Part I. Rulings — Internal Revenue Bulletin 2004-31

Section 61.—Gross Income Defined

26 CFR 1.61–12: Income from the discharge of in- debtedness.

Whether gross income includes income from the discharge of indebtedness if a subsidiary corporation makes a distribution of parent indebtedness to the parent corporation in a taxable year in which the subsidiary corporation’s earnings and profits are greater than or equal to the fair market value of the distributed indebtedness? See Rev. Rul. 2004-79, page 106.

Section 108.—Income From Discharge of Indebtedness

26 CFR 1.108–2(a): Acquisition indebtedness by a person related to the debtor.

Whether when a subsidiary corporation makes a distribution of parent indebtedness to the parent corporation in a taxable year in which the subsidiary corporation’s earnings and profits are greater than or equal to the fair market value of the distributed indebtedness, there is realization by the debtor of income from discharge of indebtedness? See Rev. Rul. 2004-79, page 106.

Section 301.—Distributions of Property

26 CFR 1.301–1: Rules applicable with respect to distributions of money and other property. (Also §§ 61, 108; 1.61–12, 1.108–2(a).)

Corporate distributions of property. This ruling addresses the tax consequences of the distribution by a subsidiary to its parent of parent indebtedness that the subsidiary previously purchased from a party unrelated to the parent.

Rev. Rul. 2004–79

ISSUE

FACTS

Situation 1

On January 1, Year 1, P, a domestic corporation, issued indebtedness that provides for monthly interest payments of $80,000 payable at the end of each month and a principal payment of $10,000,000 on its stated maturity date of December 31, Year 4. The $80,000 monthly interest payments are qualified stated interest payments within the meaning of § 1.1273–1(c) of the Income Tax Regulations. S, a domestic corporation, has only one class of stock outstanding, all of which is owned by P. On January 1, Year 2, S purchases all of the P indebtedness from A, an individual not related to S under § 1.108–2(d)(2), for cash in the amount of $9,500,000. On that date, the adjusted issue price of the P indebtedness is $10,000,000. On January 1, Year 3, S distributes all of the P indebtedness it holds to P. At the time of this distribution, the fair market value of the P indebtedness is $9,250,000. During Year 3, S makes no other distributions to P. P and S do not join in filing a consolidated return for Years 1 through 3. At all times, the fair market value of P’s assets exceeds the amount of its liabilities. At the end of Year 3, S has earnings and profits in the amount of $20,000,000.

Situation 2

The facts are the same as in Situation 1, except that at the time S distributes the P indebtedness to P, the fair market value of the P indebtedness is $10,050,000.

LAW

Section 301(a) of the Internal Revenue Code provides that a distribution of property (as defined in § 317(a)) made by a corporation to a shareholder with respect to its stock shall be treated in the manner provided in § 301(c).

Section 301(b)(1) provides, in part, that the amount of any distribution shall be the amount of money received, plus the fair market value of the other property received.

Section 301(c) provides that the portion of a distribution which is a dividend (as defined in § 316) is included in gross income,

and that the remaining portion of the distribution is applied first against the adjusted basis of the stock and then is treated as gain from the sale or exchange of property.

Section 316(a) provides that a dividend is any distribution of property made by a corporation to its shareholders out of the corporation’s earnings and profits accumulated after February 28, 1913, or out of the corporation’s earnings and profits of the taxable year, without regard to the amount of the earnings and profits at the time the distribution was made. Generally, every distribution is made out of earnings and profits to the extent thereof, and from the most recently accumulated earnings and profits.

Section 317(a) defines “property” for the purposes of the corporate distribution provisions as money, securities, and any other property, except for stock, or rights to acquire stock, in the corporation making the distribution. Section 1.317–1 provides that the term "property" also includes indebtedness to the corporation.

Section 311(a) provides that, except as provided in § 311(b), no gain or loss shall be recognized to a corporation on the distribution (not in complete liquidation) with respect to its stock of (1) its stock (or rights to acquire its stock), or (2) property.

Section 311(b) provides that, if a corporation distributes property (other than an obligation of such corporation) to a shareholder in a distribution to which subpart A applies, and the fair market value of such property exceeds its adjusted basis (in the hands of the distributing corporation), then gain shall be recognized to the distributing corporation as if such property were sold to the distributee at its fair market value.

Section 312(a) provides that, except as otherwise provided, on the distribution of property by a corporation with respect to its stock, the earnings and profits of the corporation (to the extent thereof) shall be decreased by the sum of the amount of money, the principal amount of the obligations of such corporation (or, in the case of obligations having original issue discount, the aggregate issue price of such obligations), and the adjusted basis of the other property, so distributed.

2004–31 I.R.B. 106 August 2, 2004

der § 108(e)(4), S’s purchase of the P indebtedness is treated as P’s acquisition of that indebtedness. Under § 1.108–2(a), S’s acquisition of the P indebtedness results in the realization by P of income from the discharge of indebtedness to the extent required by §§ 61(a)(12) and 108. Because S purchased the P indebtedness for an amount less than its adjusted issue price, P is treated as realizing income from the discharge of indebtedness in an amount determined under § 1.108–2(f). Because the adjusted issue price of the indebtedness ($10,000,000) exceeds S’s basis in the indebtedness on the acquisition date ($9,500,000), P realizes $500,000 of income from the discharge of indebtedness.

Under § 1.108–2(g), because P realizes income from the discharge of indebtedness in connection with S’s acquisition of the P indebtedness, the P indebtedness is treated as new indebtedness issued by P to S on the acquisition date. The new indebtedness is deemed issued with an issue price equal to S’s adjusted basis in the indebtedness, $9,500,000. Under § 1273(a)(1), the $500,000 excess of the stated redemption price at maturity of the indebtedness ($10,000,000) over its deemed issue price ($9,500,000) is OID. In Year 2, P deducts from gross income and S includes in gross income OID of $147,868, calculated pursuant to § 1272. Accordingly, as of January 1 of Year 3, under §§ 1.1275–1(b)(1) and 1.1272–1(g), respectively, the adjusted issue price of the new indebtedness and S’s adjusted basis in the indebtedness is $9,647,868.

Under §§ 317 and 1.317–1, the P indebtedness is property for purposes of the corporate distribution provisions. Therefore, S’s distribution of the P indebtedness to P is a distribution of property described in § 301. Under § 301(b), the amount of such distribution is the fair market value of the property distributed, $9,250,000. Under § 301(c), because as of the end of Year 3 S has earnings and profits in excess of that amount, the distribution in its entirety is treated as a dividend to P.

Additionally, because the distribution of the P indebtedness to P extinguishes the indebtedness, it is repurchased within the meaning of § 1.61–12(c)(2), and P is treated as having repurchased its indebtedness for an amount equal to the fair market value of the indebtedness, $9,250,000. Cf. Cora-Texas Manufacturing Co., Inc.

Section 312(b) provides that on the distribution by a corporation, with respect to its stock, of any property (other than an obligation of such corporation) the fair market value of which exceeds the adjusted basis thereof, the earnings and profits of the corporation shall be increased by the amount of such excess, and reduced by the fair market value of the property.

Section 61(a)(12) provides that gross income includes income from the discharge of indebtedness. Section 1.61–12(a) provides that the discharge of indebtedness, in whole or in part, may result in the realization of income.

Section 1.61–12(c)(2)(ii) provides that an issuer realizes income from the discharge of indebtedness upon the repurchase of a debt instrument for an amount less than its adjusted issue price (within the meaning of § 1.1275–1(b)). The amount of discharge of indebtedness income is equal to the excess of the adjusted issue price over the repurchase price. Section 1.61–12(c)(2)(iii) provides that an issuer may be entitled to a repurchase premium deduction upon the repurchase of a debt instrument for an amount greater than its adjusted issue price.

Under § 1.163–7(c), if a debt instrument is repurchased by the issuer for a price in excess of its adjusted issue price, the excess (repurchase premium) is generally deductible as interest for the taxable year in which the repurchase occurs.

Section 1.1275–1(b)(1) provides that the adjusted issue price of a debt instrument at the beginning of the first accrual period is the issue price. Thereafter, the adjusted issue price of the debt instrument is the issue price of the debt instrument increased by the amount of original issue discount (OID) previously includible in the gross income of any holder (determined without regard to §§ 1272(a)(7) and 1272(c)(1)) and decreased by the amount of any payment previously made on the debt instrument other than a payment of qualified stated interest.

Section 1.1272–1(g) provides that the basis of a debt instrument in the hands of the holder is increased by the amount of OID included in the holder’s gross income and decreased by the amount of any payment from the issuer to the holder under the debt instrument other than a payment of qualified stated interest.

Section 108(e)(4) provides that for purposes of determining income of the debtor from discharge of indebtedness, to the extent provided in regulations prescribed by the Secretary, the acquisition of outstanding indebtedness by a person bearing a relationship to the debtor specified in § 267(b) or 707(b)(1) from a person who does not bear such a relationship to the debtor shall be treated as the acquisition of such indebtedness by the debtor.

Section 1.108–2(a) provides that the direct or indirect acquisition of outstanding indebtedness by a person related to the debtor from a person who is not related to the debtor results in the realization by the debtor of income from discharge of indebtedness (to the extent required by §§ 61(a)(12) and 108 in an amount determined under § 1.108–2(f)).

Section 1.108–2(f)(1) provides that the amount of discharge of indebtedness income realized under § 1.108–2(a) is measured by reference to the adjusted basis of the related holder (or of the holder that becomes related to the debtor) in the indebtedness on the acquisition date if the holder acquired the indebtedness by purchase on or less than six months before the acquisition date.

Section 1.108–2(g) provides that for income tax purposes, if a debtor realizes income from discharge of indebtedness in a direct or an indirect acquisition under this section (whether or not the income is excludable under § 108(a)), the debtor’s indebtedness is treated as new indebtedness issued by the debtor to the related holder on the acquisition date (the deemed issuance). The new indebtedness is deemed issued with an issue price equal to the amount used under § 1.108–2(f) to compute the amount realized by the debtor under § 1.108–2(a) ( i.e., either the holder’s adjusted basis or the fair market value of the indebtedness, as the case may be). Under § 1273(a)(1), the excess of the stated redemption price at maturity (as defined in § 1273(a)(2)) of the indebtedness over its issue price is OID and, to the extent provided in §§ 163(e) and 1272, is deductible by the debtor and includible in the gross income of the related holder.

ANALYSIS

In Situation 1, because P and S have a relationship specified in § 267(b)(3), un

August 2, 2004 107 2004–31 I.R.B.

v. U.S., 222 F. Supp. 527 (E.D. La. 1963), aff’d per curiam, 341 F.2d 579 (5th Cir. 1965) (treating a partnership’s liquidating distribution to a partner of the partner’s preferred stock as if the partner retired the preferred stock for its fair market value); Rev. Rul. 93–7, 1993–1 C.B. 125 (ruling that where a partnership distributes indebtedness of a partner to the issuing partner the partner is treated as having satisfied its indebtedness for an amount equal to the fair market value of such indebtedness). Accordingly, under § 1.61–12(c)(2)(ii), P realizes income from the discharge of indebtedness in an amount equal to $397,868, the excess of the adjusted issue price of the P indebtedness ($9,647,868) over the amount of the distribution ($9,250,000).

Under § 311(a), S does not recognize the loss inherent in the P indebtedness on the distribution of the P indebtedness. As a result of the distribution, pursuant to § 312(a), S’s earnings and profits are reduced by its adjusted basis in the P indebtedness distributed, $9,647,868.

In Situation 2, the tax consequences of S’s purchase of the P indebtedness are the same as in Situation 1 . In Year 3, the amount of the distribution of the P indebtedness determined pursuant to § 301(b) and treated as a dividend under § 301(c) is $10,050,000. Additionally, P is treated as having repurchased its indebtedness for the same amount. Under § 1.163–7(c), P is generally entitled to an interest deduction in an amount equal to the $402,132 excess of the amount of the distribution ($10,050,000) over the adjusted issue price of the P indebtedness ($9,647,868). Under § 311(b), S recognizes gain as if it sold the indebtedness to P for an amount equal to its $10,050,000 fair market value. Thus, S recognizes gain in an amount equal to $402,132, the excess of the fair market value of the indebtedness distributed ($10,050,000) over S’s adjusted basis in the indebtedness distributed ($9,647,868). Under § 312(a) and (b), S’s earnings and profits must be increased by $402,132, the excess of the fair market value of the indebtedness distributed ($10,050,000) over S’s adjusted basis in the indebtedness distributed ($9,647,868), and reduced by the fair market value of the indebtedness distributed, $10,050,000.

HOLDING

If a subsidiary corporation makes a distribution of parent indebtedness to the parent corporation in a taxable year in which the subsidiary corporation’s earnings and profits are greater than or equal to the fair market value of the distributed indebtedness, the parent corporation is treated as receiving a distribution treated as a dividend in the amount of the fair market value of the indebtedness on the date of the distribution and may realize discharge of indebtedness income or be entitled to an interest deduction depending on the fair market value of the indebtedness on the date of the distribution relative to its adjusted issue price.

DRAFTING INFORMATION

The principal author of this revenue ruling is Sean McKeever of the Office of Associate Chief Counsel (Corporate). For further information regarding this revenue ruling, contact Mr. McKeever at (202) 622–7750 (not a toll-free call).

Section 354.—Exchanges of Stock and Securities in Certain Reorganizations

26 CFR 1.354–1: Exchange of stock and securities in certain reorganizations.

Corporate reorganizations; ex- change of debt instruments. This ruling discusses the exchange of a debt security for a debt instrument in a reorganization.

Rev. Rul. 2004–78

ISSUE

Under the circumstances described below, whether a debt instrument issued by the acquiring corporation in a reorganization in exchange for a security of the target corporation is a security within the meaning of § 354 of the Internal Revenue Code.

FACTS

On January 1, 2004, Target Corporation issues debt instruments with a stated maturity date of January 1, 2016. On the issue date, the debt instruments provide for a market rate of interest and are securities

within the meaning of § 354. Target Corporation has outstanding one class of common stock. On January 1, 2014, pursuant to state law, Target Corporation merges into Acquiring Corporation in a transaction that qualifies as a reorganization under § 368(a)(1)(A). In the merger, the Target Corporation stockholders exchange their Target Corporation common stock for Acquiring Corporation common stock. Also in the merger, the Target Corporation security holders exchange their Target Corporation securities for Acquiring Corporation debt instruments with terms identical to those of the Target Corporation securities (including the maturity date), except that the interest rate is changed (for example, to reflect differences in creditworthiness between Target Corporation and Acquiring Corporation). The modification of the interest rate is a significant modification under § 1.1001–3 of the Income Tax Regulations.

LAW AND ANALYSIS

Section 368(a)(1)(A) provides, in part, that the term “reorganization” includes a statutory merger. Section 368(b) provides that the term “party to a reorganization” includes a corporation resulting from a reorganization and both corporations, in the case of a reorganization resulting from the acquisition by one corporation of stock or properties of another corporation.

Section 354(a)(1) provides, in part, that no gain or loss shall be recognized if securities in a corporation that is a party to a reorganization are, in pursuance of the plan of reorganization, exchanged solely for securities in such corporation or in another corporation that is a party to the reorganization.

Section 1.368–1(b) sets forth the general rule that, upon an exchange, gain or loss must be recognized if the new property differs materially in kind or extent from the old property. The regulation then explains that the purpose of the reorganization provisions is to except from the general rule certain exchanges incident to readjustments of corporate structures that are required by business exigencies and that effect only a readjustment of continuing interests in property under modified corporate forms. Congress has recognized that when a taxpayer receives stock or securities in exchange for stock or securities

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owned by the taxpayer incident to a readjustment of a corporate structure, the new stock or securities are treated as taking the place of the stock or securities exchanged therefor. See H.R. Rep. No. 704, at 13–14 (1933).

Neither § 354 nor the regulations under § 354 define the term “securities.” Under case law, an instrument with a term of less than five years generally is not a security. See, e.g., Pinellas Ice & Cold Storage Co. v. Commissioner, 287 U.S. 462 (1933) (holding that short-term notes payable within four months were not securities within the meaning of the reorganization provisions); Lloyd-Smith v. Commissioner, 116 F.2d 642 (2d Cir.), cert. denied, 313 U.S. 588 (1941) (holding that two-year notes were not securities); Neville Coke & Chemical Co., 148 F.2d 599 (3d Cir.), cert. denied, 326 U.S. 726 (1945) (holding that three, four, and five-year notes were not securities).

Under the foregoing authorities, an instrument with a term of two years generally would not qualify as a security. However, because the debt instruments of the Acquiring Corporation are issued in the reorganization in exchange for securities of the Target Corporation and bear the same terms (other than interest rate) as the securities of the Target Corporation, the debt instruments of the Acquiring Corporation represent a continuation of the security holder’s investment in the Target Corporation in substantially the same form. Therefore, the debt instruments of the Acquiring Corporation exchanged for the securities of the Target Corporation are securities within the meaning of § 354.

HOLDING

Under the circumstances described above, a debt instrument issued by the acquiring corporation in a reorganization in exchange for a security of the target corporation is a security within the meaning of § 354.

DRAFTING INFORMATION

The principal author of this revenue ruling is Ricky Thomas of the Office of Associate Chief Counsel (Corporate). For further information regarding this revenue ruling, contact Ricky Thomas at (202) 622–7750 (not a toll-free call).

Section 412.—Minimum Funding Standards

Procedures with respect to applications for extensions of the amortization period under § 412(e) of the Code and section 304 of ERISA are set forth. See Rev. Proc. 2004-44, page 134.

Section 861.—Income From Sources Within the United States

(Also §§ 862, 933; 1.861, 1.862.)

Annuity payments. This ruling addresses the taxation of income received by residents of Puerto Rico and nonresident aliens under life insurance and annuity contracts issued by a foreign branch of a U.S. life insurance company. The ruling holds that income received by nonresident aliens under life insurance and annuity contracts issued by a foreign branch of a U.S. life insurance company is U.S.-source FDAP income. The ruling also holds that income received by bona fide residents of Puerto Rico under life insurance or annuity contracts issued by a Puerto Rican branch of a U.S. life insurance company is U.S.-source income.

Rev. Rul. 2004–75

ISSUES

Whether income received by nonresident alien individuals under life insurance and annuity contracts issued by a foreign branch of a U.S. life insurance company is U.S.-source income that is subject to 30% tax and withholding under sections 871(a) and 1441.
Whether income received by bona fide residents of Puerto Rico under life insurance and annuity contracts issued by a Puerto Rican branch of a U.S. life insurance company is U.S.-source income that is subject to the tax imposed by section 1.

FACTS

A U.S. life insurance company conducts business in Country A and Puerto Rico through a separate branch in each jurisdiction. The branches sell a wide range of insurance products including, but not limited to, whole life, universal life, and variable life insurance and fixed and

variable annuities to individuals living in Country A and Puerto Rico. These products are life insurance and annuity contracts under the Internal Revenue Code. See sections 72(s), 101(f), 817(h), and 7702. There is no income tax treaty in force between Country A and the United States.

Individuals in Country A and Puerto Rico pay premiums to the U.S. life insurance company in exchange for the benefits set forth in the relevant contracts. For example, under a life insurance contract, the life insurance company generally agrees, in exchange for premiums, to pay a certain amount to a beneficiary upon the death of the insured. Under an annuity contract, the life insurance company typically agrees, in exchange for premiums, to pay a certain amount each year to the owner of the contract beginning upon the owner’s retirement and ending upon the owner’s death. The life insurance company invests the premiums received with respect to its life insurance and annuity contracts in domestic and foreign income-producing assets, such as stocks and bonds.

The life insurance and annuity contracts issued by the U.S. life insurance company to individuals in Country A and Puerto Rico have cash values. The individuals in Country A and Puerto Rico withdraw amounts from the cash values of their life insurance and annuity contracts, and the amounts withdrawn are gross income under section 61 to the extent provided under section 72. The individuals in Country A and Puerto Rico also receive annuity payments under their annuity contracts that are gross income under section 61 to the extent provided under section 72.

This revenue ruling applies only to annuity payments and withdrawals of cash value that are gross income to the extent provided under section 72, and does not apply to amounts received under life insurance contracts by reason of the death of the insured that are excludible from gross income under section 101.

LAW

Section 861(a) specifies that certain items of income are U.S.-source income. Section 861(a)(1) generally provides that interest is U.S.-source income when paid by a U.S. obligor. Section 861(a)(2) generally provides that dividends are

August 2, 2004 109 2004–31 I.R.B.

income received under a life insurance or annuity contract is U.S. source when the issuer of the contract is a domestic corporation.

Income received from a life insurance or annuity contract under section 72 is not gain derived from the sale of property or income that is excluded from FDAP income by the IRS in published guidance. Payments from annuity contracts are specifically listed as a type of FDAP income in section 871(a)(1)(A). Thus, income received from a life insurance or annuity contract under section 72, both annuity payments and withdrawals made from the cash value of the contract, is FDAP income. Accordingly, when such income is received by nonresident alien individuals, it generally is subject to 30% tax and withholding under sections 871(a) and 1441.

Payments made to bona fide residents of Puerto Rico with respect to life insurance and annuity contracts issued by a Puerto Rican branch of a U.S. life insurance company are derived from sources within the United States under the principles described above. Because the payments are not derived from Puerto Rican sources, the payments are not excludible from gross income of the recipient under section 933.

Although the U.S.-source income of bona fide residents of Puerto Rico is subject to U.S. income tax, payments to such residents are not generally subject to tax and withholding under sections 871 and 1441. Bona fide residents of Puerto Rico who are citizens of the United States, as well as bona fide residents of Puerto Rico who are lawful permanent residents of the United States, are generally subject to the tax imposed by section 1. Moreover, under section 876, bona fide residents of Puerto Rico who are not citizens of the United States also are generally subject to the tax imposed by section 1.

HOLDINGS

Income received by nonresident alien individuals under life insurance or annuity contracts issued by a foreign branch of a U.S. life insurance company is U.S.-source FDAP income that is subject to 30% tax and withholding under sections 871(a) and

U.S.-source income when paid by a domestic corporation. Section 861(a) does not specify the source of income paid by a U.S. life insurance company under a life insurance or annuity contract.

When the source of an item of income is not specified by statute or by regulation, courts have determined the source of the item by comparison and analogy to classes of income specified within the statute. Bank of America v. United States, 680 F.2d 142, 147 (Ct. Cl. 1982); Howkins v. Commissioner, 49 T.C. 689 (1968). In Clayton v. United States, 33 Fed. Cl. 628 (1995), aff’d. without published opin- ion, 91 F.3d 170 (Fed. Cir. 1996), cert. denied, 519 U.S. 1040 (1996), the Court of Federal Claims held that the earnings and accretions component of distributions made by an employee stock ownership plan (“ESOP”) to foreign participants was U.S.-source income because the trust underlying the ESOP was a domestic trust. See also, Rev. Rul. 79–388, 1979–2 C.B. 270. Section 871(a) generally provides that a tax of 30 percent is imposed on an amount received from U.S. sources by a nonresident alien individual as interest, dividends, rents, annuities, and other fixed or determinable annual or periodical gains, profits, and income (“FDAP income”), provided that the amount is not income that is effectively connected with the conduct of a U.S. trade or business (“ECI”). The 30-percent tax is imposed by section 871(a) only upon the amount that constitutes gross income. Treas. Reg. 1.871–7(a)(2). Section 61(a) generally provides that annuities and income from life insurance and endowment contracts are included in gross income. Section 72 generally provides rules for determining the portion of certain amounts received under an annuity, endowment, or life insurance contract that is included in gross income.

FDAP income generally includes all U.S.-source income included in gross income under section 61, except for gain derived from the sale of property, or any other income that the Internal Revenue Service determines, in published guidance, is not FDAP income. Treas. Reg. §1.871–7(b)(1), 1.1441–2(b)(1)(i), and 1.1441–2(b)(2). Moreover, section 871(a)(1) specifically includes amounts received as annuities as a type of FDAP income. In Barba v. United States, 2 Cl.

Ct. 674 (1983), the court, in determining whether gambling winnings of nonresident alien individuals from U.S. sources were FDAP income, concluded that the words “fixed and determinable annual or periodical gains” should be interpreted broadly to include all classes of income, except income arising from the sale of property. See also, Commissioner v. Wodehouse, 337 U.S. 369 (1949). Section 933(1) provides that in the case of an individual who is a bona fide resident of Puerto Rico during the entire taxable year, income derived from sources within Puerto Rico (except amounts received for services performed as an employee of the United States or any agency thereof) is not included in gross income.

Treas. Reg. 1.863–6 provides that the principles applied for determining income from sources within and without the United States shall generally be applied for purposes of determining income from sources within and without a possession of the United States.

Section 876 provides that in the case of an alien individual who is a bona fide resident of Puerto Rico, sections 871 through 879 do not apply and such individual is subject to the tax imposed by section 1.

ANALYSIS

Because section 861(a) does not include rules specifying the source of income received under a life insurance or annuity contract under section 72, the source of such income is determined by comparison and analogy to classes of income that are specified within the statute. Bank of Amer- ica, 680 F.2d at 147; Howkins, 49 T.C. at 689. Income received under a life insurance or annuity contract under section 72 is an investment return on the cash value of the contract and is analogous to (1) interest on a debt obligation, (2) dividends on a stock, and (3) earnings and accretions on pension fund assets. Thus, the source of that income is determined in the same manner as the source of interest, dividends, and earnings and accretions on pension fund assets. Under sections 861(a)(1) and (2), interest or dividends are U.S. source when the obligor or corporation, respectively, is domestic. Earnings and accretions on pension fund assets are also U.S. source when the pension trust is domestic. Clayton, 33 Fed. Cl. 628. Accordingly,

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local authority thereof. This term, however, does not include any person who is liable to tax in that State in respect only of income from sources in that State or capital situated therein.

* * * Where by reason of the above paragraph, a person other than an individual is a resident of both Contracting States, the person shall be deemed to be a resident only of the State in which its place of effective management is situated.

Situation 2 The facts are the same as in Situation 1 except that Corporation A has a fixed place of business in Country X, to which the income is attributable.

LAW AND ANALYSIS

In Situation 1, before application of the X-Y Convention, Corporation A would be a resident of both Country X and Country Y under the domestic laws of each of Country X and Country Y. After the application of the relevant article of the X-Y Convention, Corporation A is treated as a resident of Country Y and not a resident of Country X because its place of effective management is situated in Country Y.

Accordingly, Corporation A continues to be liable to tax in Country Y by reason of residence. Therefore, under the relevant article of the U.S.-Y Convention, Corporation A is a resident of Country Y. Corporation A will be entitled to claim benefits under the U.S.-Y Convention as a resident of Country Y with respect to the U.S.-source income if it satisfies the requirements of the applicable limitation on benefits article, if any, and other applicable requirements in order to receive benefits under the U.S.-Y Convention.

Because Corporation A is treated as a resident of Country Y for purposes of the X-Y Convention, Corporation A is not subject to comprehensive taxation in Country X as it would be if it were liable to tax by reason of residence. Therefore, Corporation A is not a resident of Country X under the relevant article of the U.S.-X Convention and is not entitled to claim benefits under the U.S.-X Convention as a resident of Country X.

In Situation 2, after the application of the X-Y Convention, Corporation A continues to be liable to tax in Country Y by

Income received by bona fide residents of Puerto Rico under life insurance or annuity contracts issued by a Puerto Rican branch of a U.S. life insurance company is U.S.-source income that is subject to the tax imposed by section 1.

DRAFTING INFORMATION

The principal author of this revenue ruling is Gregory A. Spring of the Office of the Associate Chief Counsel (International). For further information regarding this revenue ruling, contact Mr. Spring at (202) 622–3870 (not a toll-free call).

Section 862.—Income From Sources Without the United States

A revenue ruling describes income from sources within the United States for certain income received by nonresident aliens and bona fide residents of Puerto Rico under life insurance and annuity contracts issued by a foreign branch of a U.S. life insurance company. See Rev. Rul. 2004-75, page 109.

Section 894.—Income Affected by Treaty

26 CFR 1.894–1: Income affected by treaty.

Dual resident company. This ruling concludes that a dual resident company, resident in both Country Y and Country X under the domestic laws of those countries, is not entitled to claim benefits under the U.S. income tax convention with Country X if it is treated as a resident of Country Y and not of Country X for purposes of the income tax convention between Country X and Country Y and, as a result, is not liable to tax in Country X by reason of its residence. Rev. Rul. 73–354 obsoleted.

Rev. Rul. 2004–76

ISSUE

If Corporation A, a resident of both Country X and Country Y under the laws of each country, is treated as a resident of Country Y and not of Country X for purposes of the X-Y Convention and, as a result, is not liable to tax in Country X by reason of its residence, is it entitled to

claim the benefits of the U.S.-X Convention as a resident of Country X or of the U.S.-Y Convention as a resident of Country Y?

FACTS

Situation 1 Corporation A is incorporated under the laws of Country X. Its place of effective management is situated in Country Y. Corporation A does not have a fixed place of business in Country X. Under the laws of Country X, prior to application of any income tax convention, Corporation A is liable to tax as a resident. Under the laws of Country Y, prior to application of any income tax convention, Corporation A is liable to tax as a resident. Corporation A receives U.S.-source income during the taxable year, with respect to which it seeks benefits under either the U.S. income tax convention with Country X (U.S.-X Convention) or the U.S. income tax convention with Country Y (U.S.-Y Convention).

The relevant articles of the U.S.-X Convention and the U.S.-Y Convention each provide:

Except as provided in this paragraph, for the purposes of this Convention, the term “resident of a Contracting State” means any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, citizenship, place of management, place of incorporation, or any other criterion of a similar nature.

* * * The term “resident of a Contracting State” does not include any person who is liable to tax in that State in respect only of income from sources in that State.

There is in force an income tax convention between Country X and Country Y (the X-Y Convention) that contains the following article with respect to residence:

For purposes of the Convention, the term “resident of a Contracting State” means any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, place of management or any other criterion of a similar nature, and also includes that State and any political subdivision or

August 2, 2004 111 2004–31 I.R.B.

Section 3406.—Backup Withholding

A revenue procedure establishes a procedure for a payment card organization to request a determination that it is a Qualified Payment Card Agent (QPCA) for purposes of sections 3406 and 6724 and the regulations thereunder. See Rev. Proc. 2004-42, page 121.

A revenue procedure provides an optional procedure that payors may use to determine whether payment card transactions are reportable under section 6041 or section 6041A and the regulations thereunder. In addition, this procedure may be used to determine whether payment card transactions are reportable payments for purposes of the IRS TIN Matching Program under section 3406 and the regulations thereunder. See Rev. Proc. 2004-43, page 124.

26 CFR 31.3406(g)–1: Exceptions for payments to certain payees and certain other payments.

T.D. 9136

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 31, 301, and 602

Information Reporting and Backup Withholding for Payment Card Transactions

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

SUMMARY: This document contains final regulations relating to the information reporting requirements, information reporting penalties, and backup withholding requirements for payment card transactions. This document also contains final regulations relating to the IRS TIN Matching Program. The regulations in this document affect payors (and their authorized agents) and payees of certain reportable payments and provide guidance necessary to comply with the law.

DATES:

Effective Date: These regulations are effective July 13, 2004.

reason of residence. Therefore, under the relevant article of the U.S.-Y Convention, Corporation A is a resident of Country Y. Corporation A will be entitled to claim benefits under the U.S.-Y Convention as a resident of Country Y with respect to the U.S.-source income if it satisfies the requirements of the applicable limitation on benefits article, if any, and other applicable requirements in order to receive benefits under the U.S.-Y Convention.

Because Corporation A is treated as a resident of Country Y for purposes of the X-Y Convention, Corporation A’s fixed place of business in Country X is treated as a permanent establishment within the meaning of the X-Y Convention. Thus, Corporation A is liable to tax in Country X in respect of profits attributable to its permanent establishment, but is not subject to comprehensive taxation in Country X as it would be if it were liable to tax by reason of residence. Therefore, Corporation A is not a resident of Country X under the relevant article of the U.S.-X Convention and is not entitled to claim benefits under the U.S.-X Convention as a resident of Country X.

Rev. Rul. 73–354, 1973–2 C.B. 435, provided that a bank incorporated in Switzerland, managed and controlled in the United Kingdom, and engaged in the conduct of a business in both Switzerland and the United Kingdom, could choose to apply the provisions of either the United States-Swiss Confederation Income Tax Convention then in force or the United States-United Kingdom Income Tax Convention then in force to interest arising in the United States. Under those conventions, which are no longer in force, the determination of whether a corporation was a resident did not depend on whether the corporation was liable to tax in that country.

HOLDING

If Corporation A is treated as a resident of Country Y and not of Country X for purposes of the X-Y Convention and, as a result, is not liable to tax in Country X by reason of its residence, it is not entitled to claim benefits under the U.S.-X Convention, because it is not a resident of Country X under the relevant article of the U.S.-X Convention. However, Corporation A is entitled to claim benefits under the U.S.-Y

Convention as a resident of Country Y, if it satisfies the requirements of the applicable limitation on benefits article, if any, and other applicable requirements in order to receive benefits under the U.S.-Y Convention.

This holding is applicable in interpreting income tax treaties that contain provisions that are the same as or similar to the relevant articles of the U.S.-X Convention, the U.S.-Y Convention, and the X-Y Convention.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 73–354, 1973–2 C.B. 435, is obsolete.

DRAFTING INFORMATION

The principal author of this revenue ruling is Michelle S. Lyon of the Office of Associate Chief Counsel (International). For further information regarding this revenue ruling, contact Ms. Lyon at (202) 622–3880 (not a toll-free call).

Section 933.—Income From Sources Within Puerto Rico

Section 2631.—GST Exemption

If, prior to 2001, a transferor failed to affirmatively allocate GST exemption, may the transferor request an automatic extension of time under sections 2642(g) and 301.9100–3 to make a timely allocation? See Rev. Proc. 2004-46, page 142.

Section 2642.—Inclusion Ratio

2004–31 I.R.B. 112 August 2, 2004

tions necessary or appropriate to carry out the purposes of section 3406.

A payment card transaction is a transaction in which a cardholder/payor uses a payment card to purchase goods or services and a merchant agrees to accept a payment card as a means of obtaining payment. A payment card is a card (or an account) that (1) is issued by a payment card organization or one of its members, affiliates, or licensees to a cardholder/payor and (2) represents, upon presentation to a merchant/payee, an agreement of the cardholder to pay the merchant through the payment card organization. A payment card organization is an entity that sets the standards and provides the mechanism, acting directly or indirectly through its members, affiliates, or licensees, for effectuating payment between a purchaser and a merchant in a payment card transaction.

Information reporting compliance is difficult in payment card transactions because an invoice may not be issued, and the employee representing the cardholder/payor in the transaction may not request and obtain the name/TIN combination of the merchant/payee at the time of the transaction. In addition, backup withholding may be difficult because a merchant receives payment from the payment card organization within a few days after the transaction, but the cardholder does not pay the payment card organization until after it receives a payment card monthly billing statement.

The Temporary and Proposed Regulations

On January 31, 2003, temporary regulations relating to the IRS TIN Matching Program were published in the Federal Register (T.D. 9041, 2003–1 C.B. 510 [68 FR 4922]). The temporary regulations permit a payor’s authorized agent to participate in the IRS TIN Matching Program on behalf of the payor. Under the authority of these temporary regulations, the IRS issued Rev. Proc. 2003–9, 2003–1 C.B. 516, that allows payors’ authorized agents, as well as all payors, to participate in the IRS TIN Matching Program.

A notice of proposed rulemaking (REG–116641–01, 2003–1 C.B. 518) cross-referencing the temporary regulations was also published in the Federal

Applicability Dates: The amendments to §31.3406(g)–1 are applicable for payments made on or after January 1, 2005. The amendments to §301.6724–1 are applicable for information returns required to be filed, and information statements required to be furnished, after December 31, 2005. Section 31.3406(j)–1(a) and (f) are applicable January 31, 2003.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Donna Welch, (202) 622–4910 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in these final regulations has been submitted to the Office of Management and Budget for review in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)) under control number 1545–1819. The collection of information is in §31.3406(g)–1(f)(3). This information is necessary to notify a cardholder/payor that a merchant/payee is not a qualified payee for purposes of the regulations. This information will alert a cardholder/payor that backup withholding under section 3406 may apply for future reportable payments. The collection of information is voluntary to obtain a benefit. The likely respondents are business or other for-profit institutions.

Estimated total annual reporting burden: 11,750,000 hours.

Estimated average annual burden per respondent: 5,875 hours.

Estimated number of respondents: 2,000. Estimated annual frequency of responses: monthly.

Comments concerning the accuracy of this burden and suggestions for reducing this burden should be sent to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 20224, and to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays

a valid control number assigned by the Office of Management and Budget.

Books or 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 contains amendments to 26 CFR part 31 relating to backup withholding and the IRS TIN Matching Program under section 3406 of the Internal Revenue Code (Code). It also contains amendments to 26 Part 301 relating to waivers under section 6724 of information reporting penalties under sections 6721 and 6722.

Section 6041(a) requires persons engaged in a trade or business and making payment in the course of such trade or business to another person of rent, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, or other fixed or determinable gains, profits, and income of $600 or more in any one taxable year to file information returns with the IRS and to furnish information statements to payees. Among other items, the payor must include the payee’s name and taxpayer identification number (TIN) on the information return and the information statement.

In general, section 6721(a)(1) imposes a $50 penalty for each failure to file an information return on or before the required filing date, for any failure to include all of the information required to be shown on the return, or for the inclusion of incorrect information. Section 6724(a) provides that no penalty will be imposed under section 6721 if it is shown that the failure is due to reasonable cause and not to willful neglect.

Section 3406(a)(1) requires a payor to withhold on any reportable payment (as defined in section 3406(b)(1)) if (1) the payee fails to furnish the payee’s TIN to the payor as required or (2) the Secretary notifies the payor that the TIN furnished by the payee is incorrect. Section 3406(a)(1) also requires withholding in certain other situations that are not addressed in these regulations. Section 3406(i) provides that the Secretary shall prescribe the regula

August 2, 2004 113 2004–31 I.R.B.

the payee’s identity or compliance with its tax obligations. Therefore, the final regulations do not adopt the recommendation for a complete exemption from backup withholding for payment card transactions made through a QPCA.

Several comments criticized the specific rules for determining whether a payee is a qualified payee and when backup withholding is required with respect to a payee who is not qualified. In general, the commentators viewed these rules as incompatible with current business practice because they require QPCAs to evaluate the status of payees at the time of each transaction and to communicate to cardholders through the billing process. The commentators suggested various changes to conform the rules to current business practices.

The IRS and the Treasury Department agree that the rules should accommodate current business practices to the extent practicable but believe some of the suggestions in the comments go beyond what is necessary and provide excessive periods of exemption from backup withholding for noncompliant payees. Accordingly, the final regulations include a number of new rules to address the commentators’ concerns but do not adopt all of the specific changes suggested in the comments.

As suggested in the comments, the final regulations eliminate the requirement that QPCAs include information regarding payee status with the billing statement furnished to the payor. Instead, the final regulations require that the information be furnished within four months of the date of the payment and permit the information to be furnished as part of a quarterly or other regular report of payee data to the cardholder. To eliminate the need to evaluate the status of payees at the time of each payment, the final regulations permit QPCAs to treat all payments made during a calendar quarter or any shorter reporting period as being made on the last day of the period. Thus, for a QPCA choosing this treatment, a payee will be treated as a qualified payee with respect to all payments during the period if the QPCA obtains and verifies the payee’s TIN at any time before the end of the period. Similarly, payments will be treated as being made on the last day of the reporting period for purposes of determining whether they are made within the six-month grace period. In this case, how

Register (68 FR 4970) for January 31, 2003. The notice of proposed rulemaking contained additional proposed rules relating to the information reporting and backup withholding requirements for payment card transactions effectuated through a Qualified Payment Card Agent (QPCA).

The proposed regulations provide limited exceptions to the backup withholding requirements for payment card transactions. The principal exception applies if the payment is made through a QPCA and the payee is a qualified payee.

A payee is qualified for this purpose if, at the time of the payment, the QPCA has validated the payee’s TIN through the IRS TIN Matching Program or if the payment is made during the six-month period following the date on which the QPCA first obtained the payee’s TIN (six-month grace period). Under the proposed regulations, a QPCA must notify a cardholder/payor of any merchant/payees that are not qualified payees. The notice must appear on the billing information for the payment.

The proposed regulations provide a second exception for payments to persons other than qualified payees. Under this exception, reportable payments made through a QPCA are exempt from backup withholding if the payment is made within 60 days after the date of the first payment with respect to which the QPCA is required to provide notification to the payor that the payee is not a qualified payee.

In addition, the proposed regulations provide that cardholder/payors may establish reasonable cause for a failure to include all of the information required to be shown on their information returns, or for the inclusion of incorrect information, based on reliance on merchant/payee TINs supplied through a QPCA.

The proposed regulations provide that the rules relating to backup withholding and information reporting for payment card transactions apply during 2004. The temporary rule permitting agents to participate in the TIN matching program was effective January 31, 2003.

A public hearing was held on the proposed regulations on May 2, 2003. The IRS also received written and electronic comments responding to the notice of proposed rulemaking.

Explanation of Provisions and Summary of Comments

After consideration of all the comments, the proposed regulations relating to the backup withholding requirements for payment card transactions effectuated through a QPCA and the reasonable cause exception to information reporting penalties are adopted as revised by this Treasury decision. The revisions are discussed below. The temporary amendments to the regulations relating to the IRS TIN Matching Program are also adopted as final regulations and the corresponding temporary regulations are removed.

Backup Withholding

Several commentators recommended that the final regulations eliminate the qualified payee requirement and provide a complete exemption from backup withholding for payment card transactions made through a QPCA. One commentator noted that §31.3406(g)–2(e) of the regulations provides that a real estate reporting person is not required to backup withhold on a real estate transaction subject to reporting under section 6045. As an alternative to backup withholding, this commentator suggested that the QPCA should provide a list to the IRS of the merchant/payees for whom the QPCA cannot obtain valid TINs. The commentator further suggested that the IRS should impose penalties on the merchant/payees who fail to furnish valid TINs, rather than require backup withholding.

The regulatory exception for real estate transactions is based on section 3406(h)(5)(D), which provides that, except as otherwise provided in regulations, a real estate broker (as defined in section 6045(e)(2)) is not a broker for purposes of section 3406. The Code also includes limited grants of regulatory authority to except otherwise reportable payments from backup withholding in section 3406(b)(5) (relating to payments that do not exceed $10) and in section 3406(g) (relating to payments to specified payees). The IRS and the Treasury Department do not view these limited grants of regulatory authority as authorizing a regulatory exemption for a broad class of transactions, which according to the comments involve payments of over $100 billion per year, regardless of

2004–31 I.R.B. 114 August 2, 2004

on behalf of a cardholder/payor for purposes of soliciting, collecting, and validating the names/TINs of the merchant/payees and on behalf of a merchant/payee for purposes of furnishing the payee’s name and TIN to the cardholder/payor.

The second revenue procedure provides an optional procedure for payors and their authorized agents to use in determining whether payment card transactions are reportable under section 6041 or section 6041A and are reportable payments for purposes of the IRS TIN Matching Program. In general, this revenue procedure classifies businesses by Merchant Category Codes (MCCs), or other equivalent Industry Codes, according to whether they predominantly furnish services (for which payments are reportable) or predominantly provide goods (for which payments are not reportable). Under the revenue procedure, payment card organizations would be permitted to assign MCCs, or other equivalent Industry Codes, to payees and payors would be permitted to rely on the assigned codes for information reporting and TIN matching purposes.

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.

It is hereby certified pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6) that the collection of information contained in these regulations will not have a significant economic impact on a substantial number of small entities. The reporting burden affects payment card organizations and financial institutions that issue payment cards. Most payment card organizations and payment card issuers are large businesses. To the extent that small financial institutions have a reporting burden, the burden is expected to be insignificant. Accordingly, 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 Ad

ever, the regulations also provide that the grace period with respect to a payee will be treated as beginning not on the date of the first payment to the payee but on the first day of the reporting period in which the QPCA makes the payment.

The 60-day exception from backup withholding for payments made to persons that are not qualified payees is also modified to reflect the new rules for determining payee status and notifying cardholders. The exception in the final regulations applies to purchases made no later than two months after the last date for providing the first notice informing the cardholder that the payee is not a qualified payee.

One commentator suggested that a QPCA should be allowed to furnish information regarding payee status electronically on a secure website. The IRS and the Treasury Department are continuing to consider this comment and may issue further guidance on this issue.

Several commentators requested that the final regulations clarify that the individual to whom the card is issued is not the cardholder/payor if another person is responsible for paying the charges on the card. The commentators were concerned that employees might be treated as cardholders in situations where payment cards are issued to employees of the person responsible for paying charges on the card. The final regulations provide the requested clarification.

Several commentators requested that the final regulations clarify that a QPCA may act directly or indirectly through its members, affiliates, or licensees. The final regulations also provide this clarification.

Several commentators requested clarification of the cardholder/payor’s obligations if the payor receives notification that a payee is not a qualified payee. Under the final regulations, backup withholding may be required for purchases made more than two months after the last date for furnishing the first notification that the payee is not a qualified payee. For purchases after that date, the payor must backup withhold on any reportable payment unless it has obtained the payee’s TIN in accordance with the generally applicable rules under section 3406 or the QPCA has remedied the failure that caused the disqualification by obtaining and verifying the payee’s TIN. If the payor is required to backup withhold and ordinarily uses a pay

ment method incompatible with backup withholding, the continued use of that payment method will not relieve the payor of its backup withholding obligation. (See section 3406(h)(10), which provides payments subject to backup withholding are treated as wages paid by an employer to an employee; and section 3403, which provides that an employer is liable for taxes required to be withheld and deducted.)

Effective Dates

Because the proposed rules relating to backup withholding and information reporting for payment card transactions were not finalized before the beginning of 2004, their effective dates have been delayed. The final rules relating to backup withholding will apply to payments made after 2004 and final rules relating to information reporting will apply to returns due after 2005. The temporary rule permitting agents to participate in the TIN matching program is adopted as a final regulation with no change to its effective date of January 31, 2003.

One payment card organization suggested that the IRS repropose the regulations or issue them with an effective date of not less than two years after publication. The comment noted that reproposing the regulations would provide an opportunity for further study and comment and would provide time to test the rules in a pilot program. This suggestion was not adopted. The IRS and the Treasury Department recognize that providing an opportunity for further comment may result in improved rules, but there is no assurance that this will be the case. The IRS and the Treasury Department believe that the indeterminate benefit suggested in the comment does not outweigh the certainty that the suggested delay would deny payors any benefit from the backup withholding exception and penalty relief contained in the final regulations during the period of the delay.

Other Guidance

The IRS is also issuing two revenue procedures to implement the rules contained in the final regulations. The first of these revenue procedures sets forth the requirements that a payment card organization must satisfy to obtain an IRS determination that it is a QPCA. The revenue procedure also provides that a QPCA may act

August 2, 2004 115 2004–31 I.R.B.

validated through the IRS TIN Matching Program; or

(B) The QPCA makes the payment during the six-month period beginning on the date on which the QPCA first makes a payment to the payee.

(3) Notification of payee status . In the case of a payment to a payee other than a qualified payee as defined in paragraph (f)(2)(vi) of this section with respect to the payment, the QPCA acting directly or indirectly through its members, affiliates, or licensees must notify the payor that the payee is not a qualified payee. The notification must be furnished during the four-month period beginning on the date on which the QPCA makes the payment. Notification may be provided in a quarterly or other regular report of payee data to the cardholder/payor and may consist of an asterisk, footnote, or other mark next to the payee’s name, with the text of the notification at the bottom of the page or at the end of the list of payee data. Notification by the QPCA that a payee is not a qualified payee does not constitute notice by the IRS that the payee’s TIN is incorrect for purposes of section 3406(a)(1)(B) and §31.3406(d)–5.

(4) Time of payment . A QPCA that makes reports to cardholders on the basis of a calendar quarter or any shorter period (the reporting period) may choose to treat all payments made during the reporting period as being made on the last day of the period for purposes of paragraphs (f)(2)(vi) and (f)(3) of this section. If the QPCA treats payments as being made on the last day of a reporting period, the six-month period in paragraph (f)(2)(vi) of this section and the four-month period in paragraph (f)(3) of this section are treated as beginning on the first day of the reporting period in which the QPCA makes the payment that would otherwise begin the six-month or four-month period.

(5) Examples . The following examples illustrate the rules of this section. For purposes of the examples, assume that Q meets all requirements and fulfills all duties necessary to obtain a QPCA determination from the IRS. The examples are as follows:

Example 1 . (i) Q, a QPCA, enrolls Merchant X on January 20, 2005, to accept the Q payment card as a means for obtaining payment. (The results in this example are the same whether the acts attributed to Q are performed by Q itself or by a member, affiliate, or licensee of Q.) At the time of enrollment, Q obtains

ministration for comment on its impact on small business.

Drafting Information

The principal author of the regulations is Donna Welch, Office of Associate Chief Counsel (Procedure and Administration), Administrative Provisions and Judicial Practice Division. However, other personnel from the IRS and the Treasury Department participated in the development of the regulations.

- - - -

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 31, 301, and 602 are amended as follows:

PART 31—EMPLOYMENT TAXES AND COLLECTION OF INCOME TAX AT THE SOURCE

Paragraph 1. The authority citation for part 31 is amended by removing the entry for section 31.3406(j)–1T to read in part as follows:

Authority: 26 U.S.C. 7805. - * * Par. 2. Section 31.3406(g)–1 is amended by adding paragraph (f) to read as follows:

§31.3406(g)–1 Exceptions for payments to certain payees and certain other payments.

- - - (f) Special rule for certain payment card transactions —(1) In general . No withholding under section 3406 is required for a reportable payment made through a payment card organization if the payment is made on or after January 1, 2005, the organization is a Qualified Payment Card Agent (QPCA), and—

(i) The payee is a qualified payee (as defined in paragraph (f)(2)(vi) of this section) with respect to the payment; or

(ii) The cardholder/payor made the purchase to which the payment relates no later than two months after the last date prescribed under paragraph (f)(3) of this section for furnishing the QPCA’s first notification to the cardholder/payor that the payee is not a qualified payee.

(2) Definitions —(i) Payment card de- fined . For purposes of this section, a pay-

ment card is a card (or an account) issued by a payment card organization, or one of its members, affiliates, or licensees, to a cardholder/payor which, upon presentation to a merchant/payee, represents an agreement of the cardholder to pay the merchant through the payment card organization.

(ii) Payment card organization defined . For purposes of this section, a payment card organization is an entity that sets the standards and provides the mechanism, either directly or indirectly through members, affiliates, or licensees, for effectuating payment between a purchaser and a merchant in a payment card transaction. A payment card organization acting directly or indirectly through its members, affiliates, or licensees generally provides such a payment mechanism by issuing payment cards, enrolling merchants as authorized acceptors of payment cards for payment for goods or services, and ensuring the system conducts the transactions in accordance with prescribed standards for payment card transactions.

(iii) Payment card transaction defined . For purposes of this section, a payment card transaction is a transaction in which a cardholder/payor uses a payment card to purchase goods or services and a merchant agrees to accept a payment card as a means of obtaining payment.

(iv) Cardholder/payor defined . For purposes of this section, a card- holder/payor is the person that agrees to make payments through the payment card organization. Thus, in the case of a payment card issued to an employee of a person that agrees to make payments through the payment card organization, the employer rather than the employee is the cardholder/payor.

(v) Qualified Payment Card Agent (QPCA) defined . For purposes of this section, a Qualified Payment Card Agent (QPCA) is a payment card organization that has a current QPCA determination from the Internal Revenue Service (IRS) under applicable procedures (see §601.601(d)(2) of this chapter).

(vi) Qualified payee defined . For purposes of this section, a payee is a qualified payee with respect to a reportable payment if—

(A) At the time the QPCA makes the payment, the QPCA has obtained the payee’s TIN and the payee’s TIN has been

2004–31 I.R.B. 116 August 2, 2004

Merchant X’s taxpayer identification number (TIN). Merchant X is a sole proprietor engaged in the trade or business of repairing automobiles and trucks. Q’s first payment to Merchant X for purchases through the payment card is made on January 31, 2005.

(ii) On March 1, 2005, Q issues a Q payment card to Customer A to use for the purchase of goods or services in the course of its trade or business from merchants that accept the Q payment card. During 2005, Customer A uses Q payment card to purchase repairs to A’s vehicles from Merchant X on April 29, 2005, July 29, 2005, and December 19, 2005. Q makes payments for the repairs on May 2, 2005, August 1, 2005, and December 20, 2005. Q provides reports of payee data to each of its cardholders, including Customer A, on the 15 ^th of April, July, October, and January for the quarter ending on the last day of the preceding month, but does not choose to treat payments as being made on the last day of the quarter for purposes of paragraphs (f)(2)(vi) and (f)(3) of this section.

(iii) On March 15, 2005, Q attempts to validate Merchant X’s name/TIN through the IRS TIN Matching Program. On March 20, 2005, the IRS notifies Q that the name/TIN furnished by Merchant X does not match IRS data. On June 15, 2005, and September 15, 2005, Q makes further unsuccessful attempts to validate Merchant X’s name/TIN through the IRS TIN Matching Program.

(iv) Under paragraph (f)(2)(vi)(B) of this section, Merchant X is treated as a qualified payee for the six-month period beginning on January 31, 2005 (the date of Q’s first payment to Merchant X), and ending on July 30, 2005. Accordingly, the payment on May 2, 2005, is a payment to a qualified payee and, under paragraph (f)(1)(i) of this section, is not subject to backup withholding.

(v) Q has not validated Merchant X’s TIN at the time of the payments on August 1, 2005, and December 20, 2005. Accordingly, under paragraph (f)(3) of this section, Q must notify Customer A within four months of each of these payments that Merchant X is not a qualified payee with respect to the payments. In the case of the August 1 payment, the notification must be furnished no later than November 30, 2005. Q may provide the notification in its quarterly report of payee data for the July-September quarter furnished on October 15, 2005.

(vi) Although Merchant X is not a qualified payee with respect to the payments on August 1, 2005, and December 20, 2005, paragraph (f)(1)(ii) of this section provides that backup withholding is not required for purchases made no later than two months after the last date prescribed for furnishing the first notification that Merchant X is not a qualified payee. The last date for furnishing the first notification is November 30, 2005, and the two-month period expires on January 30, 2006. Because the payments relate to purchases on July 29, 2005, and December 19, 2005, backup withholding is not required with respect to either payment. Backup withholding may be required with respect to any payment Customer A makes through the Q payment card for purchases from Merchant X after January 30, 2006, unless Q has previously succeeded in validating Merchant X’s TIN.

Example 2 . (i) Assume the same facts as in example (1) except that Q chooses to treat payments as being made on the last day of the quarter for purposes of paragraphs (f)(2)(vi) and (f)(3) of this section.

(ii) The payment Q makes on January 31, 2005, is treated under paragraph (f)(4) of this section as being made on March 31, 2005. Similarly, the payments made on May 2, 2005, August 1, 2005, and December 20, 2005, are treated as being made on June 30, 2005, September 30, 2005, and December 31, 2005.

(iii) Under paragraphs (f)(2)(vi)(B) and (f)(4) of this section, Merchant X is treated as a qualified payee for the six-month period beginning on January 1, 2005 (the beginning of the reporting period during which Q makes the first payment to Merchant X), and ending on June 30, 2005. Accordingly, the payment treated as made on June 30, 2005, is a payment to a qualified payee and, under paragraph (f)(1)(i) of this section, is not subject to backup withholding.

(iv) Q has not validated Merchant X’s TIN at the time of the payments that are treated as being made on September 30, 2005, and December 31, 2005. Accordingly, under paragraphs (f)(3) and (f)(4) of this section, Q must notify Customer A within four months of the beginning of each reporting period during which Q makes these payments that Merchant X is not a qualified payee with respect to the payments. In the case of the September 30 payment, the notification must be furnished no later than October 31, 2005. Q may provide the notification in its quarterly report of payee data for the July-September quarter furnished on October 15, 2005.

(v) Although Merchant X is not a qualified payee with respect to the payments that are treated as being made on September 30, 2005, and December 31, 2005, paragraph (f)(1)(ii) of this section provides that backup withholding is not required for purchases made no later than two months after the last date prescribed for furnishing the first notification that Merchant X is not a qualified payee. The last date for furnishing the first notification is October 31, 2005, and the two-month period expires on December 31, 2005. Because the payments relate to purchases on July 29, 2005, and December 19, 2005, backup withholding is not required with respect to either payment. Backup withholding may be required with respect to any payment Customer A makes through the Q payment card for purchases from Merchant X after December 31, 2005, unless Q has previously succeeded in validating Merchant X’s TIN.

§31.3406(j)–1T [Removed]

Par. 3. Section 31.3406(j)–1T is removed.

Par. 4. Section 31.3406(j)–1 is amended by revising paragraphs (a) and (f) to read as follows:

§31.3406(j)–1 Taxpayer Identification Number (TIN) matching program.

(a) The matching program . Under section 3406(i), the Commissioner has the authority to establish Taxpayer Identification Number (TIN) matching programs. The Commissioner may prescribe in a revenue procedure (see §601.601(d)(2) of this chapter) or other appropriate guidance the scope and the terms and conditions

of participating in any TIN matching program. In general, under a matching program, prior to filing information returns with respect to reportable payments as defined in section 3406(b)(1), a payor of those reportable payments who is entitled to participate in the matching program may contact the Internal Revenue Service (IRS) with respect to the TIN furnished by a payee who has received or is likely to receive a reportable payment. The IRS will inform the payor whether or not a name/TIN combination furnished by the payee matches a name/TIN combination maintained in the data base utilized for the particular matching program. For purposes of this section, the term payor includes an agent designated by the payor to participate in TIN matching on the payor’s behalf.

- - - (f) Effective date . The last sentence in paragraph (a) of this section is applicable on January 31, 2003. All other provisions of this section are applicable on and after June 18, 1997.

PART 3O1—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 301.6724–1 is amended by:

Revising the introductory language of paragraph (c)(6).
Adding paragraphs (e)(1)(vi)(H) and (f)(5)(vii).

The revision and additions read as follows:

§301.6724–1 Reasonable cause.

- - - (c)* - (6) Actions of the payee or any other person . In order to establish reasonable cause under paragraph (c)(1) of this section due to the actions of the payee or any other person, such as a broker as defined in section 6045(c) or a Qualified Payment Card Agent (QPCA) as defined in §31.3406(g)–1(f)(2)(v) of this chapter, providing information with respect to the return or payee statement, the filer must show either—

August 2, 2004 117 2004–31 I.R.B.

that satisfies the applicable requirement or receives from the QPCA a TIN that the filer believes in good faith to be the payee’s correct TIN.

PART 602—OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 7. The authority citation for part 602 continues to read as follows: Authority: 26 U.S.C. 7805. Par. 8. In §602.101, paragraph (b) is amended by revising the entry for 31.3406(g)–1 in the table to read as follows:

§602.101 OMB Control numbers.

- - - (b) - *

Current OMB Control No.

(e) * * * (1) * * * (vi) * - (H) In the case of information returns required to be filed, and information statements required to be furnished, after December 31, 2005, the filer—

( 1 ) Satisfies the solicitation requirements of paragraphs (e)(1)(i) and (ii) of this section with respect to a payment made through a QPCA if the filer relies in good faith on the QPCA to solicit, record, validate, and furnish the payee’s TIN; and

( 2 ) Satisfies the solicitation requirement of paragraph (e)(1)(iii) of this section with respect to such a payment if, on or before December 31 of the year immediately succeeding the calendar year in which the payment is made, the filer undertakes a solicitation of the payee’s TIN or receives from the QPCA a TIN that the filer believes in good faith to be the payee’s correct TIN.

CFR part or section where identified and described

- - - (f) - - (5) - - (vii) In the case of information returns required to be filed, and information statements required to be furnished, after December 31, 2005, the filer—

(A) Satisfies the solicitation requirement of paragraph (f)(1)(i) of this section with respect to a payment made through a QPCA if the filer relies in good faith on the QPCA to solicit, record, validate, and furnish the payee’s TIN; and

(B) Satisfies the solicitation requirement of paragraph (f)(1)(ii) or (iii) of this section, whichever is applicable, with respect to such a payment if, after the date the filer is notified that the account of the payee contains an incorrect TIN and on or before the date by which the applicable requirement must be satisfied, the filer solicits the payee’s correct TIN in a manner

31.3406(g)–1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1545–0096 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1545–0112 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1545–1819

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

Approved July 1, 2004.

Gregory Jenner, Acting Assistant Secretary of the Treasury .

(Filed by the Office of the Federal Register on July 12, 2004, 8:45 a.m., and published in the issue of the Federal Register for July 13, 2004, 69 F.R. 41938)

Section 6041.—Information at Source

Section 6041A.—Returns Regarding Payments of Remuneration for Services and Direct Sales

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

Disclosure of returns and return in- formation. Rev. Rul. 54–379 concludes that heirs at law, next of kin, or beneficiaries who are distributees of a person who dies intestate under state law have a “ma

terial interest” to receive the decedent’s return information. The statute does not clearly address the application of the “material interest” standard in the context of a taxpayer who dies intestate. Rev. Rul. 54–379 superseded.

Rev. Rul. 2004–68

ISSUE

Whether the heir at law or next of kin of a decedent who dies intestate may inspect the income tax return filed by or on behalf of the decedent for the year prior to death.

FACTS

The decedent, a resident of State X, died intestate ( i.e., without a valid will). The decedent had two brothers and two sisters, and no other pre-deceased siblings. Under applicable state law, these four siblings are the decedent’s sole heirs at law and next of kin, and each is entitled to one-fourth of decedent’s estate. The four

2004–31 I.R.B. 118 August 2, 2004

Section 6724.—Waiver; Definitions and Special Rules

Final regulations relating to information reporting requirements, information penalties, and backup withholding for payment card transactions. See T.D. 9136, page 112.

Section 7701.—Definitions

26 CFR 301.7701–1: Classification of organizations for federal tax purposes. (Also: § 301.7701–2, 301.7701–3.)

Disregarded entities. This ruling concludes that, if an eligible entity has two owners under local law, but one of the owners is, for federal tax purposes, disregarded as an entity separate from the other owner of the eligible entity, then the eligible entity cannot be classified as a partnership and is either disregarded as an entity separate from its owner or an association taxable as a corporation.

Rev. Rul. 2004–77

ISSUE

How is an eligible entity (as defined in § 301.7701–3(a) of the Procedure and Administration Regulations) classified for federal tax purposes if the entity has two members under local law, but one of the members of the eligible entity is disregarded as an entity separate from the other member of the eligible entity for federal tax purposes?

FACTS

Situation 1 . X, a domestic corporation, is the sole owner of L, a domestic limited liability company (LLC). Under § 301.7701–3(b)(1), L is disregarded as an entity separate from its owner, X . L and X are the only members under local law of P, a state law limited partnership or LLC. There are no other constructive or beneficial owners of P other than L and X . L and

siblings want to inspect the decedent’s income tax return for the year prior to the decedent’s death in order to identify and locate assets owned by the decedent at the time of the decedent’s death.

LAW AND ANALYSIS

Under I.R.C. § 6103(e)(3)(B), the return of a decedent shall, upon written request, be open to inspection by or disclosure to any heir at law, next of kin, or beneficiary under the will, of such decedent, or a donee of property, but only if the Service finds that such heir at law, next of kin, beneficiary, or donee has a material interest which will be affected by information contained therein.

Generally, the Service has interpreted the term “material interest” as an important interest that is financial in nature. In this case involving a taxpayer dying intestate, the income tax return filed by or on behalf of the decedent for the year prior to death may disclose assets or information materially affecting the distribution to each distributee of the estate. Where the heir at law or next of kin is a distributee, under applicable state law, of the estate of a decedent who dies intestate, such person shall be considered as having a “material interest” which will be affected by information contained in the income tax return filed by or on behalf of the decedent for the year prior to death, within the meaning of section 6103(e)(3)(B).

In addition to the written request for inspection or disclosure, the person requesting access under section 6103(e)(3)(B) must provide the Service with (i) proof of the date of death, place of death, and state of decedent’s residence, to help determine which state law is applicable and (ii) proof of his or her relationship to the decedent, including, but not limited to, a copy of a birth certificate, baptismal certificate, school record, or insurance designation. The person requesting access also must provide the Service with a written statement, along with supporting documents, to demonstrate that he or she has a material interest that will be affected by information contained in each requested return. Evidence sufficient to establish the nature and extent of the requester’s material interest may include, but is not limited to, a copy of the petition for probate or other comparable pleading required to institute

the proceeding for the administration of the decedent’s estate. The Service may require additional information or documentation to determine the nature and extent of the requester’s material interest in the decedent’s return. In this case, upon receipt of satisfactory evidence of (i) the relationship to the decedent, (ii) the date of death, the place of death, and the state of decedent’s residence, and (iii) the decedent’s intestacy, the Service shall disclose to any of the decedent’s siblings the income tax return filed by or on behalf of the decedent for the year prior to decedent’s death.

HOLDING

The income tax return of an intestate decedent for the calendar year prior to decedent’s death shall be open to inspection or disclosure to any heir at law or next of kin who is a distributee, under applicable state law, of the probate estate of the decedent, and the existence of a material interest of such a person that is affected by information contained in that return will be presumed. The Secretary may disclose any other income tax returns of the decedent, provided that such heir at law or next of kin establishes to the satisfaction of the Secretary that he or she has a material interest which will be affected by information contained in each requested return. If, over time, the Secretary deems it prudent to amend the material interest access procedures, individuals who request access to the returns of an intestate decedent may be required to meet additional requirements.

EFFECT ON OTHER REVENUE RULINGS

This ruling supersedes Revenue Ruling 54–379.

PROSPECTIVE APPLICATION

N/A

DRAFTING INFORMATION

The principal author of this revenue ruling is Charles B. Christopher of the Office of Associate Chief Counsel (Procedure and Administration). For further information regarding this revenue ruling, you may contact Charles B. Christopher at (202) 622–4580 (not a toll-free call).

August 2, 2004 119 2004–31 I.R.B.

of X . Because L is disregarded as an entity separate from X, X is treated as owning all of the interests in P . P is a domestic entity, with only one owner for federal tax purposes, that has not made an election to be classified as an association taxable as a corporation. Because P has only one owner for federal tax purposes, P cannot be classified as a partnership under § 7701(a)(2). For federal tax purposes, P is disregarded as an entity separate from its owner.

Situation 2 . Under § 301.7701–3(c), L is disregarded as an entity separate from its owner, X, and its activities are treated in the same manner as a branch or division of X . Because L is disregarded as an entity separate from X, X is treated as owning all of the interests in P . Because P has only one owner for federal tax purposes, P cannot be classified as a partnership under § 7701(a)(2). For federal tax purposes, P is either disregarded as an entity separate from its owner or an association taxable as a corporation.

HOLDING

If an eligible entity has two members under local law, but one of the members of the eligible entity is, for federal tax purposes, disregarded as an entity separate from the other member of the eligible entity, then the eligible entity cannot be classified as a partnership and is either disregarded as an entity separate from its owner or an association taxable as a corporation.

DRAFTING INFORMATION

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

P are eligible entities that do not elect under § 301.7701–3(c) to be treated as associations for federal tax purposes.

Situation 2 . X is an entity that is classified as a corporation under § 301.7701–2(b). X is the sole owner of L, a foreign eligible entity. Under § 301.7701–3(c), L has elected to be disregarded as an entity separate from its owner. L and X are the only members under local law of P, a foreign eligible entity. There are no other constructive or beneficial owners of P other than L and X .

LAW AND ANALYSIS

Section 7701(a)(2) of the Internal Revenue Code provides that the term partnership includes a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not a trust, estate, or corporation.

Section 301.7701–1(a)(1) provides that whether an organization is an entity separate from its owners for federal tax purposes is a matter of federal tax law and does not depend on whether the organization is recognized as an entity under local law.

Section 301.7701–2(a) provides that a business entity is any entity recognized for federal tax purposes (including an entity with a single owner that may be disregarded as an entity separate from its owner under § 301.7701–3) that is not properly classified as a trust under § 301.7701–4 or otherwise subject to special treatment under the Code. A business entity with two or more owners is classified for federal tax purposes as either a corporation or a partnership. A business entity with only one owner is classified as a corporation or is disregarded; if the entity is disregarded, its activities are treated in the same manner as

a sole proprietorship, branch, or division of the owner.

Section 301.7701–2(c)(1) provides that, for federal tax purposes, the term “partnership” means a business entity that is not a corporation under § 301.7701–2(b) and that has at least two owners.

Section 301.7701–2(c)(2)(i) provides, in general, that a business entity that has a single owner and is not a corporation under § 301.7701–2(b) is disregarded as an entity separate from its owner.

Section 301.7701–3(a) provides that a business entity that is not classified as a corporation under § 301.7701–2(b)(1), (3), (4), (5), (6), (7), or (8) (an eligible entity) can elect its classification for federal tax purposes. An eligible entity with at least two owners can elect to be classified as either an association (and thus a corporation under § 301.7701–2(b)(2)) or a partnership, and an eligible entity with a single owner can elect to be classified as an association or to be disregarded as an entity separate from its owner.

Section 301.7701–3(b)(1) provides generally that in the absence of an election otherwise, a domestic eligible entity is (a) a partnership if it has at least two members, or (b) disregarded as an entity separate from its owner if it has a single owner.

Section 301.7701–3(b)(2) provides generally that, in the absence of an election otherwise, a foreign eligible entity is (a) a partnership if it has two or more owners and at least one owner does not have limited liability, (b) an association if all its owners have limited liability, or (c) disregarded as an entity separate from its owner if it has a single owner that does not have limited liability.

Situation 1 . Under § 301.7701–2(c)(2), L is disregarded as an entity separate from its owner, X, and its activities are treated in the same manner as a branch or division

2004–31 I.R.B. 120 August 2, 2004