Part I. Rulings and Decisions Under the Internal Revenue Code of 1986

Section 42.—Low-Income Housing Credit

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of February 2005. See Rev. Rul. 2005-8, page 466.

Section 45D.—New Markets Tax Credit

26 CFR 1.45D–1: New markets tax credit.

T.D. 9171

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 1 and 602

New Markets Tax Credit

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: These regulations finalize the rules relating to the new markets tax credit under section 45D and replace the temporary regulations which expire on December 23, 2004. A taxpayer making a qualified equity investment in a qualified community development entity that has received a new markets tax credit allocation may claim a 5-percent tax credit with respect to the qualified equity investment on each of the first 3 credit allowance dates and a 6-percent tax credit with respect to the qualified equity investment on each of the remaining 4 credit allowance dates.

DATES: Effective Date : These regulations are effective December 22, 2004.

Date of Applicability : For date of applicability, see §1.45D–1(h).

FOR FURTHER INFORMATION CONTACT: Paul F. Handleman or Lauren R. Taylor, (202) 622–3040 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in these final regulations has been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under control number 1545–1765. Responses to this collection of information are mandatory so that a taxpayer may claim a new markets tax credit on each credit allowance date during the 7-year credit period and report compliance with the requirements of section 45D to the Secretary.

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

The estimated annual burden per respondent varies from 15 minutes to 5 hours, depending on individual circumstances, with an estimated average of 2.5 hours.

Comments concerning the accuracy of this burden estimate 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.

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

Background

This document amends 26 CFR part 1 to provide rules relating to the new markets tax credit under section 45D of the Internal Revenue Code (Code). On December 26, 2001, the IRS published in the Federal Register temporary and proposed

regulations (the 2001 temporary regulations) (T.D. 8971, 2002–1 C.B. 308 [66 FR 66307]), (REG–119436–01, 2002–1 C.B. 377 [66 FR 66376]) . On March 11, 2004, the IRS published in the Federal Register temporary and proposed regulations revising and clarifying the 2001 temporary regulations (the 2004 temporary regulations) (T.D. 9116, 2004–14 I.R.B. 674 [69 FR 11507]), (REG–115471–03, 2004–14 I.R.B. 706 [69 FR 11561]). On March 14, 2002, and June 2, 2004, the IRS and Treasury Department held public hearings on the 2001 temporary regulations and the 2004 temporary regulations, respectively. Written and electronic comments responding to the temporary regulations and notices of proposed rulemaking were received. After consideration of all the comments, the proposed regulations are adopted as amended by this Treasury decision, and the corresponding temporary regulations are removed. The revisions are discussed below.

Section 45D was added to the Code by section 121(a) of the Community Renewal Tax Relief Act of 2000 (Pub. L. 106–554). The Secretary has delegated certain administrative, application, allocation, monitoring, and other programmatic functions relating to the new markets tax credit program to the Under Secretary (Domestic Finance), who in turn has delegated those functions to the Community Development Financial Institutions Fund.

Sections 221 and 223 of the American Jobs Creation Act of 2004 (Pub. L. 108–357) amended the definition of a lowincome community under section 45D(e). This document does not provide guidance on these amendments. The IRS and Treasury Department are studying the amendments for guidance in the near future.

Explanation of Provisions

General Overview

Taxpayers may claim a new markets tax credit on a credit allowance date in an amount equal to the applicable percentage of the taxpayer’s qualified equity investment in a qualified community development entity (CDE). The credit allowance date for any qualified equity investment is

2005–6 I.R.B. 452 February 7, 2005

community investments are treated as invested in a qualified low-income community investment. In response to comments, the final regulations provide that reserves include fees paid to third parties to protect against loss of all or a portion of the principal of, or interest on, on a loan that is a qualified low-income community investment.

Qualified Active Low-Income Community Business

As indicated above, qualified low-income community investments include any capital or equity investment in, or loan to, any qualified active low-income community business. Under §1.45D–1T (d)(4)(i)(B), an entity is a qualified active low-income community business only if, among other requirements, at least 40 percent of the use of the tangible property of such entity (whether owned or leased) is within any low-income community. In response to comments, the final regulations provide an example of how the tangible property test applies to property that is used both outside and inside a low-income community. The example demonstrates that use is measured based on the entity’s business hours of operation and does not include non-business hours.

Under section 45D(d)(2)(C), a qualified active low-income community business includes any trade or business that would qualify as a qualified active low-income community business if such trade or business were separately incorporated. Commentators requested clarification of how this rule applies.

The final regulations provide that a CDE may treat any trade or business (or portion thereof) as a qualified active low-income community business if the trade or business (or portion thereof) would meet the requirements to be a qualified active low-income community business if the trade or business (or portion thereof) were separately incorporated and a complete and separate set of books and records is maintained for that trade or business (or portion thereof). The final regulations further provide, however, that under this rule a CDE’s capital or equity investment or loan is not a qualified low-income community investment to the extent the proceeds of the investment or loan are not used for the trade or business

the date on which the investment is initially made and each of the 6 anniversary dates thereafter. The applicable percentage is 5 percent for the first 3 credit allowance dates and 6 percent for the remaining credit allowance dates.

A CDE is any domestic corporation or partnership if: (1) the primary mission of the entity is serving or providing investment capital for low-income communities or low-income persons; (2) the entity maintains accountability to residents of low-income communities through their representation on any governing board of the entity or on any advisory board to the entity; and (3) the entity is certified by the Secretary for purposes of section 45D as being a CDE.

The new markets tax credit may be claimed only for a qualified equity investment in a CDE. A qualified equity investment is any equity investment in a CDE for which the CDE has received an allocation from the Secretary if, among other things, the CDE uses substantially all of the cash from the investment to make qualified low-income community investments. Under a safe harbor, the substantially-all requirement is treated as met if at least 85 percent of the aggregate gross assets of the CDE are invested in qualified low-income community investments.

Qualified low-income community investments consist of: (1) any capital or equity investment in, or loan to, any qualified active low-income community business; (2) the purchase from another CDE of any loan made by such entity that is a qualified low-income community investment; (3) financial counseling and other services to businesses located in, and residents of, low-income communities; and (4) certain equity investments in, or loans to, a CDE.

In general, a qualified active low-income community business is a corporation or a partnership if for the taxable year: (1) at least 50 percent of the total gross income of the entity is derived from the active conduct of a qualified business within any low-income community; (2) a substantial portion of the use of the tangible property of the entity is within any low-income community; (3) a substantial portion of the services performed for the entity by its employees is performed in any low-income community; (4) less than 5 percent of the average of the aggregate unadjusted bases

of the property of the entity is attributable to certain collectibles; and (5) less than 5 percent of the average of the aggregate unadjusted bases of the property of the entity is attributable to certain nonqualified financial property.

A recapture event requiring an investor to recapture credits previously taken occurs for an equity investment in a CDE if the CDE: (1) ceases to be a CDE; (2) ceases to use substantially all of the proceeds of the equity investment for qualified low-income community investments; or (3) redeems the investor’s equity investment. In addition, the investor’s basis in any qualified equity investment is reduced by the amount of the new markets tax credit.

Substantially All

As indicated above, a CDE must use substantially all of the cash from a qualified equity investment to make qualified low-income community investments. Section 1.45D–1T(c)(5)(i) provides that the substantially-all requirement is treated as satisfied for an annual period if either the direct-tracing calculation under §1.45D–1T(c)(5)(ii), or the safe harbor calculation under §1.45D–1T(c)(5)(iii), is performed every six months and the average of the two calculations for the annual period is at least 85 percent. The final regulations clarify that a CDE may choose the same two testing dates for all qualified equity investments regardless of the date each qualified equity investment was initially made. To conform the annual testing requirement with the 12-month time limit for making qualified low-income community investments, the final regulations provide that for the first annual period, the substantially-all calculation may be performed on a single testing date. The final regulations also amend the beginning of the 12-month period for making qualified low-income community investments to provide that the 12-month period begins on the same date as the beginning of the first annual period of the 7-year credit period.

Section 1.45D–1T(d)(3) provides that reserves (not in excess of 5 percent of the taxpayer’s cash investment under §1.45D–1T(b)(4)) maintained by the CDE for loan losses or for additional investments in existing qualified low-income

February 7, 2005 453 2005–6 I.R.B.

ment, the failure should not be a recapture event if the CDE corrects the failure within 6 months after the date the CDE discovers (or reasonably should have discovered) the failure. The final regulations provide that, if a qualified equity investment fails the substantially-all requirement, the failure is not a recapture event if the CDE corrects the failure within 6 months after the date the CDE becomes aware (or reasonably should have become aware) of the failure. Only one correction is permitted for each qualified equity investment during the 7-year credit period.

Other Issues

Section 45D(i)(1) authorizes the Secretary to prescribe regulations as may be appropriate to carry out section 45D including regulations that limit the new markets tax credit for investments that are directly or indirectly subsidized by other Federal tax benefits (including the low-income housing credit under section 42 and the exclusion from gross income under section 103). The final regulations do not prohibit a CDE from purchasing tax-exempt bonds because tax-exempt financing provides a subsidy to borrowers and not bondholders. However, the final regulations provide that if a CDE makes a capital or equity investment or loan with respect to a qualified low-income building under section 42, the investment or loan is not a qualified low-income community investment to the extent the building’s eligible basis under section 42(d) is financed by the proceeds of the investment or loan.

Effective Dates

The final regulations are effective December 22, 2004, and may be applied by taxpayers before December 22, 2004. However, both the definition of the term substantial improvements and the requirement that each lessee be a qualified business apply to qualified low-income community investments made on or after February 22, 2005.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been de

(or portion thereof) that is treated as a qualified active low-income community business.

Section §1.45D–1T(d)(4)(iv) provides that an entity will be treated as engaged in the active conduct of a trade or business if, at the time the CDE makes a capital or equity investment in, or loan to, the entity, the CDE reasonably expects that the entity will generate revenues (or, in the case of a nonprofit corporation, receive donations) within 3 years after the date the investment or loan is made. The final regulations amend this rule with respect to a nonprofit corporation by providing that the nonprofit corporation must be engaged in an activity that furthers its purpose as a nonprofit corporation within the 3-year period.

Under §1.45D–1T(d)(4)(i)(E), an entity is a qualified active low-income community business only if, among other requirements, less than 5 percent of the average of the aggregate unadjusted bases of the property of such entity is attributable to nonqualified financial property (as defined in section 1397C(e)). Section 1397C(e)(1) contains an exception to the definition of nonqualified financial property for reasonable amounts of working capital held in cash, cash equivalents, or debt instruments with a term of 18 months or less. The final regulations provide that, for these purposes, the proceeds of a capital or equity investment or loan by a CDE that will be expended on construction of real property within 12 months after the date the investment or loan is made qualify as a reasonable amount of working capital.

Section 45D(d)(3)(A) provides that the rental to others of real property located in any low-income community is treated as a qualified business only if, among other requirements, there are substantial improvements located on such property. Commentators requested clarification of the term substantial improvements . The final regulations provide that the term substantial improvements means improvements the cost basis of which equals or exceeds 50 percent of the cost basis of the land on which the improvements are located and the costs of which are incurred after the date the CDE makes the investment or loan. In addition, the final regulations provide that a CDE’s investment in or loan to a business engaged in the rental of real property is not a qualified low-income community investment to the

extent any lessee of the real property is not a qualified business.

Recapture

As indicated above, there is a recapture event with respect to an equity investment in a CDE if such investment is redeemed by the CDE. Commentators requested clarification of when distributions by a CDE to its investors will be treated as redemptions. The final regulations provide guidance on when a distribution by a CDE that is a corporation for Federal tax purposes will be treated as a redemption.

Some commentators suggested that, in the case of a CDE that is treated as a partnership for Federal tax purposes, a redemption should be limited to purchases by the CDE of a partner’s capital interest. Alternatively, commentators requested guidance on how to distinguish between a return of capital and a distribution of profits if a return of capital is treated as a redemption. In response to comments, the final regulations provide a safe harbor under which cash distributions by a partnership will not be treated as a redemption. Under the safe harbor, a pro rata cash distribution by the CDE to its partners based on each partner’s capital interest in the CDE during the taxable year will not be treated as a redemption if the distribution does not exceed the CDE’s operating income (as defined in the final regulations) for the taxable year. In addition, a non- pro rata de minimis cash distribution by a CDE to a partner or partners during the taxable year will be not treated as a redemption. A non- pro rata de minimis cash distribution may not exceed the lesser of 5 percent of the CDE’s operating income for that taxable year or 10 percent of the partner’s capital interest in the CDE.

Commentators suggested that cure periods be provided to enable CDEs to correct any noncompliance with the requirements under section 45D. One commentator suggested that a cure period be provided to allow an investment that no longer qualifies as a qualified low-income community investment to be replaced with a qualifying investment by the end of the calendar year following the year the original investment lost its status as a qualified low-income community investment. Other commentators suggested that, if a qualified equity investment fails the substantially-all require

2005–6 I.R.B. 454 February 7, 2005

(ii) Proprietorships. (iii) Portions of business. (A) In general. (B) Examples. (iv) Active conduct of a trade or business.

(A) Special rule. (B) Example. (5) Qualified business. (i) In general. (ii) Rental of real property. (iii) Exclusions. (A) Trades or businesses involving intangibles.

(B) Certain other trades or businesses. (C) Farming. (6) Qualifications. (i) In general. (ii) Control. (A) In general. (B) Definition of control. (C) Disregard of control. (7) Financial counseling and other services.

(8) Special rule for certain loans. (i) In general. (ii) Example. (e) Recapture. (1) In general. (2) Recapture event. (3) Redemption. (i) Equity investment in a C corporation.

(ii) Equity investment in an S corporation.

(iii) Capital interest in a partnership. (4) Bankruptcy. (5) Waiver of requirement or extension of time.

(i) In general. (ii) Manner for requesting a waiver or extension.

(iii) Terms and conditions. (6) Cure period. (7) Example. (f) Basis reduction. (1) In general. (2) Adjustment in basis of interest in partnership or S corporation.

(g) Other rules. (1) Anti-abuse. (2) Reporting requirements. (i) Notification by CDE to taxpayer. (A) Allowance of new markets tax credit.

(B) Recapture event. (ii) CDE reporting requirements to Secretary.

termined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. It is hereby certified that the collection of information in these regulations will not have a significant economic impact on a substantial number of small entities. This certification is based upon the fact that any burden on taxpayers is minimal. Accordingly, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of the Code, the notices of proposed rulemaking preceding these regulations were submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Drafting Information

The principal author of these regulations is Paul F. Handleman, Office of the Associate Chief Counsel (Passthroughs and Special Industries), IRS. However, other personnel from the IRS and Treasury Department participated in their development.

- - - -

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1—INCOME TAXES

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

Authority: 26 U.S.C. 7805 * * * Section 1.45D–1 also issued under 26 U.S.C. 45D(i); * * * Par. 2. Section 1.45D–1 is added to read as follows:

§1.45D–1 New markets tax credit.

(a) Table of contents . This paragraph lists the headings that appear in §1.45D–1.

(a) Table of contents. (b) Allowance of credit. (1) In general. (2) Credit allowance date. (3) Applicable percentage. (4) Amount paid at original issue. (c) Qualified equity investment. (1) In general. (2) Equity investment.

(3) Equity investments made prior to allocation.

(i) In general. (ii) Exceptions. (A) Allocation applications submitted by August 29, 2002.

(B) Other allocation applications. (iii) Failure to receive allocation. (iv) Initial investment date. (4) Limitations. (i) In general. (ii) Allocation limitation. (5) Substantially all. (i) In general. (ii) Direct-tracing calculation. (iii) Safe harbor calculation. (iv) Time limit for making investments. (v) Reduced substantially-all percentage.

(vi) Examples. (6) Aggregation of equity investments. (7) Subsequent purchasers. (d) Qualified low-income community investments.

(1) In general. (i) Investment in a qualified active lowincome community business.

(ii) Purchase of certain loans from CDEs.

(A) In general. (B) Certain loans made before CDE certification.

(C) Intermediary CDEs. (D) Examples. (iii) Financial counseling and other services.

(iv) Investments in other CDEs. (A) In general. (B) Examples. (2) Payments of, or for, capital, equity or principal.

(i) In general. (ii) Subsequent reinvestments. (iii) Special rule for loans. (iv) Example. (3) Special rule for reserves. (4) Qualified active low-income community business.

(i) In general. (A) Gross-income requirement. (B) Use of tangible property. ( 1) In general. ( 2 ) Example. (C) Services performed. (D) Collectibles. (E) Nonqualified financial property. ( 1 ) In general. ( 2 ) Construction of real property.

February 7, 2005 455 2005–6 I.R.B.

made for a credit allocation received pursuant to an allocation application submitted to the Secretary under that NOAA; and

( 3 ) The equity investment otherwise satisfies the requirements of section 45D and this section.

(iii) Failure to receive allocation . For purposes of paragraph (c)(3)(ii)(A) of this section, if the entity in which the equity investment is made does not receive an allocation pursuant to an allocation application submitted no later than August 29, 2002, the equity investment will not be eligible to be designated as a qualified equity investment. For purposes of paragraph (c)(3)(ii)(B) of this section, if the entity in which the equity investment is made does not receive an allocation under the NOAA described in paragraph (c)(3)(ii)(B)( 1 ) of this section, the equity investment will not be eligible to be designated as a qualified equity investment.

(iv) Initial investment date . If an equity investment is designated as a qualified equity investment in accordance with paragraph (c)(3)(ii) of this section, the investment is treated as initially made on the effective date of the allocation agreement between the CDE and the Secretary.

(4) Limitations —(i) In general . The term qualified equity investment does not include—

(A) Any equity investment issued by a CDE more than 5 years after the date the CDE enters into an allocation agreement (as defined in paragraph (c)(3)(i) of this section) with the Secretary; and

(B) Any equity investment by a CDE in another CDE, if the CDE making the investment has received an allocation under section 45D(f)(2).

(ii) Allocation limitation. The maximum amount of equity investments issued by a CDE that may be designated under paragraph (c)(1)(iii) of this section by the CDE may not exceed the portion of the limitation amount allocated to the CDE by the Secretary under section 45D(f)(2).

(5) Substantially all —(i) In general . Except as provided in paragraph (c)(5)(v) of this section, the term substantially all means at least 85 percent. The substantially-all requirement must be satisfied for each annual period in the 7-year credit period using either the direct-tracing calculation under paragraph (c)(5)(ii) of this section, or the safe harbor calculation under paragraph (c)(5)(iii) of this section. For

(iii) Manner of claiming new markets tax credit.

(iv) Reporting recapture tax. (3) Other Federal tax benefits. (i) In general. (ii) Low-income housing credit. (4) Bankruptcy of CDE. (h) Effective dates. (1) In general. (2) Exception for certain provisions. (b) Allowance of credit —(1) In gen- eral . For purposes of the general business credit under section 38, a taxpayer holding a qualified equity investment on a credit allowance date which occurs during the taxable year may claim the new markets tax credit determined under section 45D and this section for such taxable year in an amount equal to the applicable percentage of the amount paid to a qualified community development entity (CDE) for such investment at its original issue. Qualified equity investment is defined in paragraph (c) of this section. Credit allowance date is defined in paragraph (b)(2) of this section. Applicable percentage is defined in paragraph (b)(3) of this section. A CDE is a qualified community development entity as defined in section 45D(c). The amount paid at original issue is determined under paragraph (b)(4) of this section.

(2) Credit allowance date . The term credit allowance date means, with respect to any qualified equity investment––

(i) The date on which the investment is initially made; and

(ii) Each of the 6 anniversary dates of such date thereafter.

(3) Applicable percentage . The appli- cable percentage is 5 percent for the first 3 credit allowance dates and 6 percent for the other 4 credit allowance dates.

(4) Amount paid at original issue . The amount paid to the CDE for a qualified equity investment at its original issue consists of all amounts paid by the taxpayer to, or on behalf of, the CDE (including any underwriter’s fees) to purchase the investment at its original issue.

(c) Qualified equity investment —(1) In general . The term qualified equity invest- ment means any equity investment (as defined in paragraph (c)(2) of this section) in a CDE if—

(i) The investment is acquired by the taxpayer at its original issue (directly or through an underwriter) solely in exchange for cash;

(ii) Substantially all (as defined in paragraph (c)(5) of this section) of such cash is used by the CDE to make qualified low-income community investments (as defined in paragraph (d)(1) of this section); and

(iii) The investment is designated for purposes of section 45D and this section by the CDE on its books and records using any reasonable method.

(2) Equity investment . The term equity investment means any stock (other than nonqualified preferred stock as defined in section 351(g)(2)) in an entity that is a corporation for Federal tax purposes and any capital interest in an entity that is a partnership for Federal tax purposes. See §§301.7701–1 through 301.7701–3 of this chapter for rules governing when a business entity, such as a business trust or limited liability company, is classified as a corporation or a partnership for Federal tax purposes.

(3) Equity investments made prior to al- location —(i) In general . Except as provided in paragraph (c)(3)(ii) of this section, an equity investment in an entity is not eligible to be designated as a qualified equity investment if it is made before the entity enters into an allocation agreement with the Secretary. An allocation agreement is an agreement between the Secretary and a CDE relating to a new markets tax credit allocation under section 45D(f)(2).

(ii) Exceptions . Notwithstanding paragraph (c)(3)(i) of this section, an equity investment in an entity is eligible to be designated as a qualified equity investment under paragraph (c)(1)(iii) of this section if—

(A) Allocation applications submitted by August 29, 2002 .

( 1 ) The equity investment is made on or after April 20, 2001;

( 2 ) The designation of the equity investment as a qualified equity investment is made for a credit allocation received pursuant to an allocation application submitted to the Secretary no later than August 29, 2002; and

( 3 ) The equity investment otherwise satisfies the requirements of section 45D and this section; or

(B) Other allocation applications . ( 1 ) The equity investment is made on or after the date the Secretary publishes a Notice of Allocation Availability (NOAA) in the Federal Register ;

( 2 ) The designation of the equity investment as a qualified equity investment is

2005–6 I.R.B. 456 February 7, 2005

(vi) Examples . The following examples illustrate an application of this paragraph (c)(5):

Example 1 . X is a partnership and a CDE that has received a $1 million new markets tax credit allocation from the Secretary. On September 1, 2004, X uses a line of credit from a bank to fund a $1 million loan to Y. The loan is a qualified low-income community investment under paragraph (d)(1) of this section. On September 5, 2004, A pays $1 million to acquire a capital interest in X. X uses the proceeds of A’s equity investment to pay off the $1 million line of credit that was used to fund the loan to Y. X’s aggregate gross assets consist of the $1 million loan to Y and $100,000 in other assets. A’s equity investment in X does not satisfy the substantially-all requirement under paragraph (c)(5)(i) of this section using the direct-tracing calculation under paragraph (c)(5)(ii) of this section because the cash from A’s equity investment is not used to make X’s loan to Y. However, A’s equity investment in X satisfies the substantially-all requirement using the safe harbor calculation under paragraph (c)(5)(iii) of this section because at least 85 percent of X’s aggregate gross assets are invested in qualified low-income community investments.

Example 2 . X is a partnership and a CDE that has received a new markets tax credit allocation from the Secretary. On August 1, 2004, A pays $100,000 for a capital interest in X. On August 5, 2004, X uses the proceeds of A’s equity investment to make an equity investment in Y. X controls Y within the meaning of paragraph (d)(6)(ii)(B) of this section. For the annual period ending July 31, 2005, Y is a qualified active low-income community business (as defined in paragraph (d)(4) of this section). Thus, for that period, A’s equity investment satisfies the substantially-all requirement under paragraph (c)(5)(i) of this section using the direct-tracing calculation under paragraph (c)(5)(ii) of this section. For the annual period ending July 31, 2006, Y no longer is a qualified active low-income community business. Thus, for that period, A’s equity investment does not satisfy the substantially-all requirement using the direct-tracing calculation. However, during the entire annual period ending July 31, 2006, X’s remaining assets are invested in qualified low-income community investments with an aggregate cost basis of $900,000. Consequently, for the annual period ending July 31, 2006, at least 85 percent of X’s aggregate gross assets are invested in qualified low-income community investments. Thus, for the annual period ending July 31, 2006, A’s equity investment satisfies the substantially-all requirement using the safe harbor calculation under paragraph (c)(5)(iii) of this section.

Example 3 . X is a partnership and a CDE that has received a new markets tax credit allocation from the Secretary. On August 1, 2004, A and B each pay $100,000 for a capital interest in X. X does not treat A’s and B’s equity investments as one qualified equity investment under paragraph (c)(6) of this section. On September 1, 2004, X uses the proceeds of A’s equity investment to make an equity investment in Y and X uses the proceeds of B’s equity investment to make an equity investment in Z. X has no assets other than its investments in Y and Z. X controls Y and Z within the meaning of paragraph (d)(6)(ii)(B) of this section. For the annual period ending July 31, 2005, Y and Z are qualified active low-income com

the first annual period, the substantially-all requirement is treated as satisfied if either the direct-tracing calculation under paragraph (c)(5)(ii) of this section, or the safe-harbor calculation under paragraph (c)(5)(iii) of this section, is performed on a single testing date and the result of the calculation is at least 85 percent. For each annual period other than the first annual period, the substantially-all requirement is treated as satisfied if either the direct-tracing calculation under paragraph (c)(5)(ii) of this section, or the safe harbor calculation under paragraph (c)(5)(iii) of this section, is performed every six months and the average of the two calculations for the annual period is at least 85 percent. For example, the CDE may choose the same two testing dates for all qualified equity investments regardless of the date each qualified equity investment was initially made under paragraph (b)(2)(i) of this section, provided the testing dates are six months apart. The use of the direct-tracing calculation under paragraph (c)(5)(ii) of this section (or the safe harbor calculation under paragraph (c)(5)(iii) of this section) for an annual period does not preclude the use of the safe harbor calculation under paragraph (c)(5)(iii) of this section (or the direct-tracing calculation under paragraph (c)(5)(ii) of this section) for another annual period, provided that a CDE that switches to a direct-tracing calculation must substantiate that the taxpayer’s investment is directly traceable to qualified low-income community investments from the time of the CDE’s initial investment in a qualified low-income community investment. For purposes of this paragraph (c)(5)(i), the 7-year credit period means the period of 7 years beginning on the date the qualified equity investment is initially made. See paragraph (c)(6) of this section for circumstances in which a CDE may treat more than one equity investment as a single qualified equity investment.

(ii) Direct-tracing calculation . The substantially-all requirement is satisfied if at least 85 percent of the taxpayer’s investment is directly traceable to qualified low-income community investments as defined in paragraph (d)(1) of this section. The direct-tracing calculation is a fraction the numerator of which is the CDE’s aggregate cost basis determined under section 1012 in all of the qualified low-income community investments that

are directly traceable to the taxpayer’s cash investment, and the denominator of which is the amount of the taxpayer’s cash investment under paragraph (b)(4) of this section. For purposes of this paragraph (c)(5)(ii), cost basis includes the cost basis of any qualified low-income community investment that becomes worthless. See paragraph (d)(2) of this section for the treatment of amounts received by a CDE in payment of, or for, capital, equity or principal with respect to a qualified low-income community investment.

(iii) Safe harbor calculation . The substantially-all requirement is satisfied if at least 85 percent of the aggregate gross assets of the CDE are invested in qualified low-income community investments as defined in paragraph (d)(1) of this section. The safe harbor calculation is a fraction the numerator of which is the CDE’s aggregate cost basis determined under section 1012 in all of its qualified low-income community investments, and the denominator of which is the CDE’s aggregate cost basis determined under section 1012 in all of its assets. For purposes of this paragraph (c)(5)(iii), cost basis includes the cost basis of any qualified low-income community investment that becomes worthless. See paragraph (d)(2) of this section for the treatment of amounts received by a CDE in payment of, or for, capital, equity or principal with respect to a qualified low-income community investment.

(iv) Time limit for making investments . The taxpayer’s cash investment received by a CDE is treated as invested in a qualified low-income community investment as defined in paragraph (d)(1) of this section only to the extent that the cash is so invested within the 12-month period beginning on the date the cash is paid by the taxpayer (directly or through an underwriter) to the CDE.

(v) Reduced substantially-all percent- age . For purposes of the substantially-all requirement (including the direct-tracing calculation under paragraph (c)(5)(ii) of this section and the safe harbor calculation under paragraph (c)(5)(iii) of this section), 85 percent is reduced to 75 percent for the seventh year of the 7-year credit period (as defined in paragraph (c)(5)(i) of this section).

February 7, 2005 457 2005–6 I.R.B.

Z is a qualified active low-income community business under paragraph (d)(4)(i) of this section. Accordingly, the loan purchased by X from Y is a qualified low-income community investment under paragraphs (d)(1)(ii)(A) and (B) of this section.

Example 2 . The facts are the same as in Exam- ple 1 except that on February 1, 2004, Y sells the loan to W and on September 1, 2004, W sells the loan to X. W is a CDE. Under paragraph (d)(1)(ii)(C) of this section, X’s purchase of the loan from W is treated as the purchase of the loan from Y. Accordingly, the loan purchased by X from W is a qualified low-income community investment under paragraphs (d)(1)(ii)(A) and (C) of this section.

Example 3 . The facts are the same as in Exam- ple 2 except that W is not a CDE. Because W was not a CDE at the time it sold the loan to X, the purchase of the loan by X from W is not a qualified low-income community investment under paragraphs (d)(1)(ii)(A) and (C) of this section.

(iii) Financial counseling and other ser- vices . Financial counseling and other services (as defined in paragraph (d)(7) of this section) provided to any qualified active low–income community business, or to any residents of a low–income community (as defined in section 45D(e)).

(iv) Investments in other CDEs —(A) In general . Any equity investment in, or loan to, any CDE (the second CDE) by a CDE (the primary CDE), but only to the extent that the second CDE uses the proceeds of the investment or loan—

( 1 ) In a manner— ( i ) That is described in paragraph (d)(1)(i) or (iii) of this section; and

( ii ) That would constitute a qualified low-income community investment if it were made directly by the primary CDE;

( 2 ) To make an equity investment in, or loan to, a third CDE that uses such proceeds in a manner described in paragraph (d)(1)(iv)(A)( 1 ) of this section; or

( 3 ) To make an equity investment in, or loan to, a third CDE that uses such proceeds to make an equity investment in, or loan to, a fourth CDE that uses such proceeds in a manner described in paragraph (d)(1)(iv)(A)( 1 ) of this section.

(B) Examples . The following examples illustrate an application of paragraph (d)(1)(iv)(A) of this section:

Example 1 . X is a partnership and a CDE that has received a new markets tax credit allocation from the Secretary. On September 1, 2004, X uses $975,000 to make an equity investment in Y. Y is a corporation and a CDE. On October 1, 2004, Y uses $950,000 from X’s equity investment to make a loan to Z. Z is a qualified active low-income community business under paragraph (d)(4)(i) of this section. Of X’s equity investment in Y, $950,000 is a qualified low-income community investment under paragraph (d)(1)(iv)(A)( 1 ) of this section.

munity businesses (as defined in paragraph (d)(4) of this section). Thus, for the annual period ending July 31, 2005, A’s and B’s equity investments satisfy the substantially-all requirement under paragraph (c)(5)(i) of this section using either the direct-tracing calculation under paragraph (c)(5)(ii) of this section or the safe harbor calculation under paragraph (c)(5)(iii) of this section. For the annual period ending July 31, 2006, Y, but not Z, is a qualified active low-income community business. Thus, for the annual period ending July 31, 2006—

(1) X does not satisfy the substantially-all requirement using the safe harbor calculation under paragraph (c)(5)(iii) of this section;

(2) A’s equity investment satisfies the substantially-all requirement using the direct-tracing calculation because A’s equity investment is directly traceable to Y; and

(3) B’s equity investment does not satisfy the substantially-all requirement because B’s equity investment is traceable to Z.

Example 4 . X is a partnership and a CDE that has received a new markets tax credit allocation from the Secretary. On November 1, 2004, A pays $100,000 for a capital interest in X. On December 1, 2004, B pays $100,000 for a capital interest in X. On December 31, 2004, X uses $85,000 from A’s equity investment and $85,000 from B’s equity investment to make a $170,000 equity investment in Y, a qualified active low-income community business (as defined in paragraph (d)(4) of this section). X has no assets other than its investment in Y. X determines whether A’s and B’s equity investments satisfy the substantially-all requirement under paragraph (c)(5)(i) of this section on December 31, 2004. The calculation for A’s and B’s equity investments is 85 percent using either the direct-tracing calculation under paragraph (c)(5)(ii) of this section or the safe harbor calculation under paragraph (c)(5)(iii) of this section. Therefore, for the annual periods ending October 31, 2005, and November 30, 2005, A’s and B’s equity investments, respectively, satisfy the substantially-all requirement under paragraph (c)(5)(i) of this section. For the subsequent annual period, X performs its calculations on December 31, 2005, and June 30, 2006. The average of the two calculations on December 31, 2005, and June 30, 2006, is 85 percent using either the direct-tracing calculation under paragraph (c)(5)(ii) of this section or the safe harbor calculation under paragraph (c)(5)(iii) of this section. Therefore, for the annual periods ending October 31, 2006, and November 30, 2006, A’s and B’s equity investments, respectively, satisfy the substantially-all requirement under paragraph (c)(5)(i) of this section.

(6) Aggregation of equity investments . A CDE may treat any qualified equity investments issued on the same day as one qualified equity investment. If a CDE aggregates equity investments under this paragraph (c)(6), the rules in this section shall be construed in a manner consistent with that treatment.

(7) Subsequent purchasers . A qualified equity investment includes any equity investment that would (but for paragraph (c)(1)(i) of this section) be a quali

fied equity investment in the hands of the taxpayer if the investment was a qualified equity investment in the hands of a prior holder.

(d) Qualified low-income community investments —(1) In general . The term qualified low-income community invest- ment means any of the following:

(i) Investment in a qualified active low-income community business . Any capital or equity investment in, or loan to, any qualified active low-income community business (as defined in paragraph (d)(4) of this section).

(ii) Purchase of certain loans from CDEs —(A) In general . The purchase by a CDE (the ultimate CDE) from another CDE (whether or not that CDE has received an allocation from the Secretary under section 45D(f)(2)) of any loan made by such entity that is a qualified low-income community investment. A loan purchased by the ultimate CDE from another CDE is a qualified low-income community investment if it qualifies as a qualified low-income community investment either—

( 1 ) At the time the loan was made; or ( 2 ) At the time the ultimate CDE purchases the loan.

(B) Certain loans made before CDE certification . For purposes of paragraph (d)(1)(ii)(A) of this section, a loan by an entity is treated as made by a CDE, notwithstanding that the entity was not a CDE at the time it made the loan, if the entity is a CDE at the time it sells the loan.

(C) Intermediary CDEs . For purposes of paragraph (d)(1)(ii)(A) of this section, the purchase of a loan by the ultimate CDE from a CDE that did not make the loan (the second CDE) is treated as a purchase of the loan by the ultimate CDE from the CDE that made the loan (the originating CDE) if—

( 1 ) The second CDE purchased the loan from the originating CDE (or from another CDE); and

( 2 ) Each entity that sold the loan was a CDE at the time it sold the loan.

(D) Examples . The following examples illustrate an application of this paragraph (d)(1)(ii):

Example 1 . X is a partnership and a CDE that has received a new markets tax credit allocation from the Secretary. Y, a corporation, made a $500,000 loan to Z in 1999. In January of 2004, Y is certified as a CDE. On September 1, 2004, X purchases the loan from Y. At the time X purchases the loan,

2005–6 I.R.B. 458 February 7, 2005

Example 2 . W is a partnership and a CDE that has received a new markets tax credit allocation from the Secretary. On September 1, 2004, W uses $975,000 to make an equity investment in X. On October 1, 2004, X uses $950,000 from W’s equity investment to make an equity investment in Y. X and Y are corporations and CDEs. On October 5, 2004, Y uses $925,000 from X’s equity investment to make a loan to Z. Z is a qualified active low-income community business under paragraph (d)(4)(i) of this section. Of W’s equity investment in X, $925,000 is a qualified low-income community investment under paragraph (d)(1)(iv)(A)( 2 ) of this section because X uses proceeds of W’s equity investment to make an equity investment in Y, which uses $925,000 of the proceeds in a manner described in paragraph (d)(1)(iv)(A)( 1 ) of this section.

Example 3 . U is a partnership and a CDE that has received a new markets tax credit allocation from the Secretary. On September 1, 2004, U uses $975,000 to make an equity investment in V. On October 1, 2004, V uses $950,000 from U’s equity investment to make an equity investment in W. On October 5, 2004, W uses $925,000 from V’s equity investment to make an equity investment in X. On November 1, 2004, X uses $900,000 from W’s equity investment to make an equity investment in Y. V, W, X, and Y are corporations and CDEs. On November 5, 2004, Y uses $875,000 from X’s equity investment to make a loan to Z. Z is a qualified active low-income community business under paragraph (d)(4)(i) of this section. U’s equity investment in V is not a qualified low-income community investment because X does not use proceeds of W’s equity investment in a manner described in paragraph (d)(1)(iv)(A)( 1 ) of this section.

(2) Payments of, or for, capital, eq- uity or principal —(i) In general . Except as otherwise provided in this paragraph (d)(2), amounts received by a CDE in payment of, or for, capital, equity or principal with respect to a qualified low-income community investment must be reinvested by the CDE in a qualified low-income community investment no later than 12 months from the date of receipt to be treated as continuously invested in a qualified low-income community investment. If the amounts received by the CDE are equal to or greater than the cost basis of the original qualified low-income community investment (or applicable portion thereof), and the CDE reinvests, in accordance with this paragraph (d)(2)(i), an amount at least equal to such original cost basis, then an amount equal to such original cost basis will be treated as continuously invested in a qualified low-income community investment. In addition, if the amounts received by the CDE are equal to or greater than the cost basis of the original qualified low-income community investment (or applicable portion thereof), and the CDE reinvests, in accordance with this paragraph

(d)(2)(i), an amount less than such original cost basis, then only the amount so reinvested will be treated as continuously invested in a qualified low-income community investment. If the amounts received by the CDE are less than the cost basis of the original qualified low-income community investment (or applicable portion thereof), and the CDE reinvests an amount in accordance with this paragraph (d)(2)(i), then the amount treated as continuously invested in a qualified low-income community investment will equal the excess (if any) of such original cost basis over the amounts received by the CDE that are not so reinvested. Amounts received by a CDE in payment of, or for, capital, equity or principal with respect to a qualified low-income community investment during the seventh year of the 7-year credit period (as defined in paragraph (c)(5)(i) of this section) do not have to be reinvested by the CDE in a qualified low-income community investment in order to be treated as continuously invested in a qualified low-income community investment.

(ii) Subsequent reinvestments . In applying paragraph (d)(2)(i) of this section to subsequent reinvestments, the original cost basis is reduced by the amount (if any) by which the original cost basis exceeds the amount determined to be continuously invested in a qualified low-income community investment.

(iii) Special rule for loans . Periodic amounts received during a calendar year as repayment of principal on a loan that is a qualified low-income community investment are treated as continuously invested in a qualified low-income community investment if the amounts are reinvested in another qualified low-income community investment by the end of the following calendar year.

(iv) Example . The application of paragraphs (d)(2)(i) and (ii) of this section is illustrated by the following example:

Example . On April 1, 2003, A, B, and C each pay $100,000 to acquire a capital interest in X, a partnership. X is a CDE that has received a new markets tax credit allocation from the Secretary. X treats the 3 partnership interests as one qualified equity investment under paragraph (c)(6) of this section. In August 2003, X uses the $300,000 to make a qualified low-income community investment under paragraph (d)(1) of this section. In August 2005, the qualified low-income community investment is redeemed for $250,000. In February 2006, X reinvests $230,000 of the $250,000 in a second qualified low-income community investment and uses the remaining $20,000

for operating expenses. Under paragraph (d)(2)(i) of this section, $280,000 of the proceeds of the qualified equity investment is treated as continuously invested in a qualified low-income community investment. In December 2008, X sells the second qualified low-income community investment and receives $400,000. In March 2009, X reinvests $320,000 of the $400,000 in a third qualified low-income community investment. Under paragraphs (d)(2)(i) and (ii) of this section, $280,000 of the proceeds of the qualified equity investment is treated as continuously invested in a qualified low-income community investment ($40,000 is treated as invested in another qualified low-income community investment in March 2009). (3) Special rule for reserves . Reserves (not in excess of 5 percent of the taxpayer’s cash investment under paragraph (b)(4) of this section) maintained by the CDE for loan losses or for additional investments in existing qualified low-income community investments are treated as invested in a qualified low-income community investment under paragraph (d)(1) of this section. Reserves include fees paid to third parties to protect against loss of all or a portion of the principal of, or interest on, a loan that is a qualified low-income community investment.

(4) Qualified active low-income com- munity business —(i) In general . The term qualified active low-income commu- nity business means, with respect to any taxable year, a corporation (including a nonprofit corporation) or a partnership engaged in the active conduct of a qualified business (as defined in paragraph (d)(5) of this section), if the requirements in paragraphs (d)(4)(i)(A), (B), (C), (D), and (E) of this section are met. Solely for purposes of this section, a nonprofit corporation will be deemed to be engaged in the active conduct of a trade or business if it is engaged in an activity that furthers its purpose as a nonprofit corporation.

(A) Gross-income requirement . At least 50 percent of the total gross income of such entity is derived from the active conduct of a qualified business (as defined in paragraph (d)(5) of this section) within any low-income community (as defined in section 45D(e)). An entity is deemed to satisfy this paragraph (d)(4)(i)(A) if the entity meets the requirements of either paragraph (d)(4)(i)(B) or (C) of this section, if “50 percent” is applied instead of 40 percent . In addition, an entity may satisfy this paragraph (d)(4)(i)(A) based on all the facts and circumstances. See paragraph (d)(4)(iv) of this section for certain

February 7, 2005 459 2005–6 I.R.B.

active low-income community business if the trade or business (or portion thereof) would meet the requirements of paragraph (d)(4)(i) of this section if the trade or business (or portion thereof) were separately incorporated and a complete and separate set of books and records is maintained for that trade or business (or portion thereof). However, the CDE’s capital or equity investment or loan is not a qualified low-income community investment under paragraph (d)(1)(i) of this section to the extent the proceeds of the investment or loan are not used for the trade or business (or portion thereof) that is treated as a qualified active low-income community business under this paragraph (d)(4)(iii)(A).

(B) Examples . The following examples illustrate an application of paragraph (d)(4)(iii) of this section:

Example 1 . X is a partnership and a CDE that receives a new markets tax credit allocation from the Secretary. A pays $1 million for a capital interest in X. Z is a corporation that operates a supermarket that is not in a low-income community (as defined in section 45D(e)). X uses the proceeds of A’s equity investment to make a loan to Z that Z will use to construct a new supermarket in a low-income community. Z will maintain a complete and separate set of books and records for the new supermarket. The proceeds of X’s loan to Z will be used exclusively for the new supermarket. Assume that Z’s new supermarket in the low-income community would meet the requirements to be a qualified active low-income community business under paragraph (d)(4)(i) of this section if it were separately incorporated. Pursuant to paragraph (d)(4)(iii)(A) of this section, X treats Z’s new supermarket as the qualified active low-income community business. Accordingly, X’s loan to Z is a qualified low-income community investment under paragraph (d)(1)(i) of this section.

Example 2 . X is a partnership and a CDE that receives a new markets tax credit allocation from the Secretary. A pays $1 million for a capital interest in X. Z is a corporation that operates a liquor store in a low-income community (as defined in section 45D(e)). A liquor store is not a qualified business under paragraph (d)(5)(iii)(B) of this section. X uses the proceeds of A’s equity investment to make a loan to Z that Z will use to construct a restaurant next to the liquor store. Z will maintain a complete and separate set of books and records for the new restaurant. The proceeds of X’s loan to Z will be used exclusively for the new restaurant. Assume that Z’s restaurant would meet the requirements to be a qualified active low-income community business under paragraph (d)(4)(i) of this section if it were separately incorporated. Pursuant to paragraph (d)(4)(iii) of this section, X treats Z’s restaurant as the qualified active low-income community business. Accordingly, X’s loan to Z is a qualified low-income community investment under paragraph (d)(1)(i) of this section.

Example 3 . X is a partnership and a CDE that receives a new markets tax credit allocation from the

circumstances in which an entity will be treated as engaged in the active conduct of a trade or business.

(B) Use of tangible property —( 1 ) In general . At least 40 percent of the use of the tangible property of such entity (whether owned or leased) is within any low-income community. This percentage is determined based on a fraction the numerator of which is the average value of the tangible property owned or leased by the entity and used by the entity during the taxable year in a low-income community and the denominator of which is the average value of the tangible property owned or leased by the entity and used by the entity during the taxable year. Property owned by the entity is valued at its cost basis as determined under section 1012. Property leased by the entity is valued at a reasonable amount established by the entity.

( 2 ) Example . The application of paragraph (d)(4)(i)(B)( 1 ) of this section is illustrated by the following example:

Example . X is a corporation engaged in the business of moving and hauling scrap metal. X operates its business from a building and an adjoining parking lot that X owns. The building and the parking lot are located in a low-income community (as defined in section 45D(e)). X’s cost basis under section 1012 for the building and parking lot is $200,000. During the taxable year, X operates its business 10 hours a day, 6 days a week. X owns and uses 40 trucks in its business, which, on average, are used 6 hours a day outside a low-income community and 4 hours a day inside a low-income community (including time in the parking lot). The cost basis under section 1012 of each truck is $25,000. During non-business hours, the trucks are parked in the lot. Only X’s 10-hour business days are used in calculating the use of tangible property percentage under paragraph (d)(4)(i)(B)( 1 ) of this section. Thus, the numerator of the tangible property calculation is $600,000 (4/10 of $1,000,000 (the $25,000 cost basis of each truck times 40 trucks) plus $200,000 (the cost basis of the building and parking lot)) and the denominator is $1,200,000 (the total cost basis of the trucks, building, and parking lot), resulting in 50 percent of the use of X’s tangible property being within a low-income community. Consequently, X satisfies the 40 percent use of tangible property test under paragraph (d)(4)(i)(B)( 1 ) of this section.

(C) Services performed . At least 40 percent of the services performed for such entity by its employees are performed in a low-income community. This percentage is determined based on a fraction the numerator of which is the total amount paid by the entity for employee services performed in a low-income community during the taxable year and the denominator of

which is the total amount paid by the entity for employee services during the taxable year. If the entity has no employees, the entity is deemed to satisfy this paragraph (d)(4)(i)(C), and paragraph (d)(4)(i)(A) of this section, if the entity meets the requirement of paragraph (d)(4)(i)(B) of this section if “85 percent” is applied instead of 40 percent .

(D) Collectibles . Less than 5 percent of the average of the aggregate unadjusted bases of the property of such entity is attributable to collectibles (as defined in section 408(m)(2)) other than collectibles that are held primarily for sale to customers in the ordinary course of business.

(E) Nonqualified financial prop- erty —( 1 ) In general . Less than 5 percent of the average of the aggregate unadjusted bases of the property of such entity is attributable to nonqualified financial property . For purposes of the preceding sentence, the term nonqualified financial property means debt, stock, partnership interests, options, futures contracts, forward contracts, warrants, notional principal contracts, annuities, and other similar property except that such term does not include—

( i ) Reasonable amounts of working capital held in cash, cash equivalents, or debt instruments with a term of 18 months or less (because the definition of non- qualified financial property includes debt instruments with a term in excess of 18 months, banks, credit unions, and other financial institutions are generally excluded from the definition of a qualified active low-income community business ); or

( ii ) Debt instruments described in section 1221(a)(4).

( 2 ) Construction of real property . For purposes of paragraph (d)(4)(i)(E)( 1 )( i ) of this section, the proceeds of a capital or equity investment or loan by a CDE that will be expended for construction of real property within 12 months after the date the investment or loan is made are treated as a reasonable amount of working capital.

(ii) Proprietorships . Any business carried on by an individual as a proprietor is a qualified active low-income community business if the business would meet the requirements of paragraph (d)(4)(i) of this section if the business were incorporated.

(iii) Portions of business —(A) In gen- eral . A CDE may treat any trade or business (or portion thereof) as a qualified

2005–6 I.R.B. 460 February 7, 2005

expects, at the time the CDE makes the capital or equity investment in, or loan to, the entity, that the entity will satisfy the requirements to be a qualified active lowincome community business under paragraph (d)(4)(i) of this section throughout the entire period of the investment or loan.

(ii) Control —(A) In general . If a CDE controls or obtains control of an entity at any time during the 7-year credit period (as defined in paragraph (c)(5)(i) of this section), the entity will be treated as a qualified active low-income community business only if the entity satisfies the requirements of paragraph (d)(4)(i) of this section throughout the entire period the CDE controls the entity.

(B) Definition of control . Control means, with respect to an entity, direct or indirect ownership (based on value) or control (based on voting or management rights) of more than 50 percent of the entity. For purposes of the preceding sentence, the term management rights means the power to influence the management policies or investment decisions of the entity.

(C) Disregard of control . For purposes of paragraph (d)(6)(ii)(A) of this section, the acquisition of control of an entity by a CDE is disregarded during the 12-month period following such acquisition of control (the 12-month period) if—

( 1 ) The CDE’s capital or equity investment in, or loan to, the entity met the requirements of paragraph (d)(6)(i) of this section when initially made;

( 2 ) The CDE’s acquisition of control of the entity is due to financial difficulties of the entity that were unforeseen at the time the investment or loan described in paragraph (d)(6)(ii)(C)( 1 ) of this section was made; and

( 3 ) If the acquisition of control occurs before the seventh year of the 7-year credit period (as defined in paragraph (c)(5)(i) of this section), either—

( i ) The entity satisfies the requirements of paragraph (d)(4) of this section by the end of the 12-month period; or

( ii ) The CDE sells or causes to be redeemed the entire amount of the investment or loan described in paragraph (d)(6)(ii)(C)( 1 ) of this section and, by the end of the 12-month period, reinvests the amount received in respect of the sale or redemption in a qualified low-income community investment under paragraph

Secretary. A pays $1 million for a capital interest in X. Z is a corporation that operates an insurance company in a low-income community (as defined in section 45D(e)). Five percent or more of the average of the aggregate unadjusted bases of Z’s property is attributable to nonqualified financial property under paragraph (d)(4)(i)(E) of this section. Z’s insurance operations include different operating units including a claims processing unit. X uses the proceeds of A’s equity investment to make a loan to Z for use in Z’s claims processing operations. Z will maintain a complete and separate set of books and records for the claims processing unit. The proceeds of X’s loan to Z will be used exclusively for the claims processing unit. Assume that Z’s claims processing unit would meet the requirements to be a qualified active low-income community business under paragraph (d)(4)(i) of this section if it were separately incorporated. Pursuant to paragraph (d)(4)(iii) of this section, X treats Z’s claims processing unit as the qualified active low-income community business. Accordingly, X’s loan to Z is a qualified low-income community investment under paragraph (d)(1)(i) of this section.

(iv) Active conduct of a trade or busi- ness —(A) Special rule . For purposes of paragraph (d)(4)(i) of this section, an entity will be treated as engaged in the active conduct of a trade or business if, at the time the CDE makes a capital or equity investment in, or loan to, the entity, the CDE reasonably expects that the entity will generate revenues (or, in the case of a nonprofit corporation, engage in an activity that furthers its purpose as a nonprofit corporation) within 3 years after the date the investment or loan is made.

(B) Example . The application of paragraph (d)(4)(iv)(A) of this section is illustrated by the following example:

Example . X is a partnership and a CDE that receives a new markets tax credit allocation from the Secretary on July 1, 2004. X makes a ten-year loan to Y. Y is a newly formed entity that will own and operate a shopping center to be constructed in a low-income community. Y has no revenues but X reasonably expects that Y will generate revenues beginning in December 2005. Under paragraph (d)(4)(iv)(A) of this section, Y is treated as engaged in the active conduct of a trade or business for purposes of paragraph (d)(4)(i) of this section.

(5) Qualified business —(i) In general . Except as otherwise provided in this paragraph (d)(5), the term qualified business means any trade or business. There is no requirement that employees of a qualified business be residents of a low-income community.

(ii) Rental of real property . The rental to others of real property located in any low-income community (as defined in section 45D(e)) is a qualified business if and only if the property is not res

idential rental property (as defined in section 168(e)(2)(A)) and there are sub- stantial improvements located on the real property. For purposes of the preceding sentence, the term substantial improve- ments means improvements the cost basis of which equals or exceeds 50 percent of the cost basis of the land on which the improvements are located and the costs of which are incurred after the date the CDE makes the investment or loan. However, a CDE’s investment in or loan to a business engaged in the rental of real property is not a qualified low-income community investment under paragraph (d)(1)(i) of this section to the extent any lessee of the real property is not a qualified business under this paragraph (d)(5).

(iii) Exclusions —(A) Trades or busi- nesses involving intangibles . The term qualified business does not include any trade or business consisting predominantly of the development or holding of intangibles for sale or license.

(B) Certain other trades or businesses . The term qualified business does not include any trade or business consisting of the operation of any private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises.

(C) Farming . The term qualified busi- ness does not include any trade or business the principal activity of which is farming (within the meaning of section 2032A(e)(5)(A) or (B)) if, as of the close of the taxable year of the taxpayer conducting such trade or business, the sum of the aggregate unadjusted bases (or, if greater, the fair market value) of the assets owned by the taxpayer that are used in such a trade or business, and the aggregate value of the assets leased by the taxpayer that are used in such a trade or business, exceeds $500,000. For purposes of this paragraph (d)(5)(iii)(C), two or more trades or businesses will be treated as a single trade or business under rules similar to the rules of section 52(a) and (b).

(6) Qualifications —(i) In general . Except as provided in paragraph (d)(6)(ii) of this section, an entity is treated as a qualified active low-income community business for the duration of the CDE’s investment in the entity if the CDE reasonably

February 7, 2005 461 2005–6 I.R.B.

dition, a non- pro rata de minimis cash distribution by a CDE to a partner or partners during the taxable year will not be treated as a redemption. A non- pro rata de min- imis cash distribution may not exceed the lesser of 5 percent of the CDE’s operating income for that taxable year or 10 percent of the partner’s capital interest in the CDE. For purposes of this paragraph (e)(3)(iii), with respect to any taxable year, operating income is the sum of:

(A) The CDE’s taxable income as determined under section 703, except that—

( 1 ) The items described in section 703(a)(1) shall be aggregated with the non-separately stated tax items of the partnership; and

( 2 ) Any gain resulting from the sale of a capital asset under section 1221(a) or section 1231 property shall not be included in taxable income;

(B) Deductions under section 165, but only to the extent the losses were realized from qualified low-income community investments under paragraph (d)(1) of this section;

(C) Deductions under sections 167 and 168, including the additional first-year depreciation under section 168(k);

(D) Start-up expenditures amortized under section 195; and

(E) Organizational expenses amortized under section 709.

(4) Bankruptcy . Bankruptcy of a CDE is not a recapture event.

(5) Waiver of requirement or extension of time —(i) In general . The Commissioner may waive a requirement or extend a deadline if such waiver or extension does not materially frustrate the purposes of section 45D and this section.

(ii) Manner for requesting a waiver or extension . A CDE that believes it has good cause for a waiver or an extension may request relief from the Commissioner in a ruling request. The request should set forth all the relevant facts and include a detailed explanation describing the event or events relating to the request for a waiver or an extension. For further information on the application procedure for a ruling, see Rev. Proc. 2005–1, 2005–1 I.R.B. 1, or its successor revenue procedure (see §601.601(d)(2) of this chapter).

(iii) Terms and conditions . The granting of a waiver or an extension to a CDE under this section may require adjustments of the CDE’s requirements under

(d)(1) of this section. For this purpose, the amount treated as continuously invested in a qualified low-income community investment is determined under paragraphs (d)(2)(i) and (ii) of this section.

(7) Financial counseling and other ser- vices . The term financial counseling and other services means advice provided by the CDE relating to the organization or operation of a trade or business.

(8) Special rule for certain loans —(i) In general . For purposes of paragraphs (d)(1)(i), (ii), and (iv) of this section, a loan is treated as made by a CDE to the extent the CDE purchases the loan from the originator (whether or not the originator is a CDE) within 30 days after the date the originator makes the loan if, at the time the loan is made, there is a legally enforceable written agreement between the originator and the CDE which—

(A) Requires the CDE to approve the making of the loan either directly or by imposing specific written loan underwriting criteria; and

(B) Requires the CDE to purchase the loan within 30 days after the date the loan is made.

(ii) Example . The application of paragraph (d)(8)(i) of this section is illustrated by the following example:

Example . (i) X is a partnership and a CDE that has received a new markets tax credit allocation from the Secretary. On October 1, 2004, Y enters into a legally enforceable written agreement with W. Y and W are corporations but only Y is a CDE. The agreement between Y and W provides that Y will purchase loans (or portions thereof) from W within 30 days after the date the loan is made by W, and that Y will approve the making of the loans.

(ii) On November 1, 2004, W makes a $825,000 loan to Z pursuant to the agreement between Y and W. Z is a qualified active low-income community business under paragraph (d)(4) of this section. On November 15, 2004, Y purchases the loan from W for $840,000. On December 31, 2004, X purchases the loan from Y for $850,000.

(iii) Under paragraph (d)(8)(i) of this section, the loan to Z is treated as made by Y. Y’s loan to Z is a qualified low-income community investment under paragraph (d)(1)(i) of this section. Accordingly, under paragraph (d)(1)(ii)(A) of this section, X’s purchase of the loan from Y is a qualified low-income community investment in the amount of $850,000.

(e) Recapture —(1) In general . If, at any time during the 7-year period beginning on the date of the original issue of a qualified equity investment in a CDE, there is a recapture event under paragraph (e)(2) of this section with respect to such investment, then the tax imposed by Chap

ter 1 of the Internal Revenue Code for the taxable year in which the recapture event occurs is increased by the credit recapture amount under section 45D(g)(2). A recapture event under paragraph (e)(2) of this section requires recapture of credits allowed to the taxpayer who purchased the equity investment from the CDE at its original issue and to all subsequent holders of that investment.

(2) Recapture event . There is a recapture event with respect to an equity investment in a CDE if––

(i) The entity ceases to be a CDE; (ii) The proceeds of the investment cease to be used in a manner that satisfies the substantially-all requirement of paragraph (c)(1)(ii) of this section; or

(iii) The investment is redeemed or otherwise cashed out by the CDE.

(3) Redemption —(i) Equity investment in a C corporation . For purposes of paragraph (e)(2)(iii) of this section, an equity investment in a CDE that is treated as a C corporation for Federal tax purposes is redeemed when section 302(a) applies to amounts received by the equity holder. An equity investment is treated as cashed out when section 301(c)(2) or section 301(c)(3) applies to amounts received by the equity holder. An equity investment is not treated as cashed out when only section 301(c)(1) applies to amounts received by the equity holder.

(ii) Equity investment in an S corpora- tion . For purposes of paragraph (e)(2)(iii) of this section, an equity investment in a CDE that is an S corporation is redeemed when section 302(a) applies to amounts received by the equity holder. An equity investment in an S corporation is treated as cashed out when a distribution to a shareholder described in section 1368(a) exceeds the accumulated adjustments account determined under §1.1368–2 and any accumulated earnings and profits of the S corporation.

(iii) Capital interest in a partnership . In the case of an equity investment that is a capital interest in a CDE that is a partnership for Federal tax purposes, a pro rata cash distribution by the CDE to its partners based on each partner’s capital interest in the CDE during the taxable year will not be treated as a redemption for purposes of paragraph (e)(2)(iii) of this section if the distribution does not exceed the CDE’s op- erating income for the taxable year. In ad

2005–6 I.R.B. 462 February 7, 2005

on the line for total tax, if there is no such line for recapture taxes) and write NMCR (new markets credit recapture) next to the entry space.

(3) Other Federal tax benefits —(i) In general . Except as provided in paragraph (g)(3)(ii) of this section, the availability of Federal tax benefits does not limit the availability of the new markets tax credit. Federal tax benefits that do not limit the availability of the new markets tax credit include, for example:

(A) The rehabilitation credit under section 47;

(B) All deductions under sections 167 and 168, including the additional first-year depreciation under section 168(k), and the expense deduction for certain depreciable property under section 179; and

(C) All tax benefits relating to certain designated areas such as empowerment zones and enterprise communities under sections 1391 through 1397D, the District of Columbia Enterprise Zone under sections 1400 through 1400B, renewal communities under sections 1400E through 1400J, and the New York Liberty Zone under section 1400L.

(ii) Low-income housing credit . If a CDE makes a capital or equity investment or a loan with respect to a qualified low-income building under section 42, the investment or loan is not a qualified low-income community investment under paragraph (d)(1) of this section to the extent the building’s eligible basis under section 42(d) is financed by the proceeds of the investment or loan.

(4) Bankruptcy of CDE . The bankruptcy of a CDE does not preclude a taxpayer from continuing to claim the new markets tax credit on the remaining credit allowance dates under paragraph (b)(2) of this section.

(h) Effective dates —(1) In general . Except as provided in paragraph (h)(2) of this section, this section applies on or after December 22, 2004, and may be applied by taxpayers before December 22, 2004. The provisions that apply before December 22, 2004, are contained in §1.45D–1T (see 26 CFR part 1 revised as of April 1, 2003, and April 1, 2004).

(2) Exception for certain provisions . Paragraph (d)(5)(ii) of this section as it relates to the definition of the term substantial improvements and the requirement that each lessee must be a qualified

section 45D and this section as may be appropriate.

(6) Cure period . If a qualified equity investment fails the substantially-all requirement under paragraph (c)(5)(i) of this section, the failure is not a recapture event under paragraph (e)(2)(ii) of this section if the CDE corrects the failure within 6 months after the date the CDE becomes aware (or reasonably should have become aware) of the failure. Only one correction is permitted for each qualified equity investment during the 7-year credit period under this paragraph (e)(6).

(7) Example . The application of this paragraph (e) is illustrated by the following example:

Example . In 2003, A and B acquire separate qualified equity investments in X, a partnership. X is a CDE that has received a new markets tax credit allocation from the Secretary. X uses the proceeds of A’s qualified equity investment to make a qualified low-income community investment in Y, and X uses the proceeds of B’s qualified equity investment to make a qualified low-income community investment in Z. Y and Z are not CDEs. X controls both Y and Z within the meaning of paragraph (d)(6)(ii)(B) of this section. In 2003, Y and Z are qualified active low-income community businesses. In 2007, Y, but not Z, is a qualified active low-income community business and X does not satisfy the substantially-all requirement using the safe harbor calculation under paragraph (c)(5)(iii) of this section. A’s equity investment satisfies the substantially-all requirement of paragraph (c)(1)(ii) of this section using the direct-tracing calculation of paragraph (c)(5)(ii) of this section because A’s equity investment is traceable to Y. However, B’s equity investment fails the substantially-all requirement using the direct-tracing calculation because B’s equity investment is traceable to Z. Therefore, under paragraph (e)(2)(ii) of this section, there is a recapture event for B’s equity investment (but not A’s equity investment).

(f) Basis reduction —(1) In general . A taxpayer’s basis in a qualified equity investment is reduced by the amount of any new markets tax credit determined under paragraph (b)(1) of this section with respect to the investment. A basis reduction occurs on each credit allowance date under paragraph (b)(2) of this section. This paragraph (f) does not apply for purposes of sections 1202, 1400B, and 1400F.

(2) Adjustment in basis of interest in partnership or S corporation . The adjusted basis of either a partner’s interest in a partnership, or stock in an S corporation, must be appropriately adjusted to take into account adjustments made under paragraph (f)(1) of this section in the basis of a qualified equity investment held by the

partnership or S corporation (as the case may be).

(g) Other rules —(1) Anti-abuse . If a principal purpose of a transaction or a series of transactions is to achieve a result that is inconsistent with the purposes of section 45D and this section, the Commissioner may treat the transaction or series of transactions as causing a recapture event under paragraph (e)(2) of this section.

(2) Reporting requirements —(i) No- tification by CDE to taxpayer —(A) Al- lowance of new markets tax credit . A CDE must provide notice to any taxpayer who acquires a qualified equity investment in the CDE at its original issue that the equity investment is a qualified equity investment entitling the taxpayer to claim the new markets tax credit. The notice must be provided by the CDE to the taxpayer no later than 60 days after the date the taxpayer makes the investment in the CDE. The notice must contain the amount paid to the CDE for the qualified equity investment at its original issue and the taxpayer identification number of the CDE.

(B) Recapture event . If, at any time during the 7-year period beginning on the date of the original issue of a qualified equity investment in a CDE, there is a recapture event under paragraph (e)(2) of this section with respect to such investment, the CDE must provide notice to each holder, including all prior holders, of the investment that a recapture event has occurred. The notice must be provided by the CDE no later than 60 days after the date the CDE becomes aware of the recapture event.

(ii) CDE reporting requirements to Sec- retary . Each CDE must comply with such reporting requirements to the Secretary as the Secretary may prescribe.

(iii) Manner of claiming new markets tax credit . A taxpayer may claim the new markets tax credit for each applicable taxable year by completing Form 8874, “ New Markets Credit,” and by filing Form 8874 with the taxpayer’s Federal income tax return.

(iv) Reporting recapture tax . If there is a recapture event with respect to a taxpayer’s equity investment in a CDE, the taxpayer must include the credit recapture amount under section 45D(g)(2) on the line for recapture taxes on the taxpayer’s Federal income tax return for the taxable year in which the recapture event under paragraph (e)(2) of this section occurs (or

February 7, 2005 463 2005–6 I.R.B.

Par. 6. In §602.101, paragraph (b) is amended by adding an entry to the table in numerical order to read as follows:

§602.101 OMB Control numbers.

• • • • (b) - *

Current OMB control No.

business applies to qualified low-income community investments made on or after February 22, 2005.

§1.45D–1T [Removed]

Par. 3 Section 1.45D–1T is removed.

CFR part or section where identified and described

• ---

PART 602—OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 4. The authority citation for part 602 continues to read as follows: Authority: 26 U.S.C. 7805. Par. 5. In §602.101, paragraph (b) is amended by removing the entry for “1.45D–1T” from the table.

1.45D–1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1545–1765

• ---

Section 807.—Rules for Certain Reserves

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of February 2005. See Rev. Rul. 2005-8, page 466.

Section 817.—Treatment of Variable Contracts

26 CFR 1.817–5(f): Look-through rule for assets held through certain investment companies, partnerships, or trusts.

Segregated asset account. For purposes of determining whether a segregated asset account held by an insurance company is adequately diversified pursuant to section 817(h) of the Code, a segregated asset account that invests in a regulated investment company which in turn, holds an interest in another regulated investment company, may look through to the individual assets of both regulated investment companies.

Rev. Rul. 2005–7

ISSUE

For purposes of determining whether a segregated asset account is adequately diversified under section 817(h), how does the look-through rule of § 817(h)(4) of the Internal Revenue Code and § 1.817–5(f) of the Income Tax Regulations apply to an investment in a regulated investment company that, in turn, owns an interest in another regulated investment company?

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

Approved December 21, 2004.

Eric Solomon, Acting Deputy Assistant Secretary

of the Treasury .

(Filed by the Office of the Federal Register on December 22, 2004, 12:38 p.m., and published in the issue of the Federal Register for December 28, 2004, 69 F.R. 77625)

Section 280G.—Golden Parachute Payments

Federal short-term, mid-term, and long-term rates are set forth for the month of February 2005. See Rev. Rul. 2005-8, page 466.

Section 382.—Limitation on Net Operating Loss Carryforwards and Certain Built-In Losses Following Ownership Change

The adjusted applicable federal long-term rate is set forth for the month of February 2005. See Rev. Rul. 2005-8, page 466.

Section 412.—Minimum Funding Standards

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of February 2005. See Rev. Rul. 2005-8, page 466.

Section 467.—Certain Payments for the Use of Property or Services

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of February 2005. See Rev. Rul. 2005-8, page 466.

Section 468.—Special Rules for Mining and Solid Waste Reclamation and Closing Costs

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of February 2005. See Rev. Rul. 2005-8, page 466.

Section 482.—Allocation of Income and Deductions Among Taxpayers

Federal short-term, mid-term, and long-term rates are set forth for the month of February 2005. See Rev. Rul. 2005-8, page 466.

Section 483.—Interest on Certain Deferred Payments

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of February 2005. See Rev. Rul. 2005-8, page 466.

Section 642.—Special Rules for Credits and Deductions

Federal short-term, mid-term, and long-term rates are set forth for the month of February 2005. See Rev. Rul. 2005-8, page 466.

2005–6 I.R.B. 464 February 7, 2005

ment company shall not be treated as a single investment of a segregated asset account; instead, a pro rata portion of each asset of the investment company shall be treated, for purposes of § 1.817–5, as an asset of the segregated asset account.

Section 817–5(f)(2)(i) of the regulations provides that the look-through rule of § 1.817–5(f) shall apply to an investment company if (A) all the beneficial interests in the investment company (other than those described in § 1.817–5(f)(3)) are held by one or more segregated asset accounts of one or more insurance companies; and (B) public access to such investment company is available exclusively (except as otherwise permitted under § 1.817–5(f)(3)) through the purchase of a variable contract.

The beneficial interests described in § 1.817–5(f)(3) are interests that are held by (i) the general account of a life insurance company or a corporation related in a manner specified in § 267(b) of the Code to a life insurance company, but only if the return on those interests is computed in the same manner as the return on an interest held by a segregated asset account, there is no intent to sell the interests to the public, and a segregated asset account of the life insurance company also holds or will hold a beneficial interest in the investment company; (ii) the manager or a corporation related in a manner specified in § 267(b) to the manager of the investment company, provided similar requirements are met concerning the computation of return on the interests and intent to sell the interests to the public; (iii) the trustee of a qualified pension or retirement plan; or (iv) the public or policyholders that are treated as owners of beneficial interests in the investment company under Rev. Rul. 81–225, 1981–2 C.B. 12, but only if (A) the investment company was closed to the public in accordance with Rev. Rul. 82–55, 1982–1 C.B. 12; or (B) all the assets of the segregated asset account are attributable to premium payments made by policyholders prior to September 26, 1981, to premium payments made in connection with a qualified pension or retirement plan, or to any combination of such premium payments.

Under the look-through rule of § 817(h)(4) and § 1.817–5(f), a pro rata portion of each asset of Fund 1 is treated as an asset of the Segregated Asset Account

FACTS

IC is a life insurance company subject to tax under § 801. In states where it is authorized to do so, IC offers variable life and variable annuity contracts (the “Contracts”) that qualify as variable contracts under § 817(d). The assets that fund the Contracts are segregated from the assets that fund IC’s traditional life insurance products. IC maintains a separate account for the assets funding the Contracts, and the income and liabilities associated with the separate account are maintained separately from IC’s other accounts. The separate account is composed of several sub-accounts, one of which (the “Segregated Asset Account”) is invested exclusively in Fund 1. No holder of a variable contract supported by the Segregated Asset Account possesses sufficient incidents of ownership over the assets of the account to be treated as the owner of those assets for federal income tax purposes. See Rev. Rul. 2003–91, 2003–2 C.B. 347.

Fund 1 is a regulated investment company within the meaning of § 851. Fund 1 owns shares in Fund 2, also a regulated investment company within the meaning of § 851, the value of which is greater than 55 percent of the value of the total assets of Fund 1. Except for Fund 1’s investment in Fund 2 (and except as permitted by § 1.817–5(f)(3) of the Income Tax Regulations), all the beneficial interests in Fund 1 and Fund 2 are held by one or more segregated asset accounts of one or more insurance companies, and public access to the funds is available exclusively through the purchase of a variable contract. Pursuant to § 817(h)(1) and § 1.817–5(b) of the regulations, the investments of Fund 2 are adequately diversified. The investments of Fund 1 are likewise diversified, but only if, instead of treating its interest in Fund 2 as a single investment, Fund 1 is permitted to take into account a pro rata portion of each asset of Fund 2.

LAW AND ANALYSIS

Section 817(d) defines the term “variable contract” for purposes of part I of subchapter L of the Code (§§ 801–818). For a life insurance contract or an annuity contract to be a variable contract, it must provide for the allocation of all or a part of the amounts received under the contract to an

account that, pursuant to state law or regulation, is segregated from the general asset accounts of the issuing insurance company. In addition, for a life insurance contract to be a variable contract, it must qualify as a life insurance contract for federal income tax purposes, and the amount of the death benefit (or the period of coverage) must be adjusted on the basis of the investment return and the market value of the segregated asset account; for an annuity contract to be a variable contract, it must provide for the payment of annuities, and the amounts paid in, or the amount paid out, must reflect the investment return and the market value of the segregated asset account.

Section 817(h)(1) of the Code provides generally that a variable contract (other than a pension plan contract) that is otherwise described in § 817 and that is based on a segregated asset account shall not be treated as an annuity, endowment, or life insurance contract for any period (and for any subsequent period) for which the investments made by such account are not adequately diversified.

Section 1.817–5(e) of the regulations provides that for purposes of section 817(h) of the Code a segregated asset account shall consist of all assets the investment return and market value of each of which must be allocated in an identical manner to any variable contract invested in any of such assets.

Section 1.817–5(b) of the regulations sets forth the diversification requirements for variable contracts based on segregated asset accounts. Generally, the investments of a segregated asset account are considered to be adequately diversified for purposes of § 817(h) of the Code and § 1.817–5(b) of the regulations if no more than 55 percent of the value of the total assets of the account is represented by any one investment; no more than 70 percent by any two investments; no more than 80 percent by any three investments; and no more than 90 percent by any four investments.

Section 817(h)(4) and § 1.817–5(f) of the regulations provide a look-through rule for purposes of testing the diversification of a segregated asset account that invests in a regulated investment company, partnership, or trust. Section 1.817–5(f)(1) provides, in part, that if the look-through rule applies, a beneficial interest in an invest

February 7, 2005 465 2005–6 I.R.B.

for purposes of determining whether the Segregated Asset Account is adequately diversified. Because the value of Fund 1’s investment in Fund 2 is greater than 55 percent of the value of the total assets of Fund 1, however, the Segregated Asset Account is not adequately diversified unless its investment in Fund 1 is treated as including an investment in a pro rata portion of each of the assets of Fund 2.

In order for the look-through rule to apply to a beneficial interest in a regulated investment company, all the beneficial interests in the investment company must be held by one or more segregated asset accounts of one or more insurance companies (except as otherwise permitted pursuant to § 1.817–5(f)(3) of the regulations), and public access to the investment company must be available solely through the purchase of a variable contract. These two requirements are met with respect to both Fund 1 and Fund 2. Except as otherwise permitted under § 1.817–5(f)(3), all the beneficial interests in Fund 1 are held by segregated asset accounts that invested directly in Fund 1; all the beneficial interests in Fund 2 are held either by segregated asset accounts that invested directly in Fund 2, or by segregated asset accounts that invested directly in Fund 1 (and thus indirectly in Fund 2). Likewise, except as otherwise permitted under § 1.817–5(f)(3), public access to both Fund 1 and Fund 2 is available exclusively through the purchase of a variable contract funded by a segregated asset account that invests in Fund 1 or Fund 2. Accordingly, under the look-through rule of § 817(h), the Segregated Asset Account is treated as owning a pro rata portion of each asset of Fund 1,

including a pro rata portion of each asset of Fund 2.

HOLDING

Under the facts set forth above, the look-through rule of § 817(h)(4) and § 1.817–5(f) of the regulations requires that the Segregated Asset Account be treated as owning a pro rata portion of each asset of Fund 1 and Fund 2 for purposes of satisfying the diversification requirements of § 817(h).

DRAFTING INFORMATION

The principal author of this revenue ruling is Thomas M. Preston of the Office of Chief Counsel Associate Chief Counsel (Financial Institutions & Products). For further information regarding this revenue ruling, contact Mr. Preston at (202) 622–3970 (not a toll-free call).

Section 846.—Discounted Unpaid Losses Defined

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of February 2005. See Rev. Rul. 2005-8, page 466.

Section 1274.—Determi- nation of Issue Price in the Case of Certain Debt Instru- ments Issued for Property

(Also Sections 42, 280G, 382, 412, 467, 468, 482, 483, 642, 807, 846, 1288, 7520, 7872.)

Federal rates; adjusted federal rates; adjusted federal long-term rate and the long-term exempt rate. For purposes of

sections 382, 642, 1274, 1288, and other sections of the Code, tables set forth the rates for February 2005.

Rev. Rul. 2005–8

This revenue ruling provides various prescribed rates for federal income tax purposes for February 2005 (the current month). Table 1 contains the short-term, mid-term, and long-term applicable federal rates (AFR) for the current month for purposes of section 1274(d) of the Internal Revenue Code. Table 2 contains the short-term, mid-term, and long-term adjusted applicable federal rates (adjusted AFR) for the current month for purposes of section 1288(b). Table 3 sets forth the adjusted federal long-term rate and the long-term tax-exempt rate described in section 382(f). Table 4 contains the appropriate percentages for determining the low-income housing credit described in section 42(b)(2) for buildings placed in service during the current month. Finally, Table 5 contains the federal rate for determining the present value of an annuity, an interest for life or for a term of years, or a remainder or a reversionary interest for purposes of section 7520.

2005–6 I.R.B. 466 February 7, 2005

REV. RUL. 2005–8 TABLE 1

Applicable Federal Rates (AFR) for February 2005

Period for Compounding

Annual Semiannual Quarterly Monthly

Short-Term

AFR 2.92% 2.90% 2.89% 2.88% 110% AFR 3.22% 3.19% 3.18% 3.17% 120% AFR 3.51% 3.48% 3.46% 3.46% 130% AFR 3.81% 3.77% 3.75% 3.74%

Mid-Term

AFR 3.83% 3.79% 3.77% 3.76% 110% AFR 4.21% 4.17% 4.15% 4.13% 120% AFR 4.60% 4.55% 4.52% 4.51% 130% AFR 4.99% 4.93% 4.90% 4.88% 150% AFR 5.77% 5.69% 5.65% 5.62% 175% AFR 6.74% 6.63% 6.58% 6.54%

Long-Term

AFR 4.72% 4.67% 4.64% 4.63% 110% AFR 5.21% 5.14% 5.11% 5.09% 120% AFR 5.68% 5.60% 5.56% 5.54% 130% AFR 6.16% 6.07% 6.02% 5.99%

REV. RUL. 2005–8 TABLE 2

Adjusted AFR for February 2005

Period for Compounding

Annual Semiannual Quarterly Monthly

Short-term adjusted AFR

2.11% 2.10% 2.09% 2.09%

Mid-term adjusted AFR 2.89% 2.87% 2.86% 2.85%

Long-term adjusted AFR

4.20% 4.16% 4.14% 4.12%

REV. RUL. 2005–8 TABLE 3

Rates Under Section 382 for February 2005

Adjusted federal long-term rate for the current month 4.20%

Long-term tax-exempt rate for ownership changes during the current month (the highest of the adjusted federal long-term rates for the current month and the prior two months.) 4.27%

REV. RUL. 2005–8 TABLE 4

Appropriate Percentages Under Section 42(b)(2) for February 2005

Appropriate percentage for the 70% present value low-income housing credit 7.99%

Appropriate percentage for the 30% present value low-income housing credit 3.43%

February 7, 2005 467 2005–6 I.R.B.

REV. RUL. 2005–8 TABLE 5

Rate Under Section 7520 for February 2005

Applicable federal rate for determining the present value of an annuity, an interest for life or a term of years, or a remainder or reversionary interest 4.60%

generation-skipping transfer tax will not be imposed until a later time, as in the case of a later taxable termination or taxable distribution. In response to this comment, the final regulations provide that the determination of whether there has been a decrease in the sum of the estate tax and generation-skipping transfer tax liability (reduced by credits allowable against these taxes) is made with reference to the estate tax and generation-skipping transfer tax payable by reason of the decedent’s death.

Availability of Relief under §§301.9100–1 and 301.9100–3

In view of the 1-year limitation imposed under section 2032(d)(2), the proposed regulations provided that no request for an extension of time to make the alternate valuation election under the provisions of §§301.9100–1 and 301.9100–3 will be granted if the request is submitted to the IRS more than 1 year after the due date of the return of tax imposed by section 2001 (including extensions of time actually granted). One commentator argued that the 1-year limitation in section 2032(d)(2) applies only to late-filed returns, and therefore should not limit the availability of relief under §§301.9100–1 and 301.9100–3 to make a late alternate valuation election if the taxpayer timely filed its return, but failed to make the election on the return. After considering the language and intent of section 2032 and §§301.9100–1 and 301.9100–3, the IRS and Treasury Department have determined that taxpayers may request relief under §§301.9100–1 and 301.9100–3, even after the expiration of the 1-year period, and that such relief may be granted (subject to the requirements of §§301.9100–1 and 301.9100–3) provided that the return of tax is filed no later than 1 year after the due date of the return (including extensions of time actually granted). This rule also will apply to requests under §§301.9100–1 and 301.9100–3 for an extension of time to make a protective election under section 2032.

Section 1288.—Treatment of Original Issue Discount on Tax-Exempt Obligations

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of February 2005. See Rev. Rul. 2005-8, page 466.

Section 2032.—Alternate Valuation

26 CFR 20.2032–1: Altenate valuation.

T.D. 9172

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 20 and 301

Gross Estate; Election to Value on Alternate Valuation Date

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations that amend §20.2032–1(b) to reflect the change made to section 2032 of the Internal Revenue Code by the Deficit Reduction Act of 1984 and the technical change to that section made by the Tax Reform Act of 1986. In addition, the final regulations remove temporary regulation §301.9100–6T(b) of the Procedure and Administration Regulations so that estates that fail to make the alternate valuation election on the last estate tax return filed before the due date of the return, or on the first estate tax return filed after the due date of the return may request an extension of time to make the election under the provisions of §§301.9100–1 and 301.9100–3. The final regulations affect estates that are required to file Form 706, United States Estate (and Genera- tion-Skipping Transfer) Tax Return .

DATES: Effective Date: These regulations are effective on January 4, 2005.

Applicability Date: For dates of applicability, see §20.2032–1(h).

FOR FURTHER INFORMATION CONTACT: Theresa M. Melchiorre at (202) 622–7830 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

On December 24, 2003, proposed regulations (REG–139845–02, 2004–5 I.R.B. 397) were published in the Federal Reg- ister [68 FR 74534]. The proposed regulations contained proposed amendments to the Estate Tax Regulations [26 CFR part 20] and the Procedure and Administration Regulations [26 CFR part 301] relating to the election under section 2032 to value a decedent’s gross estate on the alternate valuation date. The proposed regulations reflected changes that were made to section 2032 by the Deficit Reduction Act of 1984, Public Law 98–369 (98 Stat. 494). Written comments were received on the proposed regulations, and a public hearing was held on June 3, 2004. The proposed regulations, with certain changes in response to the written and oral comments, are adopted as final regulations.

Summary of Comments and Explanation of Provisions

Determination of Eligibility to make the Alternate Valuation Election

The proposed regulations provided that the alternate valuation election may be made only if the election results in a decrease both in the value of the gross estate and in the sum of the estate tax and generation-skipping transfer tax liability (reduced by credits allowable against these taxes). One commentator noted that it may not be possible to determine whether the election will reduce the sum of estate tax and generation-skipping transfer tax if the

2005–6 I.R.B. 468 February 7, 2005

valuation method would not result in a decrease in both the value of the gross estate and the sum (reduced by allowable credits) of the estate tax and the generation-skipping transfer tax liability payable by reason of the decedent’s death with respect to the property includible in the decedent’s gross estate, a protective election may be made to use the alternate valuation method if it is subsequently determined that such a decrease would occur. A protective election is made on the return of tax imposed by section 2001. The protective election is irrevocable as of the due date of the return (including extensions of time actually granted). The protective election becomes effective on the date on which it is determined that use of the alternate valuation method would result in a decrease in both the value of the gross estate and in the sum (reduced by allowable credits) of the estate tax and generation-skipping transfer tax liability payable by reason of the decedent’s death with respect to the property includible in the decedent’s gross estate.

(3) Requests for extension of time to make the election . A request for an extension of time to make the election or protective election pursuant to §§301.9100–1 and 301.9100–3 of this chapter will not be granted unless the return of tax imposed by section 2001 is filed no later than 1 year after the due date of the return (including extensions of time actually granted).

• • • • (h) Effective date . Paragraph (b) of this section is applicable to decedents dying on or after January 4, 2005. However, pursuant to section 7805(b)(7), taxpayers may elect to apply paragraph (b) of this section retroactively if the period of limitations for filing a claim for a credit or refund of Federal estate or generation-skipping transfer tax under section 6511 has not expired.

PART 301—PROCEDURE AND ADMINISTRATION

Par. 3. The authority citation for part 301 continues to read in part as follows: Authority: 26 U.S.C. 7805 * * *

§301.9100–6T [Amended]

Par. 4. Section 301.9100–6T is amended by:

1. Removing the language “paragraph (b)(2)” from paragraph (a)(2) introductory

The IRS and Treasury Department also have determined that taxpayers should be permitted to apply for relief under §§301.9100–1 and 301.9100–3 to make a late election under section 2056A to be treated as a Qualified Domestic Trust (QDOT). Like the alternate valuation election of section 2032, no election under section 2056A to be treated as a QDOT may be made on a return that is filed more than 1 year after the due date of the return (including extensions of time actually granted). Section 2056A(d). Thus, taxpayers will be permitted to apply for an extension of time under the provisions of §§301.9100–1 and 301.9100–3 to make an election under section 2056A(d), provided that the return of tax is filed no later than 1 year after the due date of the return (including extensions of time actually granted).

Any taxpayer eligible for relief under §§301.9100–1 and 301.9100–3 to make the section 2032 election or the 2056A(d) election is encouraged to file promptly an application for relief and a claim for refund before the statute of limitations under section 6511 expires in the event the requested relief is granted.

Special Analyses

It has been determined that this final Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations and, because these regulations do not impose on small entities a collection of information requirement, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Code, the notice of proposed rulemaking preceding this regulation 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 Theresa Melchiorre of the Office of Associate Chief Counsel (Passthroughs and Special Industries). However, other

personnel from the IRS and the Treasury Department participated in their development.

- - - -

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 20 and 301 are amended as follows:

PART 20—ESTATE TAX; ESTATES OF DECEDENTS DYING AFTER AUGUST 16, 1954

Paragraph 1. The authority citation for part 20 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * * Par. 2. Section 20.2032–1(b) is revised and paragraph (h) is added to read as follows:

§20.2032–1 Alternate valuation.

• • • • (b) Method and effect of election —(1) In general . The election to use the alternate valuation method is made on the return of tax imposed by section 2001. For purposes of this paragraph (b), the term re- turn of tax imposed by section 2001 means the last estate tax return filed by the executor on or before the due date of the return (including extensions of time to file actually granted) or, if a timely return is not filed, the first estate tax return filed by the executor after the due date, provided the return is filed no later than 1 year after the due date (including extensions of time to file actually granted). Once the election is made, it is irrevocable, provided that an election may be revoked on a subsequent return filed on or before the due date of the return (including extensions of time to file actually granted). The election may be made only if it will decrease both the value of the gross estate and the sum (reduced by allowable credits) of the estate tax and the generation-skipping transfer tax payable by reason of the decedent’s death with respect to the property includible in the decedent’s gross estate. If the election is made, the alternate valuation method applies to all property included in the gross estate and cannot be applied to only a portion of the property.

(2) Protective election . If, based on the return of tax as filed, use of the alternate

February 7, 2005 469 2005–6 I.R.B.

to make timely payment of tax with respect to a period during which a case is pending under title 11 of the United States Code . . . .” Section 6658 applies to tax arising before the taxpayer files a bankruptcy petition if (1) the petition was filed before the due date of the return or (2) the date for making the addition to the tax occurs on or after the day on which the petition was filed. Section 6651 imposes penalties for failure to file a return or pay a tax, and sections 6654 and 6655 impose penalties for failure to pay estimated taxes. The term “pending” is not defined in section 6658.

A bankruptcy case is commenced by filing a petition with the bankruptcy court pursuant to sections 301 through 304 of the Bankruptcy Code. A case is “pending” for purposes of section 6658 after the debtor files a petition with the bankruptcy court. A bankruptcy case is no longer pending for purposes of section 6658 when it is closed or dismissed. See Carey v. Saffold, 536 U.S. 214, 219–220 (2002) (consulting Webster’s Third International Dictionary for the ordinary meaning of the word “pending,” the Court determined that a state court application for collateral review remains pending “until the application has achieved final resolution”).

Section 350 of the Bankruptcy Code requires the court to close a case once the estate is fully administered and the court has discharged the trustee. Bankruptcy Rule 5009 provides that in Chapter 7 cases, there is a presumption that the estate has been fully administered and the case may be closed if (1) the trustee has filed a final report and final account and has certified that the estate has been fully administered, and (2) within 30 days after the trustee’s filing and certification, no objection has been filed by the United States trustee or a party in interest.

Bankruptcy Rule 3022 provides that the court shall enter a final decree closing a Chapter 11 case after an estate is fully administered. The Advisory Committee Notes to the 1991 amendments to Bankruptcy Rule 3022 provide that the final decree closing the case should not be delayed solely because payments required by the plan have not been completed. Fed. R. Bankr. P. 3022 advisory committee notes.

Whether a case has been fully administered and should be closed presents a different question under Chapter 7 than under Chapter 11. Although a Chapter 7 case

text, and adding the language “paragraph (a)(2)” in its place.

2. Removing paragraph (b).

3. Redesignating paragraphs (c) through (s) as paragraphs (b) through (r), respectively.

4. Removing the language “paragraph (c)(2)” from the last sentence in newly designated paragraph (b)(2) and adding the language “paragraph (b)(2)” in its place.

5. Removing the language “paragraph (l)” from the second, fourth and last sentences in newly designated paragraph (k) and adding the language “paragraph (k)” in its place.

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

Approved December 28, 2004.

Eric Solomon, Acting Deputy Assistant Secretary

of the Treasury .

(Filed by the Office of the Federal Register on January 3, 2005, 8:45 a.m., and published in the issue of the Federal Register for January 4, 2005, 70 F.R. 295)

Section 2056A.—Qualified Domestic Trust

The preamble of the final regulations under section 2032 of the Code describes a change in the position of the IRS on the availability of relief to make the section 2056A(d) election under sections 301.9100–1 and 301.9100–3 of the regulations. See T.D. 9172, page 468.

Section 6658.—Coordina- tion With Title 11

26 CFR 301.6651–1: Failure to file tax return or to pay tax. (Also §§ 6654, 6655.)

Bankruptcy cases; definition of “pending”. This ruling discusses the definition of “pending” regarding bankruptcy cases for purposes of the relief from the imposition of certain penalties provided under section 6658 of the Code.

Rev. Rul. 2005–9

ISSUE

When is a bankruptcy case no longer “pending” for purposes of the relief from the imposition of certain penalties pro

vided under section 6658 of the Internal Revenue Code for the period during which a bankruptcy case is pending?

FACTS

In Situations A, B, and C described below: (1) an individual taxpayer files a bankruptcy petition under Chapter 7 or Chapter 11 of title 11 of the U.S. Code (“the Bankruptcy Code”) and has an income tax liability for a taxable year that ended prior to the filing of the bankruptcy petition; (2) the prepetition tax liability is excepted from discharge under section 523(a)(1)(A) of the Bankruptcy Code; (3) the tax liability is reported on a timely filed tax return, but is not paid in full; and (4) the failure to pay penalty under section 6651(a)(2) may be imposed except to the extent of the relief provided by section 6658 of the Internal Revenue Code for the period during which the bankruptcy case is pending.

Situation A . The taxpayer files a Chapter 7 bankruptcy petition on Date 1. The court enters an order granting the debtor a discharge on Date 2, which is six weeks after Date 1. Distributions from the bankruptcy estate are made and the Service receives partial payment of income taxes on Date 3, one year after Date 1. The court discharges the trustee and closes the case on Date 4, which is 30 days after receiving the trustee’s final report.

Situation B . The taxpayer files a Chapter 11 bankruptcy petition on Date 1. The plan is confirmed and the taxpayer receives a discharge on Date 2. Payments to the Service commence on Date 3. The court closes the case on Date 4, which is 30 days after Date 3. Payments under the plan are required to be made for several years after Date 4.

Situation C . The facts are the same as in Situation B, except that the court does not close the case on Date 4. Beginning approximately one year after Date 3, the taxpayer fails to make payments as required under the plan. Shortly after the default, the Service files a motion to dismiss the case and the court enters a dismissal order on Date 5.

LAW AND ANALYSIS

Section 6658(a) provides, in part, that “[n]o addition to the tax shall be made under section 6651, 6654, or 6655 for failure

2005–6 I.R.B. 470 February 7, 2005

Rev. Rul. 2005–6

ISSUE

For purposes of determining whether a contract qualifies as a life insurance contract under § 7702 of the Internal Revenue Code and as a modified endowment contract under § 7702A, should charges for qualified additional benefits (QABs) be taken into account under the mortality charge rule of § 7702(c)(3)(B)(i) or the expense charge rule of § 7702(c)(3)(B)(ii)?

FACTS

IC is a life insurance company organized and licensed to do business in State. In Year, IC issued a Policy in State with a Rider that provides term life insurance coverage on the life of a family member of the individual insured by the Policy. The Policy is a life insurance contract under the law of State and was designed to qualify as a life insurance contract under § 7702 by meeting the guideline premium requirements of § 7702(c) and falling within the cash value corridor of § 7702(d). IC imposes a charge for the mortality risk that it assumed pursuant to the Rider and subtracts this charge monthly from the Policy’s cash value.

LAW AND ANALYSIS

Section 7702(a) provides that, for a contract to qualify as a life insurance contract for Federal income tax purposes, the contract must be a life insurance contract under the applicable law and must either (1) satisfy the cash value accumulation test of § 7702(b), or (2) both meet the guideline premium requirements of § 7702(c) and fall within the cash value corridor of § 7702(d).

A contract meets the guideline premium requirements of § 7702(c) if the sum of the premiums paid under the contract does not at any time exceed the guideline premium limitation as of that time. The guideline premium limitation as of any date is the greater of (A) the guideline single premium, or (B) the sum of the guideline level premiums to that date. The guideline single premium is the premium that would be required on the date the contract is issued to fund the future benefits under the contract, based on the follow

is not fully administered and generally is not closed until after final distribution of the property of the estate, a Chapter 11 case may be considered fully administered and may be closed shortly after payments commence under the plan even though the debtor will continue to make payments. However, in both Chapters 7 and 11, the closing of the case marks the end of the bankruptcy court’s administration of the estate and is, therefore, the proper date on which a case is no longer pending for purposes of section 6658.

Similarly, the dismissal of a bankruptcy case terminates the case and the bankruptcy court’s administration of the bankruptcy estate. The legislative history to section 349 of the Bankruptcy Code, which sets forth the effect of a dismissal of a bankruptcy case, provides that the purpose of section 349 is “to undo the bankruptcy case, as far as practicable, and to restore all property rights to the position in which they were found at the commencement of the case.” S. Rep. No. 989, 95 ^th Cong., 2d Sess. 48 (1978). In Situation A, the case is pending under section 6658 until the court closes the case on Date 4. The entry of the discharge order on Date 2 does not terminate the relief provided by section 6658 because the estate has not been fully administered.

In Situation B, the confirmation of the plan on Date 2 discharges the debtor from all pre-confirmation dischargeable debts. The confirmation of the plan does not terminate the administration of the estate. Under section 350 and Bankruptcy Rule 3022, the estate is not fully administered until it is closed on Date 4. As of Date 4, the administration of the estate is complete and the case is no longer pending even though the debtor is required to make payments under the plan for several years. Thus, the penalty relief provided by section 6658 ceases as of Date 4.

In Situation C, the bankruptcy court does not close the case 30 days after confirmation of the plan as in Situation B, but keeps the case open while the debtor complies with the terms of the plan. However, one year after confirmation, the debtor fails to make the payments required by the terms of the plan. The default does not terminate the case or end the court’s involvement in the administration of the estate. The order dismissing the case terminates the administration of the estate.

The prohibition against imposition of the penalty ends on Date 5, the date on which the dismissal order is entered.

Although Situations A, B, and C describe bankruptcy cases filed under Chapters 7 and 11 of the Bankruptcy Code, the treatment of a case as no longer pending when the case is closed or dismissed as set forth in this ruling also applies to bankruptcy cases filed under Chapters 12 and 13 of the Bankruptcy Code.

HOLDING

A bankruptcy case is no longer pending for purposes of relief under section 6658 when the bankruptcy case is closed or dismissed.

DRAFTING INFORMATION

The principal author of this revenue ruling is the Collection, Bankruptcy & Summonses Division, Office of Associate Chief Counsel (Procedure and Administration). For further information regarding this revenue ruling, contact Delores Dillmann at (202) 622–3620 (not a toll-free call).

Section 7520.—Valuation Tables

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of February 2005. See Rev. Rul. 2005-8, page 466.

Section 7702.—Life Insurance Contract Defined

(Also § 7702A.)

Life insurance contracts. For purposes of determining whether a contract qualifies as a life insurance contract under section 7702 of the Code, and as a modified endowment contract under section 7702A, charges for qualified additional benefits (QABs) are to be taken into account under the expense charge rule of section 7702(c)(3)(B)(ii) rather than under the mortality charge rule of section 7702(c)(3)(B)(i). Issuers whose compliance systems do not currently account for QABs under the expense charge rule of section 7702(c)(3)(B)(ii) are provided alternatives to correct their compliance systems.

February 7, 2005 471 2005–6 I.R.B.

QABs are subject to the expense charge rule of § 7702(c)(3)(B)(ii) for purposes of the guideline premium requirements.

HOLDING

Charges for QABs should be taken into account under the expense charge rule of § 7702(c)(3)(B)(ii) for purposes of determining whether a contract qualifies as a life insurance contract under § 7702 or as a MEC under § 7702A.

EFFECTIVE DATE

This revenue ruling is effective February 7, 2005.

APPLICATION

The following alternatives are available to issuers whose compliance systems do not currently account for charges for QABs under the expense charge rule of § 7702(c)(3)(B)(ii):

A. If an issuer’s compliance system does not properly account for charges for QABs but no contracts have failed to satisfy the requirements of § 7702(a) as a result of the system’s deficiency, the issuer may correct its compliance system to account for those charges using the expense charge rule without contacting the Service.

B. If an issuer’s compliance system does not properly account for charges for QABs and, as a result, some life insurance contracts do not meet the definition of life insurance contract under § 7702(a), the issuer may request a closing agreement on or before February 7, 2006, under the procedures set forth in Rev. Proc. 2005–1, 2005–1 I.R.B. 1. In addition to the modifications to the ruling process provided by Rev. Proc. 2001–42, 2001–2 C.B. 212 (concerning inadvertent MECs), and Rev. Rul. 91–17, 1991–1 C.B. 190, as supplemented by Notice 99–48, 1999–2 C.B. 429 (concerning failures under § 7702(a)), the following modifications will apply to a closing agreement requested under this revenue ruling:

1. the issuer must identify all contracts administered under the compliance system, but need not identify which contracts fail to meet the requirements of § 7702(a) or are inadvertent MECs under § 7702A;
2. the contracts identified in the closing agreement will not be treated as fail

ing three elements enumerated in section 7702(c)(3)(B): (i) reasonable mortality charges that meet the requirements (if any) prescribed in regulations and that (except as provided in regulations) do not exceed the mortality charges specified in the prevailing commissioners’ standard tables (as defined in section 807(d)(5)) as of the time the contract is issued;

(ii) any reasonable charges (other than mortality charges) that (on the basis of the company’s experience, if any, with respect to similar contracts) are reasonably expected to be actually paid; and

(iii) interest at the greater of an annual effective rate of six percent or the rate or rates guaranteed on issuance of the contract.

The guideline level premium is the level annual amount, payable over a period not ending before the insured attains age 95, computed on the same basis but using a minimum interest rate of four percent, rather than six percent.

A contract meets the cash value accumulation test of § 7702(b) if, by the terms of the contract, the cash surrender value of the contract may not at any time exceed the net single premium that would have to be paid at that time to fund future benefits under the contract. This determination is made, in part, on the basis of the mortality charge rule of § 7702(c)(3)(B)(i) and, in the case of QABs, the expense charge rule of § 7702(c)(3)(B)(ii).

Section 7702(f)(4) defines the term “future benefits” to mean death benefits and endowment benefits. Section 7702(f)(5)(A)(iii) characterizes family term riders as QABs. Section 7702(f)(5)(B) provides that QABs are not treated as future benefits under the contract, but the charges for such benefits are treated as future benefits. Accordingly, charges for the Rider should be accounted for as future benefits under the Policy.

Under the mortality charge rule of § 7702(c)(3)(b)(i), reasonable mortality charges are taken into account if they meet the requirements (if any) prescribed in regulations and do not exceed the mortality charges specified in the prevailing commissioners’ standard tables as of the time the contract is issued. There is no requirement that the charges taken into account be charges that are expected to be paid. In contrast, under the expense

charge rule of § 7702(c)(3)(B)(ii), reasonable charges other than mortality charges are taken into account only if they are reasonably expected to be actually paid. For this reason, accounting for charges for the Rider under the mortality charge rule, rather than the expense charge rule, would in some cases produce a higher net single premium and higher guideline level premiums for purposes of testing a contract’s compliance with § 7702.

Section 7702A defines a modified endowment contract (MEC) generally as a contract that meets the requirement of § 7702 but fails to meet the 7-pay test set forth in § 7702A(b) (or that is received in exchange for a contract that is otherwise a MEC). Under § 7702A(b), a contract fails to meet the 7-pay test if the accumulated amount paid under the contract at any time during the first seven contract years exceeds the sum of the net level premiums that would have been paid on or before that time if the contract provided for paid-up future benefits after the payment of seven level annual premiums. For this purpose, § 7702A(c)(1) provides that determinations under the 7-pay test are made by applying the cash value accumulation test rules of § 7702(b)(2). Under that provision, charges for QABs are accounted for under the expense charge rule of § 7702(c)(3)(B)(ii).

Section 7702 is silent on the treatment of charges for QABs for purposes of determining whether a contract satisfies the guideline premium requirements. Under § 7702(b)(2)(B), however, charges for QABs are subject to the expense charge rule of § 7702(c)(3)(B)(ii) for purposes of determining whether a contract satisfies the cash value accumulation test. The same rule applies under § 7702A(c)(1) for purposes of determining whether a contract satisfies the 7-pay test and therefore is not a MEC. There is no indication that Congress intended charges for QABs to be accounted for under one rule for purposes of the cash value accumulation test of § 7702(b) and the 7-pay test of § 7702A(b), and under a different rule for purposes of the guideline premium requirements of § 7702(c). Moreover, there is no indication that Congress intended to take into account charges with respect to QABs that exceed amounts reasonably expected to be actually paid. Accordingly, charges taken into account with respect to

2005–6 I.R.B. 472 February 7, 2005

ing the requirements of § 7702(a) or as MECs under § 7702A by reason of improperly accounting for charges for existing QABs, including future charges resulting from an increase in an existing QAB or the addition of a new QAB pursuant to the exercise of a right that existed in the contract before April 8, 2005; relief under the closing agreement will not extend to improper

accounting for charges for an increase in an existing QAB or the addition of a new QAB that are not pursuant to the exercise of a right that existed in the contract before that date; 3. no corrective action need be taken with respect to the compliance system or with respect to contracts identified in the closing agreement;

Number of Contracts Amount due

4. in lieu of an amount based on the tax and interest that would have been owed by the policyholders if they were treated as receiving the income on the contract, the amount due under the closing agreement will be based on the aggregate number of contracts for which relief is requested, as set forth in the following schedule:

tutions & Products). For further information regarding this revenue ruling, contact Melissa S. Luxner at (202) 622–3970 (not a toll-free call).

Section 7872.—Treatment of Loans With Below-Market Interest Rates

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of February 2005. See Rev. Rul. 2005-8, page 466.

5. the request for a closing agreement must be submitted to the appropriate address and with the appropriate user fee set forth in Rev. Proc. 2005–1; in addition, the closing agreement should reflect the following address for mailing the closing agreement and amount due, after the closing agreement has been executed by the Service: Internal Revenue Service, Receipt & Control Stop 31, 201 W. Rivercenter Blvd., Covington, KY

C. After February 7, 2006, an issuer whose compliance system does not properly account for charges for QABs may re

quest a closing agreement under the terms and conditions set forth above, except that (1) the closing agreement must identify the contracts that fail to meet the requirements of § 7702(a) or are inadvertent MECs under § 7702A; and (2) the closing agreement must require the issuer to correct its compliance system and to bring the identified contracts into compliance with § 7702(a) or § 7702A, as appropriate.

DRAFTING INFORMATION

The principal author of this revenue ruling is Melissa S. Luxner of the Office of Associate Chief Counsel (Financial Insti

February 7, 2005 473 2005–6 I.R.B.