Part IV. Items — Internal Revenue Bulletin 2007-28

Notice of Proposed Rulemaking and Notice of Public Hearing

Grantor Retained Interest Trusts—Application of Sections 2036 and 2039

REG–119097–05

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

SUMMARY: This document contains proposed regulations providing guidance on the portion of a trust properly includible in a grantor’s gross estate under Internal Revenue Code (Code) sections 2036 and 2039 if the grantor has retained the use of property in a trust or the right to an annuity, unitrust, or other income payment from such trust for life, for any period not ascertainable without reference to the grantor’s death, or for a period that does not in fact end before the grantor’s death. This document also provides notice of a public hearing on these proposed regulations.

DATES: Written or electronic comments must be received by September 5, 2007. Outlines of topics to be discussed at the public hearing scheduled for September 26, 2007, must be received by September 5, 2007.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG–119097–05), Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand delivered to the Courier’s Desk, Internal Revenue Service, Attn: CC:PA:LPD:PR (REG–119097–05), room 5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, Washington DC 20044. Alternatively, submissions may be hand-delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG–119097–05), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC, or sent electronically via the Federal eRulemak

ing Portal at www.regulations.gov (IRS REG–119097–05). The public hearing will be held in the auditorium, Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, Theresa M. Melchiorre, (202) 622–7830; concerning submissions of comments, the hearing, and/or to be placed on the building access list to attend the hearing, Richard Hurst, (202) 622–7180 (not toll-free numbers) or e-mail at Richard.A.Hurst@irscounsel.treas.gov.

SUPPLEMENTARY INFORMATION:

Background

The proposed regulations provide guidance on what portion of a trust is includible in the deceased grantor’s gross estate under section 2036 if the grantor retained the right to use property in the trust or the right to receive from that trust an annuity, unitrust, or other income payment for the grantor’s life, for any period not ascertainable without reference to the grantor’s death, or for any period that does not in fact end before the grantor’s death. In addition, the proposed regulations provide guidance on the possible application of section 2039 to trusts in which the decedent has retained the use of property held in the trust or has retained an annuity, unitrust, or other income interest that is includible in the decedent’s gross estate under section 2036. These trusts include without limitation certain charitable trusts (collectively CRTs) such as charitable remainder annuity trusts (CRATs) within the meaning of section 664(d)(1), charitable remainder unitrusts (CRUTs) within the meaning of section 664(d)(2) or (d)(3), and charitable remainder trusts that do not qualify under section 664, as well as other trusts established by a grantor (collectively GRTs) such as grantor retained annuity trusts (GRATs), grantor retained unitrusts (GRUTs), and various forms of grantor retained income trusts (GRITs), such as qualified personal residence trusts (QPRTs) and personal residence trusts (PRTs). A CRT is within the scope of these proposed regulations whether or not

the CRT meets the qualifications of sections 664(d)(1), (2), or (3) and a GRT is within the scope of these proposed regulations whether or not the grantor’s retained interest is a “qualified interest” as defined in section 2702(b). This guidance does not apply to trusts or other contractual arrangements arising by reason of a decedent’s employment and generally does not apply to annuities purchased by the decedent, as these types of interests fall within the ambit of section 2039.

Under section 2036(a), a decedent’s gross estate includes the value of any interest in property transferred by the decedent in which the decedent retained for the decedent’s life, for any period not ascertainable without reference to the decedent’s death, or for any period that does not in fact end before the decedent’s death, either the possession or enjoyment of the property or a right to the income from the property, or the right (either alone or with another) to designate the persons who may possess or enjoy the property or its income. Section 20.2036–1(a) provides generally that, if the decedent retained or reserved an interest with respect to all of the property transferred by the decedent, the amount to be included in the gross estate under section 2036 is the value of the entire property on the date of death. If the decedent retained a right with respect to only part of the property transferred, the amount to be included in the decedent’s gross estate under section 2036 is the corresponding proportionate amount of the corpus. Rev. Rul. 76–273, 1976–2 C.B. 268, and Rev. Rul. 82–105, 1982–1 C.B. 133 (See §601.601(d)(2)), generally provide that the portion of the corpus of a CRUT and CRAT includible in the decedent’s gross estate under section 2036 is that portion of the trust corpus necessary to generate a return sufficient to provide the decedent’s retained annuity or unitrust payment.

Rev. Rul. 76–273 considers a situation where the decedent created an intervivos trust that provided for a stated unitrust percentage of 6 percent to be paid each year to the decedent during life. At the decedent’s death, the remainder is to be paid to a charitable organization. The revenue ruling concludes that, for purposes

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include at least some portion of a trust in the decedent’s gross estate if the decedent transfers property during life to a trust and retains the right to use the trust’s property or the right to an annuity, unitrust, or other payment from the trust, the amount includible may differ depending upon which section is applied for this purpose.

Explanation of Provisions

The proposed regulations amend §20.2036–1 to incorporate the guidance provided in Rev. Rul. 76–273 and Rev. Rul. 82–105. The proposed regulations provide that, if a decedent transfers property during life to a trust and retains the right to an annuity, unitrust, or other income payment from, or retains the use of an asset in, the trust for the decedent’s life, for a period that does not in fact end before the decedent’s death, or for a period not ascertainable without reference to the decedent’s death, the decedent has retained the right to income from all or a specific portion of the property transferred as described in section 2036. The portion of the trust corpus includible in the decedent’s gross estate is that portion of the trust corpus, valued as of the decedent’s death (or the alternate valuation date, if applicable) necessary to yield that annual payment (or use) using the appropriate section 7520 interest rate. In this regard, because the specific portion of corpus includible in the gross estate is properly determined as of the decedent’s death, the appropriate section 7520 rate is the rate in effect on the decedent’s date of death (or on the alternate valuation date, if applicable). The proposed regulations provide both rules and examples for calculating the amount of trust corpus to be included in a deceased grantor’s gross estate under section 2036 in such a case.

The IRS and Treasury Department believe that in many cases both section 2036 and section 2039 may be applicable to these annuity and unitrust interests and to such other payments retained by a deceased grantor. Although the language of section 2039 is broad enough to include all or a portion of a trust’s corpus if the grantor retains an annuity or unitrust interest in, or other payments from, a trust, the IRS and Treasury Department believe that, in the interest of ensuring similar tax treatment for similarly situated taxpayers, it

of section 2036(a), the portion of the value of the trust corpus includible in the decedent’s gross estate is the portion necessary to yield (at the then current interest rate specified under the applicable regulations) the amount of the annual unitrust payment in perpetuity. Based upon the valuation rules and interest rate assumptions specified in §20.2031–10 (the regulations applicable at the time the ruling was issued), the revenue ruling provides the following formula to be used to determine this includible portion of the trust corpus: equivalent income interest rate divided by the interest rate mandated by the applicable regulations at the date of death, where the equivalent income interest rate = adjusted payout rate/1 minus adjusted payout rate. The result, however, is limited to 100 percent of the trust corpus. (Since the issuance of this revenue ruling, the regulations (§20.2031–7(d)(1)) have been changed to instead require the use of the section 7520 interest rate in lieu of the rate specified in §20.2031–10). The revenue ruling concludes that, because the equivalent income interest of the unitrust payment exceeds the equivalent income interest required to produce that unitrust payment, the grantor retained an interest in the entire corpus of the trust, and thus the entire trust corpus is includible in the deceased grantor’s gross estate under section 2036. Rev. Rul. 82–105 considers a situation where the decedent created an intervivos CRAT, pursuant to which the decedent retained the right to receive a fixed annuity for life. The ruling confirms that the decedent’s retained annuity represents the retained right to receive all of the income from all or a specific portion of the trust for purposes of section 2036. That portion of the trust corpus with respect to which the decedent retained a right to receive all of the income is properly includible in the decedent’s gross estate under section 2036(a)(1). Under the ruling, the amount of the corpus with respect to which the decedent retained the income is that amount of corpus that would be sufficient to yield the annual annuity based on the assumed rate of return prescribed by the regulations as of the applicable valuation date. The ruling prescribes the following formula for this determination: (Annual Annuity) / (Assumed Rate of Return) = Amount Includible. Assum

ing a rate of return of 6 percent, as specified under §20.2031–10 (the regulation applicable at the time the ruling was issued), the ruling concludes that only a portion of the trust’s corpus is includible in the deceased grantor’s gross estate. (Since the issuance of this revenue ruling, the regulations (§20.2031–7(d)(1)) have been changed to instead require the use of the section 7520 interest rate in place of the rate specified in §20.2031–10.) Rev. Rul. 82–105 expressly qualifies this conclusion by stating that the ruling does not consider the amount, if any, that may be includible in the gross estate under any other provisions of the Code.

Section 2039(a) provides that a decedent’s gross estate includes the value of an annuity or other payment under any form of contract or agreement (other than an insurance policy on the decedent’s life) receivable by any beneficiary by reason of surviving the decedent if, under the contract or agreement, an annuity or other payment was payable to the decedent, or the decedent possessed the right to receive such annuity or other payment, for the decedent’s life or for any period not ascertainable without reference to the decedent’s death, or for any period that does not in fact end before the decedent’s death.

Section 2039(b) provides, in part, that the amount includible in the decedent’s gross estate is limited to that portion of the value of the annuity or other payment receivable under the contract or agreement as is proportionate to the portion of the purchase price of the contract or agreement that was contributed by the decedent. Section 20.2039–1(b)(1) provides, in part, that the term “annuity or other payment,” as used with respect to both the payment receivable by the decedent and by the beneficiary, has reference to one or more payments extending over any period of time, whether the payments are equal or unequal, conditional or unconditional, periodic or sporadic. The term “contract or agreement” includes any arrangement, understanding, or plan, or any combination of them, arising by reason of the decedent’s employment. Section 20.2039–1(b)(1).

As is acknowledged in Rev. Rul. 82–105, section 2036 as well as other sections of the Code might apply to the same interest or trust for purposes of the Federal estate tax. Although either section 2036 or section 2039 may be applied to

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access restrictions, visitors will not be admitted beyond the immediate entrance area more than 30 minutes before the hearing starts. For more information about having your name placed on the list to attend the hearing, see the “FOR FURTHER INFORMATION CONTACT” section of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who wish to present oral comments at the hearing must submit written (a signed original and eight (8) copies) or electronic comments by September 5, 2007, and an outline of the topics to be discussed and the time to be devoted to each topic by September 5, 2007. A period of 10 minutes will be allotted to each person for making comments. An agenda showing the scheduling of the speakers will be prepared after the deadline for receiving outlines has passed. Copies of the agenda will be available free of charge at the hearing.

Drafting Information

The principal author of these regulations is Theresa M. Melchiorre, Office of Chief Counsel, IRS.

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Proposed Amendments to the Regulations

Accordingly, 26 CFR part 20 is proposed to be 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 20.2036–1 is amended by:

Redesignating paragraphs (a)(i) and (a)(ii) as paragraphs (a)(1) and (a)(2), respectively.
Designating the undesignated text following newly-designated paragraph (a)(2) as paragraph (c)(1)(i) and adding new paragraph headings.
Adding paragraphs (c)(1)(ii), (c)(2), and (c)(3).

The additions read as follows:

is appropriate in this circumstance to provide regulatory rules under which only one of these two potentially applicable Code sections (section 2036 and section 2039) will be applied in the future. For the reasons mentioned below, the IRS and Treasury Department have concluded that section 2036 (and therefore, when applicable, section 2035), rather than section 2039, will be applied in the future to these interests. First, section 2039 appears to have been intended to address annuities purchased by or on behalf of the decedent and annuities provided by the decedent’s employer. Second, the interests retained by grantors in the types of trusts described in this guidance are more similar in most relevant respects to the interests addressed under section 2036 than those most clearly addressed under section 2039. Accordingly, the proposed regulations also amend §20.2039–1(b)(1) by providing that section 2039 shall not be applied to an annuity, unitrust, or other payment retained by a deceased grantor in a CRT or GRT.

Although these proposed regulations provide guidance as to which section of the Code (specifically, section 2036 or section 2039) is to be used in certain circumstances when each of those sections applies to the same CRT or GRT, these proposed regulations should not be construed to imply that only one section of the Code may apply to a particular situation or interest. These proposed regulations are not intended to foreclose the possibility that any applicable section of the Code (sections 2035 through 2039, or any other section) properly may be applied in the future by the IRS in appropriate circumstances beyond those described in these proposed regulations. (For example, although section 2039 generally will apply to govern the includability of annuities purchased by or on behalf of the decedent and annuities provided by the decedent’s employer in the decedent’s gross estate, section 2036 may instead be applied if the facts and circumstances indicate that the annuity constituted a retained interest in the property exchanged for that annuity.)

Proposed Effective Date

The first, second, and fourth sentences in §20.2039–1(a) and the provisions in §20.2036–1(a)(1), (a)(2), and (c)(1)(i) are applicable to the estates of decedents

dying after August 16, 1954. The fifth sentence of §20.2039–1(a) is applicable to the estates of decedents dying on or after October 27, 1972, and to the estates of decedents for which the period for filing a claim for credit or refund of an estate tax overpayment ends on or after October 27, 1972. The provisions of §20.2036–1(c)(1)(ii) and (2), §20.2039–1(e), and the third, sixth, and seventh sentences of §20.2039–1(a) apply to the estates of decedents for which the valuation date of the gross estate is on or after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register .

Special Analyses

It has been determined that this notice of proposed rulemaking 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. Pursuant to section 7805(f) of the Code, this regulation has been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any written (a signed original and eight (8) copies) or electronic comments that are submitted timely to the IRS. The IRS and Treasury Department also request comments on the clarity of the proposed rules and how they can be made easier to understand. All comments will be available for public inspection and copying.

A public hearing has been scheduled for September 26, 2007 in the auditorium, Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC. Due to building security procedures, visitors must use the main building entrance. In addition, all visitors must present photo identification to enter the building. Because of

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§20.2036–1 Transfers with retained life estate.

- - - (c) Retained or reserved interest —(1) Amount included in gross estate —(i) In general . - * (ii) Example . The application of paragraph (c)(1)(i) of this section is illustrated in the following example:

Example . In 2001, Decedent (D) creates an irrevocable intervivos trust. The terms of the trust provide that all of the trust’s income is to be paid to D and E, D’s spouse who is a US citizen, in equal shares during their joint lives and, on the death of either of them, all of the income is to be paid to the survivor of them. On the death of the survivor of D and E, the remainder is to be paid to another individual, F. In 2006, D dies with E still surviving. A portion of the trust’s corpus is includible in D’s gross estate because D retained the right to receive a portion of the income from the trust for a period that does not in fact end before D’s death. The portion of the trust’s corpus includible in D’s gross estate bears the same ratio to the entire corpus as D’s income interest in the trust bears to the entire income interest in the trust. Therefore, in this case, because D and E share equally in the trust’s income, 50 percent of the trust’s corpus is includible in D’s gross estate under section 2036. If instead E had predeceased D, D would have died while entitled to all of the income from the trust, so that the entire trust corpus would have been includible in D’s gross estate under section 2036.

(2) Retained annuity and unitrust in- terests in trusts —(i) In general . This paragraph (c)(2) applies to a grantor’s retained use of an asset held in trust or a retained annuity, unitrust, or other income interest in any trust (other than a trust constituting an employee benefit) including without limitation the following (collectively referred to in this paragraph (c)(2) as “trusts”): certain charitable trusts (collectively CRTs) such as a charitable remainder annuity trust (CRAT) within the meaning of section 664(d)(1), a charitable remainder unitrust (CRUT) within the meaning of section 664(d)(2) or (d)(3), and any charitable remainder trust that does not qualify under section 664(d), as well as other trusts established by a grantor (collectively GRTs) such as a grantor retained annuity trust (GRAT), a grantor retained unitrust (GRUT), and various other forms of grantor retained income trusts (GRITs), whether or not the grantor’s retained interest is a qualified interest as defined in section 2702(b), including without limitation qualified personal residence trusts (QPRTs) and personal residence trusts (PRTs). If a decedent transferred property into such a trust, and retained or reserved

the right to use such property or the right to an annuity, unitrust, other income interest in such trust with respect to the property so transferred by the decedent, or to determine the persons who may possess or enjoy the property or its income, for the decedent’s life, for any period not ascertainable without reference to the decedent’s death, or for a period that does not in fact end before the decedent’s death, then the decedent’s right to use the property or retained annuity, unitrust, or other income interest (or to designate the beneficiaries of the property) represents the retained right to receive all of the income from all or a specific portion of the trust for purposes of section 2036. The portion of the trust’s corpus includible in the decedent’s gross estate for Federal estate tax purposes is that portion of the trust corpus necessary to yield the decedent’s retained use or retained annuity, unitrust, other income payment as determined in accordance with §20.2031–7 (or §20.2031–7A, if applicable).

(ii) Examples . The application of paragraph (c)(2)(i) of this section is illustrated in the following examples:

Example 1 . (i) In 2000, Decedent (D) transferred $100,000 to a trust that qualifies as a CRAT under section 664(d)(1). The trust agreement provides for an annuity of $12,000 to be paid each year to D for D’s life, then to D’s child (C) for C’s life, with the remainder to be distributed upon the survivor’s death to N, a charitable organization described in sections 170(c), 2055(a), and 2522(a). The annuity is payable to D or C, as the case may be, annually on each December 31 ^st . D died in 2006, survived by C who was then age 40. On D’s death, the value of the trust assets was $300,000 and the section 7520 interest rate was 6 percent. D’s executor did not elect to use the alternate valuation date.

(ii) The amount of corpus with respect to which D retained the right to the income, and thus the amount includible in D’s gross estate under section 2036, is that amount of corpus necessary to yield the annual annuity payment to D. In this case, the formula for determining the amount of corpus necessary to yield the annual annuity payment to D is: annual annuity / section 7520 interest rate = amount includible under section 2036. The amount of corpus necessary to yield the annual annuity is $12,000 / .06 = $200,000. Therefore, $200,000 is includible in D’s gross estate under section 2036(a)(1). (The result would be the same if D had irrevocably relinquished D’s annuity interest no more than 3 years prior to D’s death because of the application of section 2035.) D’s estate is entitled to a charitable deduction under section 2055 for the present value of N’s remainder interest in the CRAT. The applicable annuity factor (based on C’s age on D’s death and the section 7520 rate applicable on that date) is 14.1646. Therefore, the present value of the annuity is $169,975.20 (14.1646 x $12,000). As a result, the allowable charitable deduction for D’s

estate is $30,024.80 ($200,000 - $169,975.20). Under the facts presented, the Internal Revenue Service (IRS) will not seek (and the estate will not be permitted) to include under section 2039 any amount in D’s gross estate by reason of this retained annuity. See §20.2039–1(e).

Example 2 . (i) D transferred $100,000 to a GRAT in which D’s annuity is a qualified interest described in section 2702(b). The trust agreement provides for an annuity of $12,000 per year to be paid to D for a term of ten years or until D’s earlier death. The annuity amount is payable at the end of each month in twelve equal installments. At the expiration of the term of years or on D’s earlier death, the remainder is to be distributed to C, D’s child. No additional contributions were made to the trust after D’s transfer at the creation of the trust. D dies prior to the expiration of the ten-year term. On the date of D’s death, the value of the trust assets was $300,000 and the section 7520 interest rate was 6 percent. D’s executor did not elect to use the alternate valuation date.

(ii) The amount of corpus with respect to which D retained the right to the income, and thus the amount includible in D’s gross estate under section 2036, is that amount of corpus necessary to yield the annual annuity payment to D. In this case, the formula for determining the amount of corpus necessary to yield the annual annuity payment to D is: annual annuity (adjusted for monthly payments) / section 7520 interest rate = amount includible under section 2036. The Table K adjustment factor for monthly annuity payments in this case is 1.0272. Thus, the amount of corpus necessary to yield the annual annuity is ($12,000 x 1.0272) / .06 = $205,440. Therefore, $205,440 is includible in D’s gross estate under section 2036(a)(1). Under the facts presented, the IRS will not seek (and the estate will not be permitted) to include under section 2039 any amount in D’s gross estate by reason of this retained annuity. See §20.2039–1(e).

Example 3 . (i) In 2000, D created a CRUT within the meaning of section 664(d)(2). The trust instrument directs the trustee to hold, invest, and reinvest the corpus of the trust and to pay to D for D’s life, and then to D’s child (C) for C’s life, in equal quarterly installments payable at the end of each calendar quarter, an amount equal to 6 percent of the fair market value of the trust as valued on December 15 of the prior taxable year of the trust. At the termination of the trust, the then corpus, together with any and all the accrued income, is to be distributed to N, a charitable organization described in sections 170(c), 2055(a), and 2522(a). D died in 2006, survived by C, who was then age 55. The value of the trust assets on D’s death was $300,000 and D’s executor did not elect to use the alternate valuation date.

(ii) The amount of the corpus with respect to which D retained the right to the income, and thus the amount includible in D’s gross estate under section 2036, is that amount of corpus necessary to yield the unitrust payments. In this case, such amount of corpus is determined by dividing the trust’s equivalent income interest rate by the section 7520 rate (which was 6 percent at the time of D’s death). The equivalent income interest rate is determined by dividing the trust’s adjusted payout rate by the excess of 1 over the adjusted payout rate. Based on §1.664–4(e)(3) of the Income Tax Regulations, the appropriate adjusted payout rate for the trust at D’s death is 5.786 percent (6 percent x .964365). Thus,

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- - - (e)(1) No application to certain trusts . Section 2039 shall not be applied to include in a decedent’s gross estate all or any portion of a trust (other than a trust constituting an employee benefit, but including those described in the following sentence) if the decedent retained a right to use property of the trust or retained an annuity, unitrust, or other income interest in the trust, in either case as described in section

Such trusts include without limitation the following (collectively referred to in this paragraph (e)(1) as “trusts”): certain charitable trusts (collectively CRTs) such as a charitable remainder annuity trust (CRAT) within the meaning of section 664(d)(1), a charitable remainder unitrust (CRUT) within the meaning of section 664(d)(2) or (d)(3), and any other charitable remainder trust that does not qualify under section 664(d), as well as other trusts established by a grantor (collectively GRTs) such as a grantor retained annuity trust (GRAT), a grantor retained unitrust (GRUT), and various forms of grantor retained income trusts (GRITs), whether or not the grantor’s retained interest is a qualified interest as defined in section 2702(b), including without limitation qualified personal residence trusts (QPRTs) and personal residence trusts (PRTs). For purposes of determining the extent to which a retained interest causes all or a portion of a trust to be included in a decedent’s gross estate, see §20.2036–1(c)(1), (2), and (3).

(2) Effective date . The first, second, and fourth sentences in paragraph (a) of this section are applicable to the estates of decedents dying after August 16, 1954. The fifth sentence of paragraph (a) of this section is applicable to the estates of decedents dying on or after October 27, 1972, and to the estates of decedents for which the period for filing a claim for credit or refund of an estate tax overpayment ends on or after October 27, 1972. The third, sixth, and seventh sentences of paragraph (a) of this section and this paragraph (e) are applicable to the estates of decedents for which the valuation date of the gross estate is on or after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Regis- ter .

the equivalent income interest rate is 6.141 percent (5.786 percent / (1 - 5.786 percent)). The ratio of the equivalent interest rate to the assumed interest rate under section 7520 is 102.35 percent (6.141 percent / 6 percent). Because this exceeds 100 percent, D’s retained payout interest exceeds a full income interest in the trust, and D effectively retained the income from all the assets transferred to the trust. Accordingly, because D retained for life an interest at least equal to the right to the income from all the property transferred by D to the CRUT, the entire value of the corpus of the CRUT is includible in D’s gross estate under section 2036(a)(1). D’s estate is entitled to a charitable deduction under section 2055 for the present value of N’s remainder interest in the CRAT. The remainder factor (based on C’s age at D’s death, the section 7520 rate in effect on D’s death, and the timing and frequency of the payments) is 0.28253. Therefore, the charitable deduction allowable to D’s estate is $84,759 ($300,000 x 0.28253). Under the facts presented, the IRS will not seek (and the estate will not be permitted) to include under section 2039 any amount in D’s gross estate by reason of D’s retained unitrust interest. See §20.2039–1(e).

(iii) If instead D had retained the right to a unitrust amount having an adjusted payout for which the corresponding equivalent interest rate would be less than the 6 percent assumed interest rate of section 7520, then a correspondingly reduced proportion of the trust corpus would be includible in D’s gross estate under section 2036(a)(1). Alternatively, if the interest retained by D was instead only one-half of the 6 percent unitrust interest, the computation of the portion of the trust includable in D’s gross estate (set forth in Exam- ple 3 (ii)) would be reduced by one-half. In each case, the amount of the estate’s charitable deduction for the remainder interest in the trust also would be reduced. All of the results in this Example 3 (except those relating to the charitable deduction) would be the same if the trust was a GRUT instead of a CRUT.

Example 4 . During D’s life, D established a 15-year GRIT for the benefit of individuals who are not members of D’s family within the meaning of section 2704(c)(2). D retained the right to receive all of the net income from the GRIT, payable annually, during the GRIT’s term. D died during the third year of the GRIT term. D’s executor did not elect to use the alternate valuation date. In this case, the GRIT’s corpus is includible in D’s gross estate under section 2036 because D retained the right to receive all of the income from the GRIT for a period that did not in fact end before D’s death. If instead, D had retained the right to receive 60 percent of the GRIT’s net income, then 60 percent of the GRIT’s corpus would have been includible in D’s gross estate under section 2036.

Example 5 . D transfered D’s personal residence to a trust that met the requirements of a qualified personal residence trust (QPRT) as set forth in §25.2702–5(c) of this chapter. Pursuant to the terms of the QPRT, D retained the right to use the residence for 10 years or until D’s prior death. D died before the end of the term. D’s executor did not elect to use the alternate valuation date. In this case, the fair market value of the QPRT’s assets on the date of D’s death are includible in D’s gross estate under section 2036 because D retained the right to use the residence for a period that did not in fact end before D’s death.

(3) Effective dates . Paragraphs (a)(1), (a)(2), and (c)(1)(i) of this section are applicable to the estates of decedents dying after August 16, 1954. Paragraphs (c)(1)(ii) and (c)(2) of this section apply to the estates of decedents for which the valuation date of the gross estate is on or after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register .

Par. 3. Section 20.2039–1 is amended by:

Revising paragraph (a).
Adding a new paragraph (e). The revision and addition reads as follows:

§20.2039–1 Annuities .

(a) In general . A decedent’s gross estate includes under section 2039(a) and (b) the value of an annuity or other payment receivable by any beneficiary by reason of surviving the decedent under certain agreements or plans to the extent that the value of the annuity or other payment is attributable to contributions made by the decedent or his employer. Section 2039(a) and (b), however, has no application to an amount which constitutes the proceeds of insurance under a policy on the decedent’s life. Paragraph (b) of this section describes the agreements or plans to which section 2039(a) and (b) applies; paragraph (c) of this section provides rules for determining the amount includible in the decedent’s gross estate; paragraph (d) of this section distinguishes proceeds of life insurance; and paragraph (e) of this section distinguishes annuity, unitrust, and other income interests retained by a decedent in certain trusts. The fact that an annuity or other payment is not includible in a decedent’s gross estate under section 2039(a) and (b) does not mean that it is not includible under some other section of part III of subchapter A of chapter 11. However, see section 2039(c) and (d) and §20.2039–2 for rules relating to the exclusion from a decedent’s gross estate of annuities and other payments under certain “qualified plans.” Further, the fact that an annuity or other payment may be includible under section 2039(a) will not preclude the application of another section of chapter 11 with regard to that interest. For annuity interests in trust, see paragraph (e)(1) of this section.

2007–28 I.R.B. 78 July 9, 2007

Section 199(c)(1) defines QPAI for any taxable year as an amount equal to the excess (if any) of (A) the taxpayer’s domestic production gross receipts (DPGR) for such taxable year, over (B) the sum of (i) the cost of goods sold (CGS) that are allocable to such receipts; and (ii) other expenses, losses, or deductions (other than the deduction under section 199) that are properly allocable to such receipts.

Section 199(c)(4)(A)(i) provides that the term DPGR means the taxpayer’s gross receipts that are derived from any lease, rental, license, sale, exchange, or other disposition of (I) qualifying production property (QPP) that was manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States; (II) any qualified film produced by the taxpayer; or (III) electricity, natural gas, or potable water produced by the taxpayer in the United States.

Section 199(c)(6) defines a qualified film to mean any property described in section 168(f)(3) if not less than 50 percent of the total compensation relating to production of the property is compensation for services performed in the United States by actors, production personnel, directors, and producers. The term does not include property with respect to which records are required to be maintained under 18 U.S.C. 2257 (generally, films, videotapes, or other matter that depict actual sexually explicit conduct and are produced in whole or in part with materials that have been mailed or shipped in interstate or foreign commerce, or are shipped or transported or are intended for shipment or transportation in interstate or foreign commerce).

Section 199(d)(4)(A) provides that all members of an expanded affiliated group (EAG) are treated as a single corporation for purposes of section 199. Under section 199(d)(4)(B), an EAG is an affiliated group as defined in section 1504(a), determined by substituting “more than 50 percent” for “at least 80 percent” each place it appears and without regard to section 1504(b)(2) and (4). Section 199(d)(8) authorizes the Secretary to prescribe such regulations as are necessary to carry out the purposes of section 199, including regulations that prevent more than one taxpayer from being allowed a deduction under section 199 with

Kevin M. Brown, Deputy Commissioner for Services and Enforcement.

(Filed by the Office of the Federal Register on June 6, 2007, 8:45 a.m., and published in the issue of the Federal Register for June 7, 2007, 72 F.R. 31487)

Notice of Proposed Rulemaking and Notice of Public Hearing

Qualified Films Under Section 199

REG–103842–07

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

SUMMARY: This document contains proposed amendments to the regulations involving the deduction for income attributable to domestic production activities under section 199. The proposed amendments affect taxpayers who produce qualified films under section 199(c)(4)(A)(i)(II) and (c)(6) and taxpayers who are members of an expanded affiliated group under section 199(d)(4). This document also contains a notice of a public hearing on these proposed regulations.

DATES: Written or electronic comments must be received by September 5, 2007. Outlines of topics to be discussed at the public hearing scheduled for October 2, 2007, must be received by September 11, 2007.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG–103842–07), room 5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand-delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG–103842–07), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC, or sent electronically, via the Federal eRulemaking Portal at www.regulations.gov (indicate IRS

REG–103842–07). The public hearing will be held in the auditorium, Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning §1.199–3(k) of the proposed regulations, David McDonnell, at (202) 622–3040; concerning §1.199–7 of the proposed regulations, Ken Cohen (202) 622–7790; concerning submissions of comments, the hearing, or to be placed on the building access list to attend the hearing, Richard Hurst, at Richard.A.Hurst@irscounsel.treas.gov or (202) 622–7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

This document contains proposed amendments to §§1.199–3(k) and 1.199–7 of the Income Tax Regulations (26 CFR Part 1). Section 1.199–3(k) relates to the definition of qualified film produced by the taxpayer under section 199(c)(4)(A)(i)(II) and (c)(6) of the Internal Revenue Code (Code) and §1.199–7 involves expanded affiliated groups under section 199(d)(4). Section 199 was added to the Code by section 102 of the American Jobs Creation Act of 2004 (Public Law 108–357, 118 Stat. 1418), and amended by section 403(a) of the Gulf Opportunity Zone Act of 2005 (Public Law 109–135, 119 Stat. 25), section 514 of the Tax Increase Prevention and Reconciliation Act of 2005 (Public Law 109–222, 120 Stat. 345), and section 401 of the Tax Relief and Health Care Act of 2006 (Public Law 109–432, 120 Stat. 2922).

General Overview

Section 199(a)(1) allows a deduction equal to 9 percent (3 percent in the case of taxable years beginning in 2005 or 2006, and 6 percent in the case of taxable years beginning in 2007, 2008, or 2009) of the lesser of (A) the qualified production activities income (QPAI) of the taxpayer for the taxable year, or (B) taxable income (determined without regard to section 199) for the taxable year (or, in the case of an individual, adjusted gross income).

July 9, 2007 79 2007–28 I.R.B.

film if not less than 50 percent of the total compensation for services paid by the taxpayer is compensation for services performed in the United States. The safe harbor further provides that a qualified film will be treated as produced by the taxpayer if the taxpayer satisfies the safe harbor in §1.199–3(g)(3) with respect to the qualified film, which requires that the direct labor and overhead costs incurred by the taxpayer to produce the qualified film within the United States account for 20 percent or more of the total costs of the film.

Similar to §1.199–3(k)(6) of the proposed regulations, the special rules of §1.199–3(g)(4) regarding a contract with an unrelated person and aggregation apply in determining whether the taxpayer satisfies §1.199–3(g)(3). Section 1.199–3(g)(3) and (4) are applied by substituting the term “qualified film” for QPP but not disregarding the requirement that the direct labor and overhead of the taxpayer to produce the qualified film must be within the United States. Thus, a taxpayer will be treated as having produced a qualified film if, in connection with the qualified film, the direct labor and overhead of the taxpayer to produce the qualified film within the United States account for 20 percent or more of the taxpayer’s CGS of the qualified film, or in a transaction without CGS (for example, a lease, rental, or license) account for 20 percent or more of the taxpayer’s “unadjusted depreciable basis” (as defined in §1.199–3(g)(3)(ii)) in the qualified film.

Expanded Affiliated Groups

After issuance of the final regulations, several commentators noted that §1.199–7(e), Example 10, of the final regulations misapplies §1.1502–13 of the consolidated return regulations. In Exam- ple 10, a member of a consolidated group sells QPP to another member of the consolidated group. Before the QPP is sold to an unrelated party, the purchasing corporation is disaffiliated from the consolidated group. Example 10 provides that neither the selling corporation nor the purchasing corporation has DPGR. After further consideration, the IRS and Treasury Department have determined that Example 10 does not properly apply §1.1502–13 of the consolidated return regulations and that both the selling corporation and the

respect to any activity described in section 199(c)(4)(A)(i).

Explanation of Provisions

Qualified Film Produced by the Taxpayer

On June 1, 2006, final regulations (T.D. 9263, 2006–1 C.B. 1063) under section 199 were published in the Fed- eral Register (71 FR 31268). Subsequent to the publication of the final regulations, the IRS and Treasury Department became aware that the definition of a qualified film produced by a taxpayer as outlined in the final regulations may not be consistent with the statute. Under section 199(c)(4)(A)(i)(II), a taxpayer’s gross receipts qualify as DPGR if the receipts are derived from any lease, rental, license, sale, exchange, or other disposition of any qualified film (as defined in section 199(c)(6)) produced by the taxpayer. A film must be both a “qualified film” under section 199(c)(6) and “produced by the taxpayer” under section 199(c)(4)(A)(i)(II) in order for the gross receipts to qualify as DPGR. Section 1.199–3(k)(5) of the final regulations addresses these two requirements by adding “by the taxpayer” to the not-less-than-50-percent-of-the-totalcompensation requirement under §1.199–3(k)(1). However, under the test provided in §1.199–3(k)(5) of the final regulations, a film that was produced entirely within the United States could fail to qualify for the section 199 deduction if less than 50 percent of the total compensation relating to production was paid “by the taxpayer.”

The proposed regulations more closely follow the statutory language in section 199(c)(6) by revising the fraction in §1.199–3(k)(5) for determining the not-less-than-50-percent-of-the-total-compensation requirement under §1.199–3(k)(1). Under the fraction set forth in the proposed regulations, the numerator of the revised fraction is the compensation for services performed in the United States and the denominator is the total compensation for services regardless of where the production activities are performed. The revised fraction essentially compares (in the numerator) the sum of the compensation for services paid by the taxpayer for services performed in the United

States and the compensation for services paid by others for services performed in the United States to (in the denominator) the sum of the total compensation for services paid by the taxpayer for services and the total compensation for services paid by others for services regardless of location. The proposed regulations also clarify in §1.199–8(a) that, for purposes of §§1.199–1 through 1.199–9, use of terms such as “payment,” “paid,” “incurred,” or “paid or incurred” is not intended to provide any specific rule based upon the use of one term versus another. In general, the use of the term “payment,” “paid,” “incurred,” or “paid or incurred” is intended to convey the appropriate standard under the taxpayer’s method of accounting.

Under §1.199–3(k)(6) of the proposed regulations, a film that is a qualified film under §1.199–3(k)(1) will be treated as “produced by the taxpayer” for purposes of section 199(c)(4)(A)(i)(II) if the production activity performed by the taxpayer is substantial in nature within the meaning of §1.199–3(g)(2). The special rules of §1.199–3(g)(4) regarding a contract with an unrelated person and aggregation apply in determining whether the taxpayer’s production activity is substantial in nature. Section 1.199–3(g)(2) and (4) are applied by substituting the term “qualified film” for QPP and disregarding the requirement that the production activity must be within the United States. Thus, a qualified film will be treated as produced by the taxpayer if the production of the qualified film by the taxpayer is substantial in nature taking into account all of the facts and circumstances, including the relative value added by, and relative cost of, the taxpayer’s production activity, the nature of the qualified film, and the nature of the production activity that the taxpayer performs.

The rules provided in §1.199–3(k)(5) of the proposed regulations closely follow the statutory language in section 199(c)(6) by referencing all compensation for services related to the production as opposed to a more limited “by the taxpayer” compensation test. Commentators have expressed concern over the difficulty of obtaining information related to the compensation paid by others. In response to this concern, the IRS and Treasury Department have provided a safe harbor in §1.199–3(k)(7) of the proposed regulations provides a safe harbor that will treat a film as a qualified

2007–28 I.R.B. 80 July 9, 2007

Proposed Effective Date

Sections 1.199–3(k), 1.199–7(e), Ex- ample 10, and 1.199–7(f)(1) are proposed to be applicable to taxable years beginning on or after the date the final regulations are published in the Federal Register . Until the date the final regulations are published in the Federal Register, taxpayers may rely on §1.199–3(k) and §1.199–7(e), Ex- ample 10, of the proposed regulations for taxable years beginning after December 31, 2004. However, for taxable years beginning before June 1, 2006, a taxpayer may rely on §1.199–3(k) of the proposed regulations only if the taxpayer does not apply Notice 2005–14, 2005–1 C.B. 498 (see §601.601(d)(2)(ii)( b )) or REG–105847–05, 2005–2 C.B. 987 (see §601.601(d)(2)) to the taxable year.

Special Analyses

It has been determined that this notice of proposed rulemaking 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 the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Internal Revenue Code, this notice of proposed rulemaking has been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any written comments (a signed original and eight (8) copies) or electronic comments that are submitted timely to the IRS. Comments are requested on all aspects of the proposed regulations. In addition, the IRS and Treasury Department specifically request comments on the clarity of the proposed rules and how they can be made easier to understand. All comments will be available for public inspection and copying.

A public hearing has been scheduled for October 2, 2007, at 10 a.m. in the audi

purchasing corporation have DPGR in the facts described. Accordingly, the proposed regulations remove Example 10 of the final regulations and replace it with a new Example 10, properly applying §1.1502–13 of the consolidated return regulations.

In addition, the IRS and Treasury Department discovered a problem concerning the section 199 closing of the books method under §1.199–7(f)(1)(ii) of the final regulations. A corporation that becomes or ceases to be a member of an EAG during its taxable year must allocate its taxable income or loss, QPAI, and W-2 wages between the portion of the taxable year that it is a member of the EAG and the portion of the taxable year that it is not a member of the EAG. In general, this allocation is made by using the pro rata allocation method described in §1.199–7(f)(1)(i) of the final regulations. Section 1.199–7(f)(1)(ii) provides that in lieu of the pro rata allocation method, a corporation may elect to apply the section 199 closing of the books method under which a corporation treats its taxable year as two separate taxable years, the first of which ends at the close of the day on which the corporation’s status as a member of the EAG changes and the second of which begins at the beginning of the day after the corporation’s status as a member of the EAG changes.

In certain situations, the section 199 closing of the books method can create a larger section 199 deduction than is warranted. The facts of the Example in §1.199–7(g)(3) of the final regulations demonstrate such a situation. In the Ex- ample, Corporations X and Y, calendar year corporations, are members of the same EAG for the entire 2007 taxable year. Corporation Z, also a calendar year corporation, is a member of the EAG of which X and Y are members for the first half of 2007 and not a member of any EAG for the second half of 2007. During the 2007 taxable year, Z does not join in the filing of a consolidated return. Z makes a section 199 closing of the books election. As a result, Z has $80 of taxable income and $100 of QPAI that is allocated to the first half of 2007 and a $150 taxable loss and ($200) of QPAI that is allocated to the second half of 2007. In addition to the facts presented in the Example, assume that X and Y each have $60 of taxable

income and QPAI in 2007, Z has $170 of taxable income and QPAI in 2008, and that X, Y, and Z each have W-2 wages in excess of the section 199(b) wage limitation for all relevant periods. After applying the section 199 closing of the books method, the EAG has $200 of taxable income and $220 of QPAI in 2007. Accordingly, the EAG will have a section 199 deduction of $12 (6 percent of the lesser of the EAG’s $200 of taxable income and $220 of QPAI). Z, as a stand-alone corporation for the second half of 2007, will have both negative taxable income and negative QPAI and therefore will have no section 199 deduction. In 2008, notwithstanding that Z made a section 199 closing of the books election pursuant to which Z is deemed to have a $150 taxable loss for the second half of 2007, for purposes of computing its taxable income in 2008, Z only has a $70 NOL carryover from 2007. Accordingly, Z will have taxable income of $100 in 2008 and will have a section 199 deduction of $6 (6 percent of the lesser of its $100 of taxable income and $170 of QPAI). Because X and Y had a total of $120 of taxable income and Z had total taxable income in 2007 and 2008 of $100, the maximum aggregate section 199 deduction should have been $13.20 (6 percent of the aggregate taxable income of X, Y, and Z of $220), instead of the aggregate $18 deduction derived in the above example because of the use of the section 199 closing of the books method. The section 199 closing of the books method effectively eliminated $80 of Z’s losses from being used to offset taxable income for purposes of the section 199 deduction in either 2007 or 2008.

The proposed regulations remove the section 199 closing of the books method and revise the Example in §1.199–7(g)(3) to apply the pro rata allocation method. However, the IRS and Treasury Department invite comments concerning the necessity for a section 199 closing of the books method and suggestions under which a section 199 closing of the books election would be allowable, provided that the election does not create an unwarranted section 199 deduction nor does it impose an undue burden on either taxpayers or the government.

July 9, 2007 81 2007–28 I.R.B.

elements of compensation as provided for in §1.263A–1(e)(2)(i)(B) and (3)(ii)(D). Compensation for services is not limited to W-2 wages and includes compensation paid to independent contractors. In the case of a taxpayer that uses the income forecast method of section 167(g) and capitalizes participations and residuals into the adjusted basis of the qualified film, the taxpayer must use the same estimate of participations and residuals in determining compensation for services. In the case of a taxpayer that excludes participations and residuals from the adjusted basis of the qualified film under section 167(g)(7)(D)(i), the taxpayer must use the amount expected to be paid as participations and residuals based on the total forecasted income used in determining income forecast depreciation in determining compensation for services.

(5) Determination of 50 percent . The not-less-than-50-percent-of-the-totalcompensation requirement under paragraph (k)(1) of this section is calculated using a fraction. The numerator of the fraction is the compensation for services performed in the United States and the denominator is the total compensation for services regardless of where the production activities are performed. A taxpayer may use any reasonable method that is satisfactory to the Secretary based on all of the facts and circumstances, including all historic information available, to determine the compensation for services performed in the United States and the total compensation for services regardless of where the production activities are performed. Among the factors to be considered in determining whether a taxpayer’s method of allocating compensation is reasonable is whether the taxpayer uses that method consistently from one taxable year to another.

(6) Produced by the taxpayer . A qualified film will be treated as produced by the taxpayer for purposes of section 199(c)(4)(A)(i)(II) if the production activity performed by the taxpayer is substantial in nature within the meaning of paragraph (g)(2) of this section. The special rules of paragraph (g)(4) of this section regarding a contract with an unrelated person and aggregation apply in determining whether the taxpayer’s production activity is substantial in nature. Paragraphs (g)(2) and (4) of this section are applied by substi

torium of the Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC. Because of access restrictions, visitors will not be admitted beyond the Internal Revenue Building lobby more than 30 minutes before the hearing starts. Due to building security procedures, visitors must enter at the Constitution Avenue entrance. In addition, all visitors must present photo identification to enter the building. For information about having your name placed on the building access list to attend the hearing, see the “FOR FURTHER INFORMATION CONTACT” section of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who wish to present oral comments at the hearing must submit electronic or written comments by September 5, 2007, and submit an outline of the topics to be discussed and the time to be devoted to each topic (signed original and eight (8) copies) by September 11, 2007. A period of 10 minutes will be allotted to each person for making comments. An agenda showing the scheduling of the speakers will be prepared after the deadline for receiving outlines has passed. Copies of the agenda will be available free of charge at the hearing.

Drafting Information

The principal authors of these regulations are Lauren Ross Taylor and David M. McDonnell, Office of the Associate Chief Counsel (Passthroughs and Special Industries), IRS. However, other personnel from the IRS and Treasury Department participated in their development.

- - - -

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be 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 1.199–3 also issued under 26 U.S.C. 199(d). - * *

Section 1.199–7 also issued under 26 U.S.C. 199(d). - * *

Section 1.199–8 also issued under 26 U.S.C. 199(d). - * *

Par. 2. Section 1.199–3 is amended by:

Revising paragraphs (k)(1), (k)(4), and (k)(5).
Redesignating paragraph (k)(6) as (k)(9).
Redesignating paragraph (k)(7) as (k)(10).
Adding new paragraphs (k)(6), (k)(7), and (k)(8).
Revising Example 6 of newly designated paragraph (k)(10).

The revisions and additions read as follows:

§1.199–3 Domestic production gross receipts .

- - - (k) - * (1) In general . The term qualified film means any motion picture film or video tape under section 168(f)(3), or live or delayed television programming (film), if not less than 50 percent of the total compensation relating to the production of such film is compensation for services performed in the United States by actors, production personnel, directors, and producers. For purposes of this paragraph (k), the term actors includes players, newscasters, or any other persons who are compensated for their performance or appearance in a film. For purposes of this paragraph (k), the term production personnel includes writers, choreographers and composers who are compensated for providing services during the production of a film, as well as casting agents, camera operators, set designers, lighting technicians, make-up artists, and other persons who are compensated for providing services that are directly related to the production of the film. Except as provided in paragraph (k)(2) of this section, the definition of a qualified film does not include tangible personal property embodying the qualified film, such as DVDs or videocassettes.
- - - (4) Compensation for services . For purposes of this paragraph (k), the term compensation for services means all payments for services performed by actors, production personnel, directors, and producers relating to the production of the film, including participations and residuals. Payments for services include all

2007–28 I.R.B. 82 July 9, 2007

tuting the term qualified film for QPP and disregarding the requirement that the production activity must be within the United States. The production activity of the taxpayer must consist of more than the minor or immaterial combination or assembly of two or more components of a film. For purposes of paragraph (g)(2) of this section, the relative value added by affixing trademarks or trade names as defined in §1.197–2(b)(10)(i) will be treated as zero.

(7) Qualified film produced by the taxpayer — safe harbor . A film will be treated as a qualified film under paragraph (k)(1) of this section and produced by the taxpayer under paragraph (k)(6) of this section (qualified film produced by the taxpayer) if the taxpayer meets the requirements of paragraphs (k)(7)(i) and (ii) of this section. A taxpayer that chooses to use this safe harbor must apply all the provisions of this paragraph (k)(7).

(i) Safe harbor . A film will be treated as a qualified film produced by the taxpayer if not less than 50 percent of the total compensation for services paid by the taxpayer is compensation for services performed in the United States and the taxpayer satisfies the safe harbor in paragraph (g)(3) of this section. The special rules of paragraph (g)(4) of this section regarding a contract with an unrelated person and aggregation apply in determining whether the taxpayer satisfies paragraph (g)(3) of this section. Paragraphs (g)(3) and (4) of this section are applied by substituting the term qual- ified film for QPP but not disregarding the requirement that the direct labor and overhead of the taxpayer to produce the qualified film must be within the United States. Paragraph (g)(4)(ii)(A) of this section includes any election under section 181.

(ii) Determination of 50 percent . The not-less-than-50-percent-of-the-totalcompensation requirement under paragraph (k)(7)(i) of this section is calculated using a fraction. The numerator of the fraction is the compensation for services paid by the taxpayer for services performed in the United States and the denominator is the total compensation for services paid by the taxpayer regardless of where the production activities are performed. For purposes of this paragraph (k)(7)(ii), the term paid by the taxpayer includes amounts that are treated as paid by the taxpayer under paragraph (g)(4) of this section. A taxpayer may use any

reasonable method that is satisfactory to the Secretary based on all of the facts and circumstances, including all historic information available, to determine the compensation for services paid by the taxpayer for services performed in the United States and the total compensation for services paid by the taxpayer regardless of where the production activities are performed. Among the factors to be considered in determining whether a taxpayer’s method of allocating compensation is reasonable is whether the taxpayer uses that method consistently from one taxable year to another.

(8) Production pursuant to a contract . With the exception of the rules applicable to an expanded affiliated group (EAG) under §1.199–7 and EAG partnerships under §1.199–3T(i)(8), only one taxpayer may claim the deduction under §1.199–1(a) with respect to any activity related to the production of a qualified film performed in connection with the same qualified film. If one taxpayer performs a production activity pursuant to a contract with another party, then only the taxpayer that has the benefits and burdens of ownership of the qualified film under Federal income tax principles during the period in which the production activity occurs is treated as engaging in the production activity.

- - - (10) - * * Example 6 . X creates a television program in the United States that includes scenes from films licensed by X from unrelated persons Y and Z. Assume that Y and Z produced the films licensed by X. The not-less-than-50-percent-of-the-total-compensation requirement under paragraph (k)(1) of this section is determined by reference to all compensation for services paid in the production of the television program, including the films licensed by X from Y and Z, and is calculated using a fraction as described in paragraph (k)(5) of this section. The numerator of the fraction is the compensation for services performed in the United States and the denominator is the total compensation for services regardless of where the production activities are performed. However, for purposes of calculating the denominator, in determining the total compensation paid by Y and Z, X need only include the total compensation paid by Y and Z to actors, production personnel, directors, and producers for the production of the scenes used by X in creating its television program.

Par. 3. Section 1.199–7 is amended by:

Revising Example 10 of paragraph (e).
Revising paragraphs (f)(1) and (g)(3).

The revisions read as follows:

§1.199–7 Expanded affiliated groups .

- - - (e) * - * Example 10 . (i) Facts . Corporation P owns all of the stock of Corporations S and B. P, S, and B file a consolidated Federal income tax return on a calendar year basis. P, S, and B each use the section 861 method for allocating and apportioning their deductions. In 2010, S MPGE QPP in the United States at a cost of $1,000. On November 30, 2010, S sells the QPP to B for $2,500. On February 28, 2011, P sells 60% of the stock of B to X, an unrelated person. On June 30, 2011, B sells the QPP to U, another unrelated person, for $3,000.

(ii) Consolidated group’s 2010 QPAI . Because S and B are members of a consolidated group in 2010, pursuant to §1.199–7(d)(1) and §1.1502–13, neither S’s $1,500 of gain on the sale of QPP to B nor S’s $2,500 gross receipts from the sale are taken into account in 2010. Accordingly, neither S nor B has QPAI in 2010.

(iii) Consolidated group’s 2011 QPAI . B becomes a nonmember of the consolidated group at the end of the day on February 28, 2011, the date on which P sells 60% of the B stock to X. Under §1.199–7(d)(1) and §1.1502–13(d), S takes the intercompany transaction into account immediately before B becomes a non-member of the consolidated group. Pursuant to §1.1502–13(d)(1)(ii)(A)( 1 ), because the QPP is owned by B, a nonmember of the consolidated group immediately after S’s gain is taken into account, B is treated as selling the QPP to a nonmember for $2,500, B’s adjusted basis in the property, immediately before B becomes a nonmember of the consolidated group. Accordingly, immediately before B becomes a nonmember of the consolidated group, S takes into account $1,500 of QPAI (S’s $2,500 DPGR received from B - S’s $1,000 cost of MPGE the QPP).

(iv) B’s 2011 QPAI . Pursuant to §1.1502– 13(d)(2)(i)(B), the attributes of B’s corresponding item, that is, its sale of the QPP to U, are determined as if the S division (but not the B division) were transferred by the P, S, and B consolidated group (treated as a single corporation) to an unrelated person. Thus, S’s activities in MPGE the QPP before the intercompany sale of the QPP to B continue to affect the attributes of B’s sale of the QPP. As such, B is treated as having MPGE the QPP. Accordingly, upon its sale of the QPP, B has $500 of QPAI (B’s $3,000 DPGR received from U - B’s $2,500 cost of MPGE the QPP).

- - - (f) Allocation of income and loss by a corporation that is a member of the ex- panded affiliated group for only a portion of the year —(1) In general . A corporation that becomes or ceases to be a member of an EAG during its taxable year must allocate its taxable income or loss, QPAI, and W-2 wages between the portion of the taxable year that it is a member of the EAG and the portion of the taxable year that it is not a member of the EAG. This allocation of items is made by using the pro rata allocation method described in this para

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graph (f)(1). Under the pro rata allocation method, an equal portion of a corporation’s taxable income or loss, QPAI, and W-2 wages for the taxable year is assigned to each day of the corporation’s taxable year. Those items assigned to those days that the corporation was a member of the EAG are then aggregated.

- - - (g) - * (3) Example . The following example illustrates the application of paragraphs (f) and (g) of this section:

Example . (i) Facts . Corporations X and Y, calendar year corporations, are members of the same EAG for the entire 2010 taxable year. Corporation Z, also a calendar year corporation, is a member of the EAG of which X and Y are members for the first half of 2010 and not a member of any EAG for the second half of 2010. During the 2010 taxable year, neither X, Y, nor Z join in the filing of a consolidated Federal income tax return. Assume that X, Y, and Z each have W-2 wages in excess of the section 199(b) wage limitation for all relevant periods. In 2010, X has taxable income of $2,000 and QPAI of $600, Y has a taxable loss of $400 and QPAI of ($200), and Z has taxable income of $1,400 and QPAI of $2,400.

(ii) Analysis . Pursuant to the pro rata allocation method, $700 of Z’s 2010 taxable income and $1,200 of Z’s 2010 QPAI are allocated to the first half of the 2010 taxable year (the period in which Z is a member of the EAG) and $700 of Z’s 2010 taxable income and $1,200 of Z’s 2010 QPAI are allocated to the second half of the 2010 taxable year (the period in which Z is not a member of any EAG). Accordingly, in 2010, the EAG has taxable income of $2,300 (X’s $2,000 + Y’s ($400) + Z’s $700) and QPAI of $1,600 (X’s $600 + Y’s ($200) + Z’s $1,200). The EAG’s section 199 deduction for 2010 is therefore $144 (9% of the lesser of the EAG’s $2,300 of taxable income or $1,600 of QPAI). Pursuant to §1.199–7(c)(1), this $144 deduction is allocated to X, Y, and Z in proportion to their respective QPAI. Accordingly, X is allocated $48 of the EAG’s section 199 deduction, Y is allocated $0 of the EAG’s section 199 deduction, and Z is allocated $96 of the deduction. For the second half of 2010, Z has taxable income of $700 and QPAI of $1,200. Therefore, for the second half of 2010, Z has a section 199 deduction of $63 (9% of the lesser of its $700 taxable income or $1,200 QPAI for the second half of 2010). Accordingly, X’s 2010 section 199 deduction is $48, Y’s 2010 section 199 deduction is $0, and Z’s 2010 section 199 deduction is $159, the sum of the $96 section 199 deduction of the EAG allocated to Z for the first half of 2010 and Z’s $63 section 199 deduction for the second half of 2010.

Par. 4. Section 1.199–8 is amended by:

Adding two sentences at the end of paragraph (a).
Adding new paragraphs (i)(8) and (i)(9).

The revisions and additions read as follows:

§1.199–8 Other rules .

(a) - - - For purposes of §§1.199–1 through 1.199–9, use of terms such as pay- ment, paid, incurred, or paid or incurred is not intended to provide any specific rule based upon the use of one term versus another. In general, the use of the term pay- ment, paid, incurred, or paid or incurred is intended to convey the appropriate standard under the taxpayer’s method of accounting.

- - - (i) - - (8) Qualified film produced by the tax- payer . Section 1.199–3(k) is proposed to be applicable to taxable years beginning on or after the date the final regulations are published in the Federal Register . Until the date the final regulations are published in the Federal Register, taxpayers may rely on §1.199–3(k) of these proposed regulations for taxable years beginning after December 31, 2004. However, for taxable years beginning before June 1, 2006, a taxpayer may rely on §1.199–3(k) of the proposed regulations only if the taxpayer does not apply Notice 2005–14, 2005–1 C.B. 498 (see §601.601(d)(2)(ii)( b ) of this chapter), or REG–105847–05, 2005–2 C.B. 987 (see §601.601(d)(2)(ii)( b ) of this chapter), to the taxable year.

(9) Expanded affiliated groups . Section 1.199–7(e), Example 10, and §1.199–7(f)(1) are proposed to be applicable to taxable years beginning on or after the date the final regulations are published in the Federal Register . Until the date the final regulations are published in the Federal Register, taxpayers may rely on §1.199–7(e), Example 10, of these proposed regulations for taxable years beginning after December 31, 2004.

Kevin M. Brown, Deputy Commissioner for Services and Enforcement.

(Filed by the Office of the Federal Register on June 6, 2007, 8:45 a.m., and published in the issue of the Federal Register for June 7, 2007, 72 F.R. 31478)

Closing of the GUST Program for Pre-Approved Defined Benefit Plans

Announcement 2007–61

On September 7, 2007, the Service will discontinue accepting applications for opinion and advisory letters for pre-approved ( i.e., master and prototype (M&P) and volume submitter (VS)) defined benefit plans that have not been restated to comply with the Economic Growth and Tax Relief Reconciliation Act of 2001, Pub. L. 107–16, (“EGTRRA”) and other changes in plan qualification requirements listed in Notice 2007–3, 2007–2 I.R.B. 254 (“the 2006 Cumulative List”). The Service is taking this action because the timely submission period for the initial (EGTRRA) six-year amendment/approval cycle for pre-approved defined benefit plans described in Rev. Proc. 2007–44, page 54, this Bulletin, is now open.

Rev. Proc. 2007–44 and Rev. Proc. 2005–16, 2005–1 C.B. 674, describe a staggered remedial amendment system for plans that are qualified under § 401(a) of the Internal Revenue Code, with five-year amendment/approval cycles for individually designed plans and six-year cycles for pre-approved plans. The submission period for the initial cycle for pre-approved defined benefit plans started on February 1, 2007 and runs through January 31, 2008. Sponsors and practitioners are required to restate their pre-approved defined benefit plans for EGTRRA and the 2006 Cumulative List and apply for new opinion or advisory letters during this submission period.

Applications for opinion/advisory letters for pre-approved defined benefit plans that were filed before February 1, 2007 will be reviewed by the Service for compliance with GUST ¹ and letters for these plans will not consider EGTRRA or subsequent changes in the plan qualification re

1 The term “GUST” refers to the following:

the Uruguay Round Agreements Act, Pub. L. 103–465;
the Uniformed Services Employment and Reemployment Rights Act of 1994, Pub. L. 103–353;
the Small Business Job Protection Act of 1996, Pub. L. 104–188;
the Taxpayer Relief Act of 1997, Pub. L. 105–34;
the Internal Revenue Service Restructuring and Reform Act of 1998, Pub. L. 105–206; and
the Community Renewal Tax Relief Act of 2000, Pub. L. 106–554.

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stated for EGTRRA and the 2006 Cumulative List.

This announcement does not affect the ability of employers to apply for individual determination letters. Thus, the Service will continue to accept applications for determination letters on Form 5307, Appli- cation for Determination for Adopters of Master or Prototype or Volume Submitter Plans, which are filed by adopters of both defined contribution and defined benefit pre-approved plans.

quirements. Applications filed on or after February 1, 2007 and before September 7, 2007, will also be reviewed only for GUST unless the plan submitted with the application was restated to comply with EGTRRA and the 2006 Cumulative List.

Because the plans described in the preceding paragraph must be restated for EGTRRA and resubmitted to the Service during the current submission period, sponsors and practitioners may wish to withdraw applications for such plans that are currently pending with the Service. In

this case, the user fee paid with the application will not be refunded, but the user fee requirement will be waived for a new application for the same plan that is filed within the submission period. The sponsor or practitioner should indicate on the face of the application form that the user fee is being waived pursuant to Announcement 2007–61. Applications for opinion/advisory letters for pre-approved defined benefit plans that are filed on or after September 7, 2007, will be returned if the plan has not been re

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