–1, paragraph (c) is amended by adding a sentence to the end of the paragraph to read as follows:

§ 1.6037–1 Return of electing small business corporation.

- - - (c) - - - For the rules requiring the disclosure of certain transactions, see § 1.6011–4T.

PART 301—PROCEDURE AND ADMINISTRATION

Par. 5. The authority citation for part 301 continues to read in part as follows: Authority: 26 U.S.C. 7805 - - Par. 6. Section 301.6111–2T is amended as follows:

Paragraph (a)(3) is amended by adding four sentences to the end of the paragraph.
The paragraph heading for (h) is revised and the entire text after the second sentence is removed and four new sentences are added in their place.

The revision and additions read as follows:

as a party not subject to tax. Transactions utilizing different intermediaries to prevent the recognition of gain would be the same as or substantially similar to the transaction described in Notice 2001–16. An example is a transaction in which M is a corporation that does not file a consolidated return but which buys T stock, liquidates T, sells assets of T to Y, and offsets the gain recognized on the sale of those assets with currently generated losses.

- - - (5) - - Example 3 . - - - However, E does reasonably determine that the terms of the leases are consistent with customary commercial form in the leasing industry, and that there is a generally accepted understanding that the combination of Federal income tax consequences it is claiming with respect to the leases are allowable under the Internal Revenue Code for substantially similar transactions.
- - - (c) - - *(1) - - (iii) A brief description of the principal elements of the transaction that give rise to the expected tax benefits, including the manner of the taxpayer’s direct or indirect participation in the transaction.
- - - (v) An identification of each taxable year (including prior taxable years) for which the transaction is expected to have the effect of reducing the Federal income tax liability of the taxpayer, or of any partner or shareholder of the taxpayer, and an estimate of the amount by which the transaction is expected to reduce the Federal income tax liability of the taxpayer, or of any partner or shareholder of the taxpayer, for each such taxable year.

(d) Time of providing disclosure —(1) In general . The disclosure statement for a reportable transaction must be attached to the taxpayer’s Federal income tax return for each taxable year for which the taxpayer’s Federal income tax liability is affected by the taxpayer’s participation in the transaction. In the case of a taxpayer that is a partnership or an S corporation, the disclosure statement for a listed transaction must be attached to the taxpayer’s Federal income tax return for each taxable year ending with or within the taxable year of any partner or shareholder whose income tax liability is affected or is reasonably expected to be affected by the partnership’s or the S corporation’s

participation in the transaction. In addition, at the same time that any disclosure statement is first attached to the taxpayer’s Federal income tax return, the taxpayer must file a copy of that disclosure statement with the Office of Tax Shelter Analysis (OTSA) at: Internal Revenue Service LM:PFTG:OTSA, Large & MidSize Business Division, 1111 Constitution Ave., NW, Washington, DC 20224. Regardless of whether the taxpayer plans to disclose the transaction under other published guidance, for example, Rev. Proc. 94–69, 1994–2 C.B. 804, (see § 601.601(d)(2) of this chapter), the taxpayer also must disclose the transaction in the time and manner provided for under the provisions of this section. If a transaction becomes a reportable transaction ( e.g., the transaction subsequently becomes one identified in published guidance as a listed transaction described in (b)(2) of this section, or there is a change in facts affecting the expected Federal income tax effect of the transaction) on or after the date the taxpayer has filed the return for the first taxable year for which the transaction affected the taxpayer’s or a partner’s or a shareholder’s Federal income tax liability, the disclosure statement must be filed as an attachment to the taxpayer’s Federal income tax return next filed after the date the transaction becomes a reportable transaction (whether or not the transaction affects the taxpayer’s or any partner’s or shareholder’s Federal income tax liability for that year). If a disclosure statement is required as an attachment to a Federal income tax return that is filed after June 14, 2002, but on or before 180 days after June 14, 2002, the taxpayer must either attach the disclosure statement to the return, or file the disclosure statement as an amendment to the return no later than 180 days after June 14, 2002.

(g) Effective date . This section applies to Federal income tax returns filed after February 28, 2000. However, paragraphs (a)(1), (a)(2), (a)(3), (b)(1), (b)(4)(i), (b)(5) Example 3, (c)(1)(iii), (c)(1)(v), (c)(2) Example, (d)(1), and (e) of this section apply to any transaction entered into on or after January 1, 2001, unless such transaction is reported on a tax return of the taxpayer that is filed on or before

2002–28 I.R.B. 91 July 15, 2002

§ 301.6111–2T Confidential corporate tax shelters (Temporary).

(a) - - (3) - - - For purposes of this section, the term substantially similar includes any transaction that is expected to obtain the same or similar types of tax benefits and that is either factually similar or based on the same or similar tax strategy. Receipt of an opinion concluding that the tax benefits from the taxpayer’s transaction are allowable is not relevant to the determination of whether the taxpayer’s transaction is the same as or substantially similar to a listed transaction. Further, the term substantially similar must be

broadly construed in favor of disclosure. For examples, see § 1.6011–4T(b)(1)(ii) of this chapter.

(h) Effective dates . - - - However, paragraph (a)(3) of this section applies to confidential corporate tax shelters in which any interests are offered for sale after June 14, 2002. The rule in paragraph (a)(3) of this section may be relied upon for confidential corporate tax shelters in which any interests are offered for sale after February 28, 2000. Otherwise, the rules that apply to confidential corporate tax shelters in which any interests are offered for sale after February 28, 2000,

and on or before June 14, 2002, are contained in this § 301.6111–2T in effect prior to June 14, 2002. (See 26 CFR part 301 revised as of April 1, 2002).

Robert E. Wenzel, Deputy Commissioner

of Internal Revenue.

Approved June 11, 2002.

Pamela F. Olson, Acting Assistant Secretary

of the Treasury.

(Filed by the Office of the Federal Register on June 14, 2002, 11:32 a.m., and published in the issue of the Federal Register for June 18, 2002, 67 F.R. 41324)

July 15, 2002 92 2002–28 I.R.B.