Part I. Rulings — Internal Revenue Bulletin 2004-21

Section 197.—Amortization of Goodwill and Certain Other Intangibles

26 CFR 197–2: Amortization of goodwill and certain other intangibles.

If, pursuant to section 1.704–1(b)(2)(iv)( f ) of the Income Tax Regulations, a partnership revalues a section 197 intangible, may the partnership allocate amortization with respect to the section 197 intangible so as to take into account the built-in gain or loss from the revaluation? See Rev. Rul. 2004-49, page 939.

26 CFR 1.197–2: Amortization of goodwill and cer- tain other intangibles. (Also §§ 704; 1.704–1; 1.704–3.)

Partnerships; amortization of in- tangibles. This ruling provides that if a section 197(f)(9) intangible is amortizable in the hands of a partnership, the anti-churning rules under section 1.197–2(h)(12)(vii)(A) of the regulations do not apply to curative or remedial reverse section 704(c) allocations of amortization. It also provides that if a section 197(f)(9) intangible was not amortizable in the hands of the partnership, then remedial, not curative, reverse section 704(c) allocations of amortization are permitted.

Rev. Rul. 2004–49

ISSUE

If, pursuant to § 1.704–1(b)(2)(iv)( f ) of the Income Tax Regulations, a partnership revalues a section 197 intangible, may the partnership allocate amortization with respect to the section 197 intangible so as to take into account the built-in gain or loss from the revaluation?

FACTS

Situation 1 . A and B are partners in the AB partnership. C contributes money (more than a de minimis amount) to the partnership in exchange for a partnership interest. The partnership revalues the assets of the partnership under § 1.704–1(b)(2)(iv)( f ). The AB partnership owns several assets, including Asset 1, a section 197 intangible. Asset 1 is

amortizable in the hands of the partnership. A, B, and C are not related.

Situation 2 . Situation 2 is the same as Situation 1 except that Asset 1 is not amortizable in the hands of the partnership.

LAW

Section 197(a) provides that a taxpayer is entitled to an amortization deduction with respect to any amortizable section 197 intangible. The amount of the deduction is determined by amortizing the adjusted basis (for purposes of determining gain) of the intangible ratably over the 15-year period beginning with the month in which the intangible was acquired.

Section 197(c)(1) provides that, with certain exceptions, the term “amortizable section 197 intangible” means any section 197 intangible, (A) that is acquired by the taxpayer after the date of the enactment of § 197, and (B) that is held in connection with the conduct of a trade or business or an activity described in § 212.

Section 197(d)(1) provides that the term “section 197 intangible” means (A) goodwill; (B) going concern value; (C) any of the following intangible items: (i) workforce in place including its composition and terms and conditions (contractual or otherwise) of its employment, (ii) business books and records, operating systems, or any other information base (including lists or other information with respect to current or prospective customers), (iii) any patent, copyright, formula, process, design, pattern, knowhow, format, or other similar items, (iv) any customer-based intangible, (v) any supplier-based intangible, and (vi) any other similar item; (D) any license, permit, or other right granted by a governmental unit or an agency or instrumentality thereof; (E) ) any covenant not to compete (or other arrangement to the extent the arrangement has substantially the same effect as a covenant not to compete) entered into in connection with an acquisition (directly or indirectly) of an interest in a trade or business or substantial portion thereof; and (F) any franchise, trademark, or trade name.

Under § 197(f)(9)(A), the term “amortizable section 197 intangible” does not in

clude any section 197 intangible that is goodwill or going concern value (or for which depreciation or amortization would not have been allowable but for § 197) and that is acquired by the taxpayer after the date of the enactment of § 197, if (i) the intangible was held or used at any time on or after July 25, 1991, and on or before such date of enactment by the taxpayer or a related person, (ii) the intangible was acquired from a person who held such intangible at any time on or after July 25, 1991, and on or before such date of enactment, and, as part of the transaction, the user of such intangible does not change, or (iii) the taxpayer grants the right to use such intangible to a person (or a person related to such person) who held or used such intangible at any time on or after July 25, 1991, and on or before such date of enactment.

An intangible described in § 197(f)(9) (a section 197(f)(9) intangible) is treated as an amortizable section 197 intangible only to the extent permitted under § 1.197–2(h). The purpose of the anti-churning rules of § 197(f)(9) and § 1.197–2(h) is to prevent the amortization of section 197(f)(9) intangibles unless they are transferred after the applicable effective date in a transaction giving rise to a significant change in ownership or use. Section 1.197–2(h)(1)(ii). Section 1.197–2(h)(12) provides special rules that apply for purposes of determining whether transactions involving partnerships give rise to a significant change in ownership or use.

Under § 1.197–2(h)(5), a section 197(f)(9) intangible may be amortized by the acquirer of the intangible if the intangible was an amortizable section 197 intangible in the hands of the seller (or transferor), but only if the acquisition transaction and the transaction in which the seller (or transferor) acquired the intangible or interest therein are not part of a series of related transactions.

Under § 704(b), a partner’s distributive share of income, gain, loss, deduction, or credit (or item thereof) is determined in accordance with the partnership agreement provided that those allocations have substantial economic effect. If the allocations under the partnership agreement do not have substantial economic effect or the

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does not contravene the purposes of the anti-churning rules.

ANALYSIS

If, under § 1.704–1(b)(2)(iv)( f ), a partnership revalues a section 197 intangible that is amortizable in the hands of the partnership, then the partnership may make allocations of amortization deductions with respect to the built-in gain or loss from the revaluation ( i.e., the increase or decrease, respectively, in the book value of the intangible as a result of the revaluation) to all of its partners under any of the permissible methods described in § 1.704–3. If the revalued section 197 intangible is not amortizable in the hands of the partnership, then §§ 1.197–2(g)(4)(ii) and 1.197–2(h)(12)(vii) generally prevent the partnership from allocating amortization with respect to the intangible under § 1.704–3(a)(6)(i), but do not prevent the partnership from making remedial allocations of amortization with respect to the intangible. However, remedial allocations of amortization with respect to built-in gain or loss from the revaluation of a section 197(f)(9) intangible are not allowed to the extent that such allocations are, in substance, the equivalent of a remedial allocation of amortization to a partner that is related to the “contributing partner” (with respect to the revaluation). Also, under § 1.197–2(h)(12)(vii)(B), remedial allocations of amortization with respect to the built-in gain or loss from the revaluation of a section 197(f)(9) intangible are not allowed if, as part of a series of related transactions that includes the revaluation, the “contributing partners” (with respect to the revaluation) or related persons (other than the partnership) become (or remain) direct users of the intangible.

In Situation 1, the partnership may make traditional, curative, or remedial allocations of amortization under § 1.704–3 to take into account the built-in gain or loss from the revaluation of Asset 1. Section 1.197–2(g)(4)(i). Because Asset 1 is amortizable in the hands of the AB partnership, the anti-churning rules do not apply to reverse § 704(c) allocations of amortization from Asset 1.

In Situation 2, because Asset 1 is not amortizable in the hands of AB, the anti-churning rules apply. Under §197–2(g)(4)(ii) and (h)(12)(vii)(B), the

partnership agreement does not provide as to a partner’s distributive shares of partnership items, then the partner’s distributive share of such items is determined in accordance with the partner’s interest in the partnership (determined by taking into account all facts and circumstances).

Section 1.704–1(b) describes various requirements that must be met for partnership allocations to have substantial economic effect. Among these requirements is that (except as otherwise provided in § 1.704–1(b)) the partnership agreement must provide for the determination and maintenance of capital accounts in accordance with the rules of § 1.704–1(b)(2)(iv).

Section 1.704–1(b)(2)(iv)( f ) provides that, if certain criteria are met, the capital account maintenance rules of § 1.704–1(b)(2)(iv) will not be violated if a partnership agreement, upon the occurrence of certain events, increases or decreases the capital accounts of the partners to reflect a revaluation of partnership property (including intangibles such as goodwill) on the partnership’s books.

Section 704(c)(1)(A) provides that, under regulations prescribed by the Secretary, income, gain, loss, and deduction with respect to property contributed to the partnership by a partner shall be shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of contribution.

Section 1.704–3 provides rules applicable to partnership allocations under § 704(c)(1)(A). Section 1.704–3(a)(1) provides that allocations under § 704(c)(1)(A) must be made using a reasonable method that is consistent with the purpose of § 704(c). Section 1.704–3 describes three allocation methods that are generally reasonable: the traditional method, the traditional method with curative allocations, and the remedial allocation method.

Section 1.704–3(a)(6)(i) provides that the principles of § 1.704–3 apply to allocations with respect to property for which differences between book value and adjusted tax basis are created when a partnership revalues partnership property pursuant to § 1.704–1(b)(2)(iv)( f ) (reverse § 704(c) allocations). Partnerships are not required to use the same allocation method for reverse § 704(c) allocations as for contributed property, even if at the

time of revaluation the property is already subject to §§ 704(c)(1)(A) and 1.704–3.

Section 1.197–2(g)(4)(i) provides that, to the extent that an intangible was an amortizable section 197 intangible in the hands of the contributing partner, a partnership may make allocations of amortization deductions with respect to the intangible to all of its partners under any of the permissible methods described in the regulations under § 704(c).

Section 1.197–2(g)(4)(ii) provides that, to the extent that an intangible was not an amortizable section 197 intangible in the hands of the contributing partner, the intangible is not amortizable by the partnership. However, if a partner contributes a section 197 intangible to a partnership and the partnership adopts the remedial allocation method for making § 704(c) allocations of amortization deductions, the partnership generally may make remedial allocations of amortization deductions with respect to the contributed section 197 intangible in accordance with § 1.704–3(d).

Section 1.197–2(h)(12)(vii)(A) provides that the anti-churning rules do not apply to curative or remedial allocations of amortization with respect to a section 197(f)(9) intangible if the intangible was an amortizable section 197 intangible in the hands of the contributing partner (unless § 1.197–2(h)(10) causes the intangible to cease to be an amortizable section 197 intangible in the hands of the partnership).

Section 1.197–2(h)(12)(vii)(B) provides that, if a section 197(f)(9) intangible was not amortizable in the hands of the contributing partner, a non-contributing partner generally may receive remedial allocations of amortization under § 704(c) that are deductible for federal income tax purposes. However, such a partner may not receive remedial allocations of amortization under § 704(c) if that partner is related to the partner that contributed the intangible or if, as part of a series of related transactions that includes the contribution of the section 197(f)(9) intangible to the partnership, the contributing partner or related person (other than the partnership) becomes (or remains) a direct user of the contributed intangible. Under § 1.197–2(h)(12)(vii)(B), taxpayers may use any reasonable method to determine amortization of the asset for book purposes, provided that the method used

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partnership may make deductible remedial, but not traditional or curative, allocations of amortization to take into account the built-in gain or loss from the revaluation of Asset 1, provided that such allocations are not limited by § 1.197–2(h)(12)(vii)(B).

HOLDING

If, pursuant to § 1.704–1(b)(2)(iv)( f ), a partnership revalues a section 197 intangible that was amortizable in the hands of the partnership, then the § 197 anti-churning rules do not apply and the partnership may make reverse § 704(c) allocations (including curative and remedial allocations) of amortization to take into account the built-in gain or loss from the revaluation of the intangible. If the revalued section 197 intangible was not amortizable in the hands of the partnership, then the partnership may make remedial, but not traditional or curative, allocations of amortization to take into account the built-in gain or loss from the revaluation of the intangible, provided that such allocations are not limited by § 1.197–2(h)(12)(vii)(B).

DRAFTING INFORMATION

The principal author of this revenue ruling is Laura C. Nash of the Office of Associate Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling, contact Ms. Nash at (202) 622–3050 (not a toll-free call).

Section 246A.—Dividends Received Deduction Reduced Where Portfolio Stock is Debt Financed

Generally, section 246A reduces the dividend received deduction otherwise allowable under sections 243, 244, or 245(a) in proportion to the extent that the portfolio stock, with respect to which the dividends are received, is debt-financed. Stock is treated as debt-financed if there is indebtedness directly attributable to the stock investment. See Announcement 2004-44, page 957, and Rev. Rul. 2004-47, page 941.

Section 265.—Expenses and Interest Relating to Tax-Exempt Income

Section 265(a) disallows expenses that would otherwise be allowable as a deduction when these expenses are allocable to income that is wholly exempt from Federal Income taxes. Section 265(a)(2) disallows interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is wholly exempt from Federal income taxes. See Announcement 2004-44, page 957, and Rev. Rul. 2004-47, page 941.

26 CFR 1.265–2: Interest relating to tax-exempt in- come.

Section 265(a)(2); expenses and inter- est relating to tax-exempt income. This ruling deals with the application of section 265 of the Code to affiliated corporate groups when one member of the group borrows from outside the group and makes funds available to another member of the group that is a dealer in tax-exempt securities.

Rev. Rul. 2004–47

ISSUE

If a member of an affiliated group borrows money and transfers the money to another member of the group that is a dealer in tax-exempt obligations, does § 265(a)(2) of the Internal Revenue Code apply to disallow the interest expense of the borrowing corporation?

FACTS

Situation 1 . - P and S are corporations that are members of the same affiliated group, but file separate tax returns. P and S use the calendar year as their taxable year. S is a dealer in tax-exempt obligations, whose general business includes purchasing and carrying tax-exempt securities.

On January 1, 2004, L, a bank unrelated to the affiliated group that includes P and S, lends $40x to P for 5 years. L’s loan to P provides for payments of interest on December 31 of each year at a rate higher than the appropriate applicable Federal rate. P contributes the $40x borrowed from L to the capital of S, and S uses the contributed funds in its business. Although the borrowed funds are directly traceable from P to S, they are not directly traceable to

the purchase or carry of specific tax-exempt obligations by S. During its taxable year 2004, S holds an average of $500x of tax-exempt obligations (valued at their adjusted bases), and an average of $1,000x of total assets (valued at their adjusted bases). During its taxable year 2004, P holds an average of $10,000x of total assets (valued at their adjusted bases) and no tax-exempt obligations in the active conduct of its trade or business, and incurs $2x of interest expense on its $40x loan from L.

Situation 2 . - The facts are the same as in Situation 1, except that P and S file a consolidated return.

Situation 3 . - The facts are the same as in Situation 1, except that the funds that P borrowed from L are not directly traceable to any funds transferred from P to S and there is no other direct evidence linking the borrowed funds to any funds transferred from P to S.

Situation 4 . - The facts are the same as in Situation 1, except that P loans to S the $40x borrowed from L on the same terms and conditions as the loan from L to P. During its taxable year 2004, S incurs $2x of interest expense on its $40x loan from P.

LAW AND ANALYSIS

In general, a deduction is allowed under § 163 of the Code for all interest paid or accrued on indebtedness. Under § 265(a)(2), however, no deduction is allowed for interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is wholly exempt from Federal income taxes.

Rev. Proc. 72–18, 1972–1 C.B. 740, sets forth guidelines for the application of § 265(a)(2). Section 3.01, which applies to all taxpayers, states that the application of § 265(a)(2) requires a determination of the taxpayer’s purpose in incurring or continuing each item of indebtedness, based on all the facts and circumstances. That section further states that the taxpayer’s purpose may be established by either direct or circumstantial evidence.

Section 3.02 of Rev. Proc. 72–18 provides that direct evidence of a purpose to purchase tax-exempt obligations exists when the proceeds of indebtedness are used for, and are directly traceable to, the purchase of tax-exempt obligations. Wynn v. United States, 411 F.2d 614 (3d

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Cir. 1969), cert. denied, 396 U.S. 1008 (1970). Section 265(a)(2) does not apply, however, when proceeds of a bona fide business indebtedness are temporarily invested in tax-exempt obligations under circumstances similar to those set forth in Rev. Rul. 55–389, 1955–1 C.B. 276.

Section 3.03 of Rev. Proc. 72–18 provides that direct evidence of a purpose to carry tax-exempt obligations exists when tax-exempt obligations are used as collateral for indebtedness. “[One] who borrows to buy tax-exempts and one who borrows against tax-exempts already owned are in virtually the same economic position. Section 265(2) [the predecessor of § 265(a)(2)] makes no distinction between them.” Wisconsin Cheeseman v. United States, 388 F.2d 420 (7 ^th Cir. 1968), at 422. Section 3.04 of Rev. Proc. 72–18 states that in the absence of direct evidence linking indebtedness with the purchase or carrying of tax-exempt obligations as illustrated in paragraphs 3.02 and 3.03 of Rev. Proc. 72–18, section 265(a)(2) of the Code will apply only if the totality of facts and circumstances supports a reasonable inference that the purpose to purchase or carry tax-exempt obligations exists. Stated alternatively, section 265(a)(2) will apply only when the totality of facts and circumstances establishes a “sufficiently direct relationship” between the borrowing and the investment in tax-exempt obligations. See Wisconsin Cheeseman, 388 F.2d at 422. The guidelines set forth in sections 4, 5, and 6 of Rev. Proc. 72–18 are used to determine whether such a relationship exists.

Section 3.05 of Rev. Proc. 72–18 provides that generally, when a taxpayer’s investment in tax-exempt obligations is insubstantial, the purpose to purchase or carry tax-exempt obligations will ordinarily not be inferred in the absence of direct evidence as set forth in sections 3.02 and 3.03 of that revenue procedure. Section 3.05 provides further that in the case of a corporation, an investment in tax-exempt obligations shall be presumed insubstantial only when during the taxable year the average amount of the tax-exempt obligations (valued at their adjusted bases) does not exceed 2 percent of the average total assets (valued at their adjusted bases) held in the active conduct of the trade or business. The de minimis rule of paragraph 3.05 does not apply to dealers in tax-exempt obligations.

Section 5 of Rev. Proc. 72–18 provides special rules for dealers in tax-exempt obligations. Specifically, section 5.03 states that if debt is incurred or continued for the general purpose of carrying on a brokerage business that includes the purchase of both taxable and tax-exempt obligations, and the use of the borrowed funds cannot be directly traced, it is reasonable to infer that the borrowed funds were used for all the activities of the business, including the purchase of tax-exempt obligations. Section 5 of Rev. Proc. 72–18 refers to a specific allocation formula in section 7 of Rev. Proc. 72–18, derived from the formula in Commissioner v. Leslie, 413 F.2d 636 (2d. Cir. 1969), cert. denied, 396 U.S. 1007 (1970). The formula is applied to interest on borrowed funds that are not directly traceable to tax-exempt obligations. The formula consists of a fraction, whose numerator is the average amount during the taxable year of the taxpayer’s tax-exempt obligations (valued at their adjusted bases), and whose denominator is the average amount during the taxable year of the taxpayer’s total assets (valued at their adjusted bases) minus the amount of any indebtedness the interest on which is not subject to disallowance to any extent under Rev. Proc. 72–18.

In H Enterprises International v. Com- missioner, 75 T.C.M. 1948 (1998), aff’d, 183 F.3d 907 (8 ^th Cir. 1999), a parent and a subsidiary were members of the same consolidated group of corporations. The subsidiary declared a dividend and, a few days later, borrowed funds and immediately used part of those funds to make the dividend distribution to the parent. A portion of the distributed funds was disbursed to two investment divisions of the parent, which used the funds to acquire investments including tax-exempt obligations.

The court held that a portion of the subsidiary’s indebtedness was incurred for the purpose of purchasing or carrying tax-exempt obligations (held in the parent’s investment divisions) and, therefore, no deduction was allowed for the interest on this portion of the indebtedness under § 265(a)(2). To establish the required purposive connection under § 265(a)(2), the court reasoned that the activities of the parent corporation were relevant in determining the subsidiary’s purpose for borrowing the funds. If the analysis only focused on the borrower and

not the transferee, then the purpose of the borrower corporation would always be acceptable, frustrating the legislative intent of § 265(a)(2).

In both Situations 1 and 2, following the rationale of H Enterprises, the activities of S must be taken into account to determine P’s purpose under § 265(a)(2) for borrowing the $40x of funds that are directly traceable to P’s contribution to the capital of S. In order to determine the activities of S, however, Rev. Proc. 72–18 must be applied. Because S’s brokerage business includes the purchase of both taxable and tax-exempt obligations, it is reasonable to infer under section 5.03 of Rev. Proc. 72–18 that part of P’s debt was incurred for the purpose of purchasing or carrying tax-exempt obligations. Applying the allocation formula in section 7 of Rev. Proc. 72–18, the interest expense incurred by P on the $40x borrowed is subject to partial disallowance. The ratio of S’s average tax-exempt obligations to S’s total assets is $500x/$1,000x. Therefore, one-half of the $2x interest expense incurred by P ( i.e., $1x) is disallowed as a deduction to P under § 265(a)(2). P is not entitled to the 2 percent de minimis rule provided by section 3.05 of Rev. Proc. 72–18 because S is a dealer in tax-exempt obligations.

In Situation 3, there is no direct evidence that P transferred to S any portion of the $40X P borrowed from L. Without such direct evidence, the activities of S will not be taken into account to determine P’s purpose under § 265(a)(2) for borrowing the $40x and it is not reasonable to infer that part of P’s debt was incurred for the purpose of purchasing or carrying tax-exempt obligations. Therefore, none of the $2x interest expense incurred by P is disallowed as a deduction under § 265(a)(2).

In Situation 4, the $40x that P borrowed from L is directly traceable to P’s loan to S. Accordingly, the two separate back-to-back loans ( i.e., the loan from L to P, followed by the loan from P to S) must each be examined for the potential application of § 265(a)(2). With regard to the loan from L to P, P uses the borrowed funds to make a loan to S, and separately accounts for the taxable interest income from this loan. P does not have a purpose of using the borrowed funds to purchase or carry tax-exempt obligations within the meaning of § 265(a)(2). With regard to the loan from P to S, although the borrowed

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funds are not directly traceable to S’s purchase or carry of tax-exempt obligations, § 265(a)(2) applies to S, a dealer in tax-exempt obligations, to disallow a portion of its interest expense. The portion of S’s interest deduction that is disallowed is computed by applying the allocation formula in section 7 of Rev. Proc. 72–18. The ratio of S’s average tax-exempt obligations to S’s total assets is $500x/$1,000x. Accordingly, one-half of the $2x interest expense incurred by S ( i.e., $1x) is disallowed to S as a deduction under § 265(a)(2). S is not entitled to the 2 percent de minimis rule provided by section 3.05 of Rev. Proc. 72–18 because S is a dealer in tax-exempt obligations.

HOLDINGS

If a member of an affiliated group borrows money and contributes the borrowed funds to another member that is a dealer in tax-exempt obligations such that the funds contributed to the dealer are directly traceable to the contributor’s borrowing, but are not directly traceable to the dealer’s purchase or carry of tax-exempt obligations, § 265(a)(2) applies to disallow a portion of the interest expense of the contributor. The portion of the contributor’s interest deduction to be disallowed is determined by applying the allocation formula in section 7 of Rev. Proc. 72–18 to the dealer that uses the borrowed funds in its business.

If a member of an affiliated group borrows money and there is no direct evidence linking the borrowed funds to any funds transferred to another member who is a dealer in tax-exempt obligations, § 265(a)(2) does not apply to disallow any portion of the interest expense of the borrowing member based on the dealer member’s investment in tax-exempt obligations.

If the funds borrowed by a member of an affiliated group are directly traceable to a loan to another member that is a dealer in tax-exempt obligations, § 265(a)(2) does not apply to disallow the interest expense of the lending member, but does apply to disallow a portion of the interest expense of the dealer. The portion of the dealer’s interest deduction to be disallowed is determined by applying the allocation formula in section 7 of Rev. Proc. 72–18.

DRAFTING INFORMATION

The principal authors of this revenue ruling are David B. Silber and Avital Grunhaus of the Office of the Associate Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling, contact Mr. Silber or Ms. Grunhaus at (202) 622–3930 (not a toll-free call).

Section 446.—General Rule for Methods of Accounting

26 CFR 1.446–1: General rule for methods of ac- counting.

Rev. Proc. 2004–30 provides automatic consent procedures for taxpayers to change their method of accounting for income from REMIC inducement fees to a safe harbor method set forth in T.D. 9128, published May 11, 2004, in the Federal Register. See Rev. Proc. 2004-30, page 950.

26 CFR 1.446–6: REMIC inducement fees.

T.D. 9128

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

Real Estate Mortgage Investment Conduits; Application of Section 446 With Respect to Inducement Fees

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulation.

SUMMARY: This document contains final regulations relating to the proper timing and source of income from fees received to induce taxpayers to become the holders of noneconomic residual interests in Real Estate Mortgage Investment Conduits (REMICs).

DATES: Effective Date : These regulations are effective May 11, 2004.

Applicability Dates : For dates of applicability of the final regulations, see §§1.446–6(g) and 1.863–1(f).

FOR FURTHER INFORMATION CONTACT: For information concerning accounting for inducement fees relating to noneconomic REMIC residual interests, contact John W. Rogers III at (202) 622–3950 (not a toll-free number). For information concerning the source of REMIC inducement fee income, contact Bethany Ingwalson at (202) 622–3850 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document contains amendments to the Income Tax Regulations (26 CFR part 1) under sections 446(b) (relating to general rules for methods of accounting), 860C (relating to other definitions and special rules applicable to REMICs), and 863(a) (relating to special rules for determining source) of the Internal Revenue Code of 1986 (Code). On July 21, 2003, the IRS and Treasury Department published a notice of proposed rulemaking (REG–162625–02, 2003–35 I.R.B. 500

[68 FR 43055]) in the Federal Register.

In the notice of proposed rulemaking, the IRS and Treasury Department requested comments on the proper method of accounting to be used by taxpayers for inducement fee income. No written or electronic comments were received from the public in response to the notice of proposed rulemaking. No requests to speak at the public hearing were received, and, accordingly, the hearing was canceled. Therefore, these final regulations adopt without substantive changes the proposed regulations set out in the notice of proposed rulemaking.

Explanation of Provisions

Final regulations governing REMICs, issued in 1992, contain rules governing the transfer of noneconomic residual interests. Those regulations do not, however, contain rules that address the transferee’s treatment of the fee received to induce the transferee to become the holder of a noneconomic residual interest. Following release of the final REMIC regulations, the IRS and the Treasury Department received requests for guidance on the proper method of accounting to be used by taxpayers for inducement fee income. These

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noneconomic residual interest with respect to which the inducement fee is paid.

(2) Inducement fee . An inducement fee is the amount paid to induce a person to become the holder of a noneconomic residual interest in an applicable REMIC.

(3) Noneconomic residual interest . A REMIC residual interest is a noneconomic residual interest if it is a noneconomic residual interest within the meaning of §1.860E–1(c)(2).

(4) Remaining anticipated weighted average life . The remaining anticipated weighted average life is the anticipated weighted average life determined using the methodology set forth in §1.860E–1(a)(3)(iv) applied as of the date of acquisition of the noneconomic residual interest.

(5) REMIC . The term REMIC has the same meaning in this section as given in §1.860D–1.

(c) General rule . All taxpayers, regardless of their overall method of accounting, must recognize an inducement fee over the remaining expected life of the applicable REMIC in a manner that reasonably reflects, without regard to this paragraph, the after-tax costs and benefits of holding that noneconomic residual interest.

(d) Special rule on disposition of a residual interest . If any portion of an inducement fee received with respect to becoming the holder of a noneconomic residual interest in an applicable REMIC has not been recognized in full by the holder as of the time the holder transfers, or otherwise ceases to be the holder for Federal tax purposes of, that residual interest in the applicable REMIC, then the holder must include the unrecognized portion of the inducement fee in income at that time. This rule does not apply to a transaction to which section 381(c)(4) applies.

(e) Safe harbors . If inducement fees are recognized in accordance with a method described in this paragraph (e), that method complies with the requirements of paragraph (c) of this section.

(1) The book method . Under the book method, an inducement fee is recognized in accordance with the method of accounting, and over the same period, used by the taxpayer for financial reporting purposes (including consolidated financial statements to shareholders, partners, beneficiaries, and other proprietors and

regulations provide rules relating to the proper timing and source of income from an inducement fee received in connection with becoming the holder of a noneconomic residual interest in a REMIC.

The notice of proposed rulemaking published on July 21, 2003, stated that, to clearly reflect income, an inducement fee must be included in income over a period that is reasonably related to the period during which the applicable REMIC is expected to generate taxable income or net loss allocable to the holder of the noneconomic residual interest. The notice of proposed rulemaking further stated that an inducement fee generally may not be taken into account in a single tax year. The notice of proposed rulemaking also set forth two safe harbor methods of accounting for inducement fees and contained a rule clarifying that an inducement fee is income from sources within the United States. The final regulations adopt these provisions without substantive change. For further information on the rationale for the rules set out in these final regulations, see the preamble for the proposed regulations in the notice of proposed rulemaking.

The effective date provision of §1.446–6(g) contained in the notice of proposed rulemaking stated that these regulations would become effective upon publication of the final regulations in the Federal Register. The notice of proposed rulemaking specifically requested comments on whether the applicability of these regulations should be limited to transactions arising on or after their effective date and whether some delay in the effective date of these regulations is warranted. No comments were received from the public in response to this request. In finalizing these regulations, the IRS and Treasury Department have determined not to limit the applicability of these regulations to transactions arising on or after the effective date of the final regulations or to delay the effective date. The effective date provision in §1.446–6(g), therefore, is also adopted without substantive change.

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 has also been determined

that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because these regulations do not impose 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 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 John W. Rogers III, Office of Associate Chief Counsel (Financial Institutions & Products). However, other personnel from the IRS and the Treasury Department participated in their development.

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 is amended by adding an entry in numerical order to read, in part, as follows:

Authority: 26 U.S.C. 7805 * * * Section 1.446–6 also issued under 26 U.S.C. 446 and 26 U.S.C. 860G; * * *

Par. 2. Section 1.446–6 is added to read as follows:

§1.446–6 REMIC inducement fees .

(a) Purpose . This section provides specific timing rules for the clear reflection of income from an inducement fee received in connection with becoming the holder of a noneconomic REMIC residual interest. An inducement fee must be included in income over a period reasonably related to the period during which the applicable REMIC is expected to generate taxable income or net loss allocable to the holder of the noneconomic residual interest.

(b) Definitions . For purposes of this section:

(1) Applicable REMIC . The applicable REMIC is the REMIC that issued the

May 24, 2004 944 2004-21 I.R.B.

April 1, 1996). See paragraph (d)(4) of this section for rules regarding the applicability date of paragraph (d) of this section. Paragraph (e) of this section is applicable for taxable years ending on or after May 11, 2004.

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

Approved May 4, 2004.

Gregory Jenner, Acting Assistant Secretary of the Treasury .

(Filed by the Office of the Federal Register on May 7, 2004, 8:45 a.m., and published in the issue of the Federal Register for May 11, 2004, 69 F.R. 26040)

Section 472.—Last-in, First-out Inventories

26 CFR 1.472–1: Last-in, first-out inventories.

LIFO; price indexes; department stores. The March 2004 Bureau of Labor Statistics price indexes are accepted for use by department stores employing the retail inventory and last-in, first-out inventory methods for valuing inventories for tax years ended on, or with reference to, March 31, 2004.

Rev. Rul. 2004–48

The following Department Store Inventory Price Indexes for March 2004 were issued by the Bureau of Labor Statistics. The indexes are accepted by the Internal Revenue Service, under § 1.472–1(k) of the Income Tax Regulations and Rev. Proc. 86–46, 1986–2 C.B. 739, for appropriate application to inventories of department stores employing the retail inventory and last-in, first-out inventory methods for tax years ended on, or with reference to, March 31, 2004.

The Department Store Inventory Price Indexes are prepared on a national basis and include (a) 23 major groups of departments, (b) three special combinations of the major groups - soft goods, durable goods, and miscellaneous goods, and (c) a store total, which covers all departments, including some not listed separately, except for the following: candy, food, liquor, tobacco, and contract departments.

for credit purposes), provided that the inducement fee is included in income for financial reporting purposes over a period that is not shorter than the period during which the applicable REMIC is expected to generate taxable income.

(2) The modified REMIC regulatory method . Under the modified REMIC regulatory method, the inducement fee is recognized ratably over the remaining anticipated weighted average life of the applicable REMIC as if the inducement fee were unrecognized gain being included in gross income under §1.860F–2(b)(4)(iii).

(3) Additional safe harbor methods . The Commissioner, by revenue ruling or revenue procedure (see §601.601(d)(2) of this chapter), may provide additional safe harbor methods for recognizing inducement fees relating to noneconomic REMIC residual interests.

(f) Method of accounting . The treatment of inducement fees is a method of accounting to which the provisions of sections 446 and 481 and the regulations thereunder apply. A taxpayer is generally permitted to adopt a method of accounting for inducement fees that satisfies the requirements of paragraph (c) of this section. Once a taxpayer adopts a method of accounting for inducement fees, that method must be applied consistently to all inducement fees received in connection with noneconomic REMIC residual interests and may be changed only with the consent of the Commissioner, as provided by section 446(e) and the regulations and procedures thereunder.

(g) Effective date . This section is applicable for taxable years ending on or after May 11, 2004.

Par. 3. Section 1.860A–0 is amended by adding an entry in the outline for §1.860C–1(d) to read as follows:

§1.860A–0 Outline of REMIC provisions .

§1.860C–1 Taxation of holders of residual interests .

- - - (d) Treatment of REMIC inducement fees.

Par. 4. Section 1.860C–1 is amended by adding paragraph (d) to read as follows:

§1.860C–1 Taxation of holders of residual interests .

- - - (d) For rules on the proper accounting for income from inducement fees, see §1.446–6.
- - - Par. 5. Section 1.863–0 is amended by:

Revising the entry for the section heading for §1.863–1.
Adding an entry for §1.863–1(d).
Redesignating the entry for §1.863–1(e) as §1.863–1(f).
Adding a new entry for §1.863–1(e). The additions and revisions read as follows:

§1.863–0 Table of contents .

§1.863–1 Allocation of gross income under section 863(a) .

- - - (d) Scholarships, fellowship grants, grants, prizes and awards.

(e) REMIC inducement fees.

- - - Par. 6. Section 1.863–1 is amended as follows:

Paragraph (e) is revised.
Paragraph (f) is added. The revision and addition read as follows:

§1.863–1 Allocation of gross income under section 863(a) .

- - - (e) REMIC inducement fees . An inducement fee (as defined in §1.446–6(b)(2)) shall be treated as income from sources within the United States.

(f) Effective dates . The rules of paragraphs (a), (b), and (c) of this section apply to taxable years beginning after December 30, 1996. However, taxpayers may apply the rules of paragraphs (a), (b), and (c) of this section for taxable years beginning after July 11, 1995, and on or before December 30, 1996. For years beginning before December 30, 1996, see §1.863–1 (as contained in 26 CFR part 1 revised as of

2004-21 I.R.B. 945 May 24, 2004

BUREAU OF LABOR STATISTICS, DEPARTMENT STORE INVENTORY PRICE INDEXES BY DEPARTMENT GROUPS

(January 1941 = 100, unless otherwise noted)

Groups March 2003 March 2004

Percent Change from March 2003

to March 2004 ¹

Piece Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 458.9 491.8 7.2
Domestics and Draperies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 552.6 537.6 -2.7
Women’s and Children’s Shoes . . . . . . . . . . . . . . . . . . . . . . . . . . . . 642.6 643.4 0.1
Men’s Shoes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 842.0 840.1 -0.2
Infants’ Wear . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600.3 593.2 -1.2
Women’s Underwear. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 524.9 493.6 -6.0
Women’s Hosiery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341.2 334.6 -1.9
Women’s and Girls’ Accessories . . . . . . . . . . . . . . . . . . . . . . . . . . . 556.0 561.7 1.0
Women’s Outerwear and Girls’ Wear . . . . . . . . . . . . . . . . . . . . . . . 380.1 379.7 -0.1
Men’s Clothing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 570.0 539.2 -5.4
Men’s Furnishings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 591.1 580.7 -1.8
Boys’ Clothing and Furnishings . . . . . . . . . . . . . . . . . . . . . . . . . . . . 470.9 451.9 -4.0
Jewelry. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 871.7 890.0 2.1
Notions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 797.1 798.5 0.2
Toilet Articles and Drugs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 976.3 982.7 0.7
Furniture and Bedding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 625.2 620.3 -0.8
Floor Coverings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 589.1 596.8 1.3
Housewares. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 734.0 714.4 -2.7
Major Appliances. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217.5 205.2 -5.7
Radio and Television. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46.6 43.1 -7.5
Recreation and Education ² . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83.8 81.6 -2.6
Home Improvements ² . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125.7 127.8 1.7
Automotive Accessories ² . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111.7 112.3 0.5

Groups 1–15: Soft Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 570.4 564.9 -1.0 Groups 16–20: Durable Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400.8 387.2 -3.4 Groups 21–23: Misc. Goods ² . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95.0 93.8 -1.3

Store Total ³ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 508.5 501.0 -1.5

1Absence of a minus sign before the percentage change in this column signifies a price increase. 2Indexes on a January 1986 = 100 base. 3The store total index covers all departments, including some not listed separately, except for the following: candy, food, liquor, tobacco and contract departments.

Section 860C.—Taxation of Residual Interests

26 CFR 1.860C–1: Taxation of holders of residual interests.

DRAFTING INFORMATION

The principal author of this revenue ruling is Michael Burkom of the Office of Associate Chief Counsel (Income Tax and Accounting). For further information regarding this revenue ruling, contact Mr. Burkom at (202) 622–7924 (not a toll-free call).

Section 481.—Adjustments Required by Changes in Method of Accounting

May 24, 2004 946 2004-21 I.R.B.