Part IV. Applicable — Internal Revenue Bulletin 2004-8

TABLE OF APPLICABLE FEDERAL INTEREST RATES

FOR PURPOSES OF § 807

Year Interest Rate

2003 5.27

2004 4.82

Sources: Rev. Rul. 2002–81, 2002–2 C.B. 928 for the 2003 rate and Rev. Rul. 2003–122, 2003–49 I.R.B. 1179 for the 2004 rate.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 92–19 is supplemented by the addition to Part III of that ruling of prevailing state assumed interest rates under § 807 for certain insurance products issued in 2003 and 2004 and is further supplemented by an addition to the table in Part IV of Rev. Rul. 92–19 listing applicable federal interest rates. Parts I and II of Rev. Rul. 92–19 are not affected by this ruling.

DRAFTING INFORMATION

The principal author of this revenue ruling is Ann H. Logan of the Office of Associate Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling, contact her at (202) 622–3970 (not a toll-free call).

Section 1233.—Gains and Losses From Short Sales

(Also § 1259; 26 CFR 1.1233–1.)

Short sale; broker; transfer. This ruling provides guidance on whether the delivery of shares made to a broker in transferring a short sale position from one broker to another broker will (1) cause a short sale to be deemed consummated under regulations section 1.1233–1(a), and (2) cause a short-against-the-box transaction to cease to be covered by the transition rule of section 1259 of the Code.

Rev. Rul. 2004–15

ISSUES

(1) If a taxpayer is obligated to transfer stock to a broker as a result of a short sale

and borrows stock from another broker to satisfy the obligation to the first broker by having the second broker transfer the borrowed stock to the first broker, does the transfer close the short sale for purposes of § 1.1233–1(a) of the Income Tax Regulations?

(2) If a taxpayer held appreciated stock, entered into a short sale prior to June 9, 1997, of identical stock borrowed from a broker, identified the short sale and the stock as offsetting positions in accordance with the transition rule in § 1001(d)(2) of the Taxpayer Relief Act of 1997, 1997–4 (Vol. 1) C.B. 1, 121, and continues to hold the appreciated stock, does a transfer of stock borrowed from another broker to satisfy the obligation to the first broker cause the transition rule to cease to apply?

FACTS

In January 1997, Taxpayer TP owned 100 shares of XYZ stock. In May 1997, at a time when the value of the XYZ stock exceeded TP ’s basis in the stock, TP effected a short sale (the Short Sale) of 100 shares of XYZ stock. To do this, TP borrowed 100 shares of XYZ stock from Broker A and instructed Broker A to sell those borrowed shares on TP ’s behalf. Thus, as a result of the Short Sale, TP incurred an obligation to transfer 100 shares of XYZ stock to Broker A . Before September 4, 1997, in its books and records, TP clearly identified the Short Sale and the XYZ stock (which TP still owned) as offsetting positions under § 1001(d)(2) of the Taxpayer Relief Act of 1997.

In January 2004, TP decides to replace its obligation to Broker A with a substantially identical obligation to Broker B . To do so, TP arranges for Broker B to deliver

100 shares of XYZ stock to Broker A in satisfaction of TP ’s obligation to Broker A, and TP thus incurs an obligation to transfer 100 shares of XYZ stock to Broker B . After Broker B ’s transfer of 100 shares of XYZ stock to Broker A, TP continues to have the obligation to deliver 100 shares of XYZ stock, but the obligation is owed to Broker B rather than to Broker A .

TP continues to hold the XYZ stock, and TP has not satisfied its obligation to Broker B .

LAW AND ANALYSIS

(1) Section 1233

Section 1.1233–1(a)(1) provides, “For income tax purposes, a short sale is not deemed to be consummated until delivery of property to close the short sale.” Pursuant to § 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 general, a short sale is closed (and thus is consummated) by the transfer of property that the short seller already owns or property that the short seller purchases for the purpose of satisfying the obligation from the short sale. If, however, a taxpayer satisfies its obligation created under a short sale by transferring property borrowed from another lender, the transfer of the borrowed property does not close the short sale. In Richardson v. Commis- sioner, 42 B.T.A. 830, 840 (1940), aff’d, 121 F.2d 1 (2d Cir. 1941), the taxpayer borrowed stock to sell short. With respect to a portion of the borrowed stock,

2004-8 I.R.B. 515 February 23, 2004

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 1341.—Com- putation of Tax Where Taxpayer Restores Sub- stantial Amount Held Under Claim of Right

26 CFR 1.1341–1: Restoration of amounts received or accrued under claim of right. (Also § 263A.)

Treatment of environmental remedi- ation expenses under section 1341. This ruling holds that amounts paid or incurred in the current taxable year to remediate environmental contamination that occurred in prior taxable years do not qualify for treatment under section 1341 of the Code.

Rev. Rul. 2004–17

ISSUES

Do amounts paid or incurred in the current taxable year to remediate environmental contamination that occurred in prior taxable years qualify for treatment under § 1341 of the Internal Revenue Code?

FACTS

Situation 1

N manufactures products that it sells to wholesalers and retailers. N ’s manufacturing process creates hazardous waste. N uses an accrual method of accounting and the calendar taxable year. From the inception of its business in 1950 until 1979, N buried the hazardous waste on land that it owned in accordance with then applicable state, federal, and local environmental laws. N accounted for waste disposal costs as a deducible expense under § 162.

Significantly stricter state, federal, and local hazardous waste disposal laws were enacted in later years. In 2004, in order to comply with current environmental laws,

the taxpayer subsequently borrowed other stock from another lender to satisfy the obligation that resulted from the original borrowing. The taxpayer later satisfied the obligation under the second borrowing by transferring shares that he purchased. The Board of Tax Appeals required the taxpayer to recognize the gain or loss in the year in which the obligation from the second borrowing was satisfied, and the Board calculated the amount of the gain or loss on the short sale by reference to the purchase price of the stock used to satisfy the second borrowing. Although the opinion does not discuss the effect of using borrowed shares to satisfy an obligation to replace other shares previously borrowed from another lender, it is implicit in the computation of gain or loss that the satisfaction was not treated as closing the short sale.

Section 1.1233–1(a) does not require a different result. When a taxpayer transfers borrowed property to satisfy its initial obligation under a short sale, the taxpayer’s short sale obligation is not “finally discharged.” Here, the obligation of TP to deliver 100 shares of XYZ stock continues to exist, and thus Broker B ’s delivery of borrowed stock to Broker A on TP ’s behalf does not close the Short Sale under § 1.1233–1(a).

(2) Section 1259 Transition Rule

Section 1259(a)(1) provides that, if there is a constructive sale of an appreciated financial position, the taxpayer must recognize gain as if the position were sold, assigned, or otherwise terminated at its fair market value on the date of the constructive sale. “Appreciated financial position” is defined in § 1259(b)(1) as including a position with respect to stock if there would be gain were the position sold, assigned, or otherwise terminated at its fair market value. Pursuant to § 1259(c)(1)(A), a taxpayer is treated as having made a constructive sale of an appreciated financial position if the taxpayer enters into a short sale of the same or substantially identical property.

Under § 1001(d)(2) of the Taxpayer Relief Act of 1997 (the transition rule), if “before June 9, 1997, the taxpayer entered into any transaction which is a constructive sale of any appreciated financial position, and . . . before the close of the 30-day period

beginning on the date of the enactment of this Act [August 5, 1997] or before such later date as may be specified by the Secretary of the Treasury, such transaction and position are clearly identified in the taxpayer’s records as offsetting, such transaction and position shall not be taken into account in determining whether any other constructive sale after June 8, 1997, has occurred. The preceding sentence shall cease to apply as of the date such transaction is closed or the taxpayer ceases to hold such position.” Section 1001(d)(2) of the Taxpayer Relief Act of 1997, 1997–4 (Vol. 1) C.B. 1, 121.

In May 1997, when the value of the XYZ stock exceeded its basis, TP entered into the Short Sale. Thus, TP entered into a transaction that is described in § 1259(c)(1), but, because the Short Sale was entered into before June 9, 1997, no gain was recognized under § 1259(a)(1).

Furthermore, before the close of the 30-day period beginning on August 5, 1997, TP clearly identified the XYZ stock and the Short Sale in its books and records as offsetting positions. Thus, the XYZ stock and the Short Sale fall within the transition rule, and, until either TP ceases to hold the XYZ stock or the Short Sale is closed, neither the XYZ stock nor the Short Sale is taken into account in determining whether any constructive sale has occurred after June 8, 1997.

In January 2004, when TP replaces the obligation to Broker A with the obligation to Broker B, TP continues to hold the XYZ stock, and the Short Sale has not been closed for purposes of § 1.1233–1(a). Accordingly, the transition rule continues to apply to the Short Sale and the XYZ stock.

HOLDINGS

(1) When, as a result of the Short Sale, TP is obligated to transfer stock to Broker A and TP satisfies the obligation by causing Broker B to transfer stock that TP borrows from Broker B, the transfer of the borrowed stock does not close the Short Sale under § 1.1233–1(a).

(2) Because replacing the obligation to Broker A with the obligation to Broker B does not close the Short Sale under § 1.1233–1(a), the transfer does not cause the transition rule to cease to apply to either the Short Sale or the XYZ stock.

February 23, 2004 516 2004-8 I.R.B.

118; H.R. Rep. No. 1337, 83d Cong. 2d Sess. at 86.

For purposes of § 1341, to restore an item included in income, the repayment must arise out of the same circumstances, terms, and conditions as the original payment of the item to the taxpayer. Griffiths v. United States, 54 Fed. Cl. 198 (2002). The fact that the amount of the repayment bears no relationship to the amount included in income indicates that the repayment does not arise from the same or specific circumstances, terms, and conditions as the original transaction. Bailey v. Com- missioner, 756 F.2d 44 (6 ^th Cir. 1985); Uhlenbrock v. Commissioner, 67 T.C. 818 (1977).

In both Situation 1 and Situation 2, the environmental remediation costs N incurs in 2004 do not qualify for treatment under § 1341(a). N did not include an item in gross income that N is repaying or restoring in a later year. In these situations, the item of gross income for purposes of §1341(a) is the proceeds received from the sale of N ’s products from 1950 to 1979. See Rev. Rul. 72–28, 1972–1 C.B. 269. During 1950 to 1979, N had an unrestricted right to the proceeds received from the sale of N ’s products during those years. In 2004, N ’s right to the sales proceeds received during 1950 to 1979 remains unrestricted. N ’s payment of the environmental remediation costs does not restore in a later taxable year any portion of the proceeds received from the original sale of N ’s products in 1950 through 1979. Moreover, N ’s obligation to incur the environmental remediation costs does not arise from the same or specific circumstances, terms, or conditions as the original sale of N ’s products in 1950 to 1979. The amount of N ’s environmental remediation costs bears no relation to the amount of proceeds received from the sale of N ’s products in 1950 to 1979. Accordingly, N ’s payment of environmental remediation costs in 2004 is not a repayment or restoration of an item included in gross income. N ’s environmental remediation costs do not satisfy the repayment or restoration requirement of § 1341(a)(2).

Section 1341(a)(2) also requires, as a prerequisite to § 1341 treatment, that a deduction must be allowable to the taxpayer for the repayment or restoration of the item included in income. Section 1341 itself provides no right to a deduction.

N incurs expenses for all necessary services to eliminate soil and water contamination caused by the buried waste, transport the waste to a waste disposal facility that complies with current environmental laws, and restore the land.

Situation 2

The facts are the same as in Situation 1 except that N accounted for waste disposal costs as a production cost in calculating its inventory costs for all years.

LAW AND ANALYSIS

Section 1341 applies if: (1) the taxpayer included an item in gross income for a prior taxable year (or years) because it appeared that the taxpayer had an unrestricted right to the item, (2) a deduction is allowable to the taxpayer for the taxable year because it was established after the close of the taxable year (or years) of inclusion that the taxpayer did not have an unrestricted right to the item or to a portion of the item, and (3) the amount of the deduction exceeds $3,000. Section 1341(a)(1)–(3). If § 1341 applies, the chapter 1 tax for the taxable year equals the lesser of: (1) the tax for the taxable year computed with the current deduction, or (2) the tax for the taxable year computed without the deduction, less the decrease in tax for the prior taxable year (or years) that would have occurred if the item or portion thereof had been excluded from gross income in the prior taxable year (or years). Section 1341(a)(4) and (5). Section 1341 ensures that the taxpayer’s position is not worse than the position the taxpayer would have been in if the taxpayer had not included the item or portion thereof in gross income in the earlier year (except for the time value of money).

Section 1.1341–1(a)(1) of the Income Tax Regulations provides that § 1341 applies if the taxpayer is entitled to a deduction of more than $3,000 because of the restoration to another of an item that was included in the taxpayer’s gross income for a prior taxable year (or years) under a claim of right.

Under the claim of right doctrine, a taxpayer that receives an amount under a claim of right without restriction on disposition must include the amount in gross income in the taxable year received, notwithstanding that the taxpayer’s right to retain

the amount received may be uncertain and the taxpayer subsequently may be required to restore the amount to the rightful owner. North American Oil Consol. v. Burnet, 286 U.S. 417, 424 (1932). In United States v. Lewis, 340 U.S. 590 (1951), the Supreme Court concluded that a taxpayer who was required under the claim of right doctrine to include a bonus in income in the taxable year received, and who had to repay part of the bonus in a later year, could not amend his tax return for the earlier year. The taxpayer’s only remedy was to deduct the amount repaid in the taxable year in which the taxpayer restored it to the payor. The Court followed the principle that income is properly reported under the claim of right doctrine in the year received, consistent with a tax system based on annual rather than transactional accounting. See Burnet v. San- ford & Brooks Co., 282 U.S. 359, 364, 365 (1931).

The application of the claim of right doctrine may result in an inequity when, because of changes in tax rates or other circumstances, the tax increase resulting from the income inclusion in the earlier year exceeds the tax decrease that results from the deduction in the later year. Congress enacted § 1341 to ameliorate this inequity in cases such as Lewis, in which a taxpayer receives an amount that it is required in a later taxable year to restore or repay to another claimant. See S. Rep. No. 1622, 83d Cong. 2d Sess. 118 (1954) (“Under present law if a taxpayer is obligated to re- pay amounts which he had received in a prior year and included in income because it appeared that he had an unrestricted right to such amounts, he may take a deduction in the year of restitution”) (emphasis added); H.R. Rep. No. 1337, 83d Cong. 2d Sess. 86 (1954) (same). Section 1341(a)(2) requires that it be established after the close of the taxable year or years that the taxpayer did not have an unrestricted right to the item of gross income or portion thereof. To satisfy this test the taxpayer must repay or restore the item or portion of the item to another claimant. Section 1.1341–1(a)(1); see also Chernin v. United States, 149 F.3d 805 (8 ^th Cir. 1998) (relying on a “legislative history [that] is replete with references to repayment, restoration, and restitution”); S. Rep. No. 1622, 83d Cong. 2d Sess. at

2004-8 I.R.B. 517 February 23, 2004

Instead, the deduction must be allowable under another provision of the Code. Section 1.1341–1(a)(1); Wood v. United States, 863 F.2d 417, 420 (5 ^th Cir. 1989); MidAmerican Energy Co. v. Commis- sioner, 114 T.C. 570, 583 (2000), aff’d, 271 F.3d 740 (8 ^th Cir. 2001). Inventory costs under § 263A are recovered through cost of goods sold when the inventory is sold. Section 1.263A–1(c)(4). Costs of goods sold, or inventory costs, are not deductions but are properly treated as adjustments to gross income. Section 1.61–3(a). Environmental remediation costs incurred by reason of a production activity must be included in inventory costs. See Rev. Rul. 2004–18, 2004–8 I.R.B. 509 (clarifying Rev. Rul. 94–38, 1994–1 C.B. 35); § 1.263A–1(e)(3). Thus, under § 263A, N ’s environmental remediation costs are inventory costs, not deductions. Furthermore, in Situation 2, because the environmental remediation costs N incurs in 2004 would have been accounted for under N ’s method of accounting as inventory costs in 1950 through 1979 if incurred in those earlier years, the costs are properly treated as inventory costs under N ’s method of accounting when incurred in 2004. Therefore, N ’s environmental remediation costs do not qualify for treatment under § 1341 because the costs are inventory costs and do not satisfy the deduction requirement of § 1341(a)(2).

Section 1341(b)(2) provides that § 1341(a) does not apply to any deduction allowable with respect to an item included in gross income by reason of the sale or other disposition of the taxpayer’s stock in trade (or other property of a kind that would have been included in the taxpayer’s inventory if on hand at the close of the prior taxable year) or property held by the taxpayer primarily for sale to customers in the ordinary course of its trade or business. Thus, even if N ’s environmental remediation costs constituted deductible expenses rather than inventory costs recovered through cost of goods sold, § 1341(a) would not apply. N ’s environmental remediation costs are a consequence of the manufacture and sale of N ’s products and, if not an inventory cost, would be deductible as an ordinary and necessary business expense of selling N ’s products. Accordingly, in both Situations 1 and 2, the environmental remediation costs would be allowable with respect to

an item that is included in gross income by reason of the sale of N ’s products and would not be eligible for § 1341(a) treatment by reason of § 1341(b)(2).

HOLDING

Amounts paid or incurred in the current taxable year to remediate environmental contamination that occurred in prior taxable years do not qualify for treatment under § 1341.

DRAFTING INFORMATION

The principal author of this revenue ruling is Forest Boone of the Office of Associate Chief Counsel (Income Tax & Accounting). For further information regarding this revenue ruling, contact Mr. Boone at 202–622–4960 (not a toll-free call).

Section 6103.—Confi- dentiality and Disclosure of Returns and Return Information

26 CFR 301.6103(l)–1: Disclosure of returns and re- turn information for purposes other than tax admin- istration.

T.D. 9111

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 301

Definition of Agent for Certain Purposes

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations relating to the definition of agent for certain purposes. The final regulations clarify that the term agent in certain provisions of section 6103 of the Internal Revenue Code (Code) includes contractors.

DATES: Effective Date: These regulations are effective January 6, 2004.

Applicability Date: For dates of applicability, see §§301.6103(l)–1(b) and 301.6103(m)–1(b).

FOR FURTHER INFORMATION CONTACT: Helene R. Newsome, 202–622–4570 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document contains amendments to 26 CFR part 301 under section 6103(l) and (m) of the Code. On February 1, 2002, the Federal Register published a notice of proposed rulemaking (REG–120135–01, 2002–1 C.B. 552 [67 FR 4938]) regarding the definition of agent for certain purposes. No public comments or requests for hearing were received. The Treasury decision adopts the regulations as proposed.

Generally, returns and return information are confidential under section 6103 of the Code unless a specific statutory exception applies. In cases of non-tax-related disclosures, returns and return information generally may be disclosed only to officers and employees of Federal, state, and local government agencies, and not to contractors or agents of such agencies. In certain limited circumstances, however, Congress has permitted disclosures to “agents” of these agencies. See section 6103(l)(6)(B), (l)(12), (m)(2), (m)(4), (m)(5), (m)(7).

This document contains final regulations that clarify that the term agent in section 6103(l) and (m) includes contractors. Clarification that the term agent includes contractors is necessary for the purpose of bringing certain statutory grants of disclosure authority into alignment with the reality of many agencies’ operations. Agencies generally procure the services of third parties under public contracting laws, which do not necessarily incorporate common law concepts of agent . This clarification is also consistent with Congressional intent. For example, the Senate Finance Committee, in amending section 6103(m)(2), stated, “[a]gents are those who are engaged directly in performing or assisting in collection functions for the federal government, presumably, private collection agencies who have contracted with the government to collect claims ... .” S. Rep. No. 97–378, at 15 (1982).

This clarification does not provide any new disclosure authority, nor does it authorize the disclosure of return information to contractors that Congress has not previously specifically authorized in the Code.

February 23, 2004 518 2004-8 I.R.B.

With regard to protection of taxpayer data, agents/contractors are subject to safeguard requirements, redisclosure prohibitions, and civil and criminal penalties for unauthorized disclosures. Accordingly, the regulations do not have an impact on taxpayer privacy.

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) and (d) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Code, the notice of proposed rulemaking preceding these regulations was submitted to the Chief Counsel of the Small Business Administration for comment on its impact on small businesses.

Drafting Information

The principal author of these regulations is Helene R. Newsome, Office of the Associate Chief Counsel (Procedure & Administration), Disclosure & Privacy Law Division.

- - - -

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 301 is amended as follows:

PART 301 - PROCEDURE AND ADMINISTRATION

Paragraph 1. The authority citation for part 301 is amended by adding entries in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * * Section 301.6103(l)–1 also issued under 26 U.S.C. 6103(q).

Section 301.6103(m)–1 also issued under 26 U.S.C. 6103(q). - * *

Par. 2. Section 301.6103(l)–1 is added to read as follows:

§301.6103(l)–1 Disclosure of returns and return information for purposes other than tax administration.

(a) Definition . For purposes of applying the provisions of section 6103(l) of the Internal Revenue Code, the term agent includes a contractor.

(b) Effective date . This section is applicable January 6, 2004.

Par. 3. Section 301.6103(m)–1 is added to read as follows:

§301.6103(m)–1 Disclosure of taxpayer identity information.

(a) Definition . For purposes of applying the provisions of section 6103(m) of the Internal Revenue Code, the term agent includes a contractor.

(b) Effective date . This section is applicable January 6, 2004.

Mark E. Matthews, Deputy Commissioner for Services and Enforcement .

Approved December 16, 2003.

Pamela F. Olson, Assistant Secretary of the

Treasury (Tax Policy) .

(Filed by the Office of the Federal Register on December 31, 2003, 11:59 a.m., and published in the issue of the Federal Register for January 6, 2004, 69 F.R. 506)

Section 6662.—Imposition of Accuracy-Related Penalty

26 CFR 1.6662–2: Accuracy-related penalty.

T.D. 9109

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

Establishing Defenses to the Imposition of the Accuracy-Related Penalty

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations that affect the defenses available to the imposition of the accuracy-related penalty when taxpayers fail to disclose reportable transactions or fail to disclose that they have taken a return position based on the conclusion that a regulation is invalid. The final regulations are intended to promote disclosure of reportable transactions and positions based on the conclusion that a regulation is invalid by narrowing a taxpayer’s ability to establish good faith and reasonable cause as a defense. The final regulations also clarify the existing regulations with respect to the facts and circumstances to be considered in determining whether a taxpayer acted with reasonable cause and in good faith.

DATES: Effective Dates: These regulations are effective December 30, 2003.

Applicability Dates: These regulations apply to returns filed after December 31, 2002, with respect to transactions entered into on or after January 1, 2003.

FOR FURTHER INFORMATION CONTACT: Jamie G. Bernstein at (202) 622–4940 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document contains amendments to 26 CFR part 1. On December 31, 2002, the IRS and the Treasury Department published in the Federal Register proposed amendments to the regulations (REG–126016–01, 2003–1 C.B. 486 [67 FR 79894]) under sections 6662 and 6664 of the Internal Revenue Code (Code). No public hearing was requested or held. Written and electronic comments responding to the notice of proposed rulemaking were received. After consideration of all the comments, the proposed regulations under sections 6662 and 6664 are adopted as amended by this Treasury decision. The revisions are discussed below.

Explanation of Revisions and Summary of Comments

These final regulations generally adopt the provisions of the proposed regulations. The changes to the proposed regulations reflected in these final regulations, as well

2004-8 I.R.B. 519 February 23, 2004

the term advice . Neither the proposed nor the final regulations change the definition of the term advice.

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, and because these regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, the proposed regulations preceding these regulations were 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 Jamie Bernstein, Office of the Associate Chief Counsel (Procedure and Administration), Administrative Provisions and Judicial Practice Division.

- - - -

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1—INCOME TAXES

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

Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.6662–0 is amended by adding an entry for §1.6662–2(d)(5) to read as follows:

§1.6662–0 Table of Contents.

§1.6662–2 Accuracy-related penalty.

- - - (d) - * (5) Returns filed after December 31,

as comments received, are discussed below.

Applicability of Disclosure Regulations Under Section 6011 and Effective Date

These final regulations were proposed to apply to returns filed after December 30, 2002, with respect to transactions entered into on or after January 1, 2003, to coincide with temporary regulations relating to disclosure, promulgated under section 6011 and applicable for transactions entered into on or after January 1, 2003 (the Temporary Disclosure Regulations). The Temporary Disclosure Regulations were published in the Federal Register on October 22, 2002. See 67 FR 64799 (T.D. 9017, 2002–2 C.B. 815) and 67 FR 64840 (REG–103735–00, 2002–2 C.B. 832) (October 22, 2002). Final regulations under section 6011 were published on March 4, 2003, and apply to transactions entered into on or after February 28, 2003. See 68 FR 10161, 10163 (T.D. 9046, 2003–1 C.B. 614) (March 4, 2003) (the Final Disclosure Regulations). The Final Disclosure Regulations define reportable transactions more narrowly than the Temporary Disclosure Regulations. For transactions entered into on or after January 1, 2003, and before February 28, 2003, the taxpayer may apply the Final Disclosure Regulations instead of the Temporary Disclosure Regulations. Revisions throughout these final regulations refer to the definition of reportable transaction in §1.6011–4(b) or 1.6011–4T(b), as applicable, to accommodate situations in which the Temporary Disclosure Regulations apply to a transaction.

One commentator suggested that the final regulations under sections 6662 and 6664 apply to transactions entered into on or after February 28, 2003, because that date is the effective date for the Final Disclosure Regulations. See 68 FR 10161, 10163 (March 4, 2003). The final regulations do not adopt this recommendation. The proposed regulations under sections 6662 and 6664 provided adequate notice that failure to comply with the Temporary or Final Disclosure Regulations could limit the penalty defenses available under sections 6662 and 6664.

Applicability of the Reasonable Cause and Good Faith Defense

The proposed regulations prohibited reliance on tax advice to establish a reasonable cause and good faith defense to the accuracy-related penalties if a taxpayer failed to disclose a reportable transaction pursuant to the Final or Temporary Disclosure Regulations, as applicable. Three commentators suggested that it is inappropriate to preclude a taxpayer from relying on the advice of a tax advisor in circumstances in which the taxpayer does not lack good faith in failing to disclose a reportable transaction. The Treasury Department and the IRS believe that good faith requires taxpayers to be forthcoming and that taxpayers should construe the Final and Temporary Disclosure Regulations broadly in favor of disclosure. Nonetheless, there may be circumstances in which a taxpayer does not lack good faith in failing to disclose a reportable transaction. Accordingly, the final regulations revise the proposed regulations to provide that a taxpayer’s failure to disclose a reportable transaction is a strong indication that the taxpayer failed to act in good faith, which would bar relief under section 6664(c).

These final regulations also adopt the requirement in the proposed regulations that a taxpayer may not rely on an opinion or advice that a regulation is invalid to establish that the taxpayer acted with reasonable cause and in good faith unless the taxpayer adequately disclosed its position that the regulation is invalid. One commentator suggested that this provision is inappropriate because it would be difficult for a taxpayer to discern whether its position is contrary to a regulation without consulting with a tax advisor. This suggestion was rejected because the requirement of revised §1.6664–4(c)(2)(iii) does not apply to situations in which a taxpayer has taken a position that is merely contrary to a regulation, but instead applies to situations in which a taxpayer has taken a return position based on advice or an opinion that a regulation is invalid.

Definition of Advice

One commentator suggested that the proposed regulations more clearly define what constitutes professional advice or opinion. Section 1.6664–4(c)(2) defines

February 23, 2004 520 2004-8 I.R.B.

“§1.6664–4(e)” and adding the reference “§1.6664–4(f)” in its place.

Par. 6. Section 1.6664–0 is amended by:

Adding entries for §§1.6664–1 (b)(2)(i), (b)(2)(ii) and 1.6664–4(c)(1)(iii).
Redesignating the entries for §1.6664–4(d), (e), (f), and (g), as §1.6664–4(e), (f), (g), and (h), respectively.
Adding a new entry for §1.6664–4(d).

The additions read as follows:

§1.6664–0 Table of contents.

§1.6664–1 Accuracy-related and fraud penalties, definitions and special rules.

- - - (b) - - (2) - - (i) For returns due after September 1, 1995. (ii) For returns filed after December 31,

§1.6664–4 Reasonable cause and good faith exception to section 6662 penalties.

- - - (c) - - (1) - - (iii) Reliance on the invalidity of a regulation. (d) Underpayments attributable to reportable transactions.
- - - Par. 7. Section 1.6664–1 is amended by:

Redesignating the text of paragraph (b)(2) as (b)(2)(i).
Adding a new paragraph heading for newly designated paragraph (b)(2)(i).
Adding paragraph (b)(2)(ii). The revisions and additions are as follows:

§1.6664–1 Accuracy-related and fraud penalties; definitions and special rules.

- - - (b) * * * (1) * * * (2) - - - (i) For returns due after September 1, 1995 . - * *

Par. 3. Section 1.6662–2 is amended by:

Revising the first sentence of paragraph (d)(2).
Adding new paragraph (d)(5). The revision and addition read as follows:

§1.6662–2 Accuracy-related penalty.

- - - (d) * * * (1) * * * (2) - - - Except as provided in paragraphs (d)(3), (4) and (5) of this section and the last sentence of this paragraph (d)(2), the provisions of §§1.6662–1 through 1.6662–4 and §1.6662–7 (as revised to reflect the changes made to the accuracy-related penalty by the Omnibus Budget Reconciliation Act of 1993) and of §1.6662–5 apply to returns the due date of which (determined without regard to extensions of time for filing) is after December 31, 1993. - * *
- - - (5) For returns filed after Decem- ber 31, 2002 . Sections 1.6662–3(a), 1.6662–3(b)(2) and 1.6662–3(c)(1) (relating to adequate disclosure) apply to returns filed after December 31, 2002, with respect to transactions entered into on or after January 1, 2003. Except as provided in paragraph (d)(1) of this section, §§1.6662–3(a), 1.6662–3(b)(2) and 1.6662–3(c)(1) (as contained in 26 CFR part 1 revised April 1, 2003) apply to returns filed with respect to transactions entered into prior to January 1, 2003.

Par. 4. Section 1.6662–3 is amended by revising paragraph (a), the last sentence of paragraph (b)(2), and the first sentence of paragraph (c)(1) to read as follows:

§1.6662–3 Negligence or disregard of rules or regulations.

(a) In general . If any portion of an underpayment, as defined in section 6664(a) and §1.6664–2, of any income tax imposed under subtitle A of the Internal Revenue Code that is required to be shown on a return is attributable to negligence or disregard of rules or regulations, there is added to the tax an amount equal to 20 percent of such portion. The penalty for disregarding rules or regulations does not apply, however, if the requirements of paragraph (c)(1) of this section are satisfied

and the position in question is adequately disclosed as provided in paragraph (c)(2) of this section (and, if the position relates to a reportable transaction as defined in §1.6011–4(b) (or §1.6011–4T(b), as applicable), the transaction is disclosed in accordance with §1.6011–4 (or §1.6011–4T, as applicable)), or to the extent that the reasonable cause and good faith exception to this penalty set forth in §1.6664–4 applies. In addition, if a position with respect to an item (other than with respect to a reportable transaction, as defined in §1.6011–4(b) or §1.6011–4T(b), as applicable) is contrary to a revenue ruling or notice (other than a notice of proposed rulemaking) issued by the Internal Revenue Service and published in the Internal Revenue Bulletin (see §601.601(d)(2) of this chapter), this penalty does not apply if the position has a realistic possibility of being sustained on its merits. See §1.6694–2(b) of the income tax return preparer penalty regulations for a description of the realistic possibility standard.

(b)* * * * * (2)* - - Nevertheless, a taxpayer who takes a position (other than with respect to a reportable transaction, as defined in §1.6011–4(b) or §1.6011–4T(b), as applicable) contrary to a revenue ruling or notice has not disregarded the ruling or notice if the contrary position has a realistic possibility of being sustained on its merits.

- - - (c)* * * (1) * * * No penalty under section 6662(b)(1) may be imposed on any portion of an underpayment that is attributable to a position contrary to a rule or regulation if the position is disclosed in accordance with the rules of paragraph (c)(2) of this section (and, if the position relates to a reportable transaction as defined in §1.6011–4(b) (or §1.6011–4T(b), as applicable), the transaction is disclosed in accordance with §1.6011–4 (or §1.6011–4T, as applicable)) and, in case of a position contrary to a regulation, the position represents a good faith challenge to the validity of the regulation. - * *

§1.6662–4 [Amended]

Par. 5. Section 1.6662–4(g)(1)(iv) is amended by removing the reference to

2004-8 I.R.B. 521 February 23, 2004

knows, or reasonably should know, to be relevant to the proper tax treatment of an item.

- - - (iii) Reliance on the invalidity of a reg- ulation . A taxpayer may not rely on an opinion or advice that a regulation is invalid to establish that the taxpayer acted with reasonable cause and good faith unless the taxpayer adequately disclosed, in accordance with §1.6662–3(c)(2), the position that the regulation in question is invalid.

(d) Underpayments attributable to re- portable transactions . If any portion of an underpayment is attributable to a reportable transaction, as defined in §1.6011–4(b) (or §1.6011–4T(b), as applicable), then failure by the taxpayer to disclose the transaction in accordance with §1.6011–4 (or §1.6011–4T, as applicable) is a strong indication that the taxpayer did not act in good faith with respect to the portion of the underpayment attributable to the reportable transaction.

Mark E. Matthews, Deputy Commissioner for Services and Enforcement .

Approved December 18, 2003.

Pamela F. Olson, Assistant Secretary of the Treasury .

(Filed by the Office of the Federal Register on December 29, 2003, 8:45 a.m., and published in the issue of the Federal Register for December 30, 2003, 68 F.R. 75126)

(ii) For returns filed after December 31, 2002 . Sections 1.6664–4(c) (relating to relying on opinion or advice) and (d) (relating to underpayments attributable to reportable transactions) apply to returns filed after December 31, 2002, with respect to transactions entered into on or after January 1, 2003. Except as provided in paragraph (b)(2)(i) of this section, §1.6664–4 (as contained in 26 CFR part 1 revised April 1, 2003) applies to returns filed with respect to transactions entered into before January 1, 2003.

Par. 8. Section 1.6664–4 is amended by:

Removing the language “(g) of this section” from the last sentence of paragraph (a) and adding the language “(h) of this section” in its place.
Revising paragraph (c)(1) introductory text and the last sentence of paragraph (c)(1)(i).
Adding paragraph (c)(1)(iii).
Redesignating paragraphs (d), (e), (f) and (g) as paragraphs (e), (f), (g) and (h), respectively.
Adding a new paragraph (d).
Removing the language “(e)” wherever it appears in newly designated paragraphs (f)(1), (f)(2)(i), (f)(2)(ii), (f)(3), and (f)(4) and adding the language “(f)” in its place.
Removing the language “(g)” wherever it appears in newly designated paragraphs (h)(1), (h)(1)(i), (h)(2), and (h)(3) and adding the language “(h)” in its place.

The revisions and additions read as follows:

§1.6664–4 Reasonable cause and good faith exception to section 6662 penalties.

- - - (c) Reliance on opinion or advice —(1) Facts and circumstances; minimum re- quirements . All facts and circumstances must be taken into account in determining whether a taxpayer has reasonably relied in good faith on advice (including the opinion of a professional tax advisor) as to the treatment of the taxpayer (or any entity, plan, or arrangement) under Federal tax law. For example, the taxpayer’s education, sophistication and business experience will be relevant in determining whether the taxpayer’s reliance on tax advice was reasonable and made in good faith. In no event will a taxpayer be considered to have reasonably relied in good faith on advice (including an opinion), unless the requirements of this paragraph (c)(1) are satisfied. The fact that these requirements are satisfied, however, will not necessarily establish that the taxpayer reasonably relied on the advice (including the opinion of a tax advisor) in good faith. For example, reliance may not be reasonable or in good faith if the taxpayer knew, or reasonably should have known, that the advisor lacked knowledge in the relevant aspects of Federal tax law.

(i) - - - In addition, the requirements of this paragraph (c)(1) are not satisfied if the taxpayer fails to disclose a fact that it

February 23, 2004 522 2004-8 I.R.B.