Part I. Rulings — Internal Revenue Bulletin 2008-16

Section 165.—Losses

26 CFR 1.165–5: Worthless securities.

T.D. 9386

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

Abandonment of Stock or Other Securities

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations concerning the availability and character of a loss deduction under section 165 of the Internal Revenue Code (Code) for losses sustained from abandoned stock or other securities. The final regulations clarify the tax treatment of losses from abandoned securities, and affect any taxpayer claiming a deduction for a loss from abandoned securities after the date these regulations are published in the Federal Register .

DATES: Effective Date: These final regulations are effective on March 12, 2008.

Applicability Date: For dates of applicability, see §1.165–5(i)(2).

FOR FURTHER INFORMATION CONTACT: Sean M. Dwyer at (202) 622–5020 or Peter C. Meisel at (202) 622–7750 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

This document contains amendments to 26 CFR part 1. On July 30, 2007, the IRS published a notice of proposed rulemaking (REG–101001–05, 2007–36 I.R.B. 548) in the Federal Register (72 FR 41468). The notice of proposed rulemaking clarified the treatment of abandoned stock or other securities under section 165 of the Code, specifically providing that a loss

from an abandoned security is governed by section 165(g), and that the loss is only allowed if all rights in the security are permanently surrendered and relinquished for no consideration. The IRS received no comments in response to the notice of proposed rulemaking. No public hearing was requested or held.

The proposed regulations are adopted as final regulations by this Treasury decision.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. 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, the notice of proposed rulemaking that preceded this final 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 authors of these final regulations are Sean M. Dwyer, Office of the Associate Chief Counsel (Income Tax & Accounting), and Peter C. Meisel, Office of the Associate Chief Counsel (Corporate). However, other personnel from the IRS and Treasury Department participated in their development.

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Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1—INCOME TAXES

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

Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.165–5 is amended by:

Redesignating paragraph (i) as paragraph (j).
Adding a new paragraph (i). The addition reads as follows:

§1.165–5 Worthless securities.

- - - (i) Abandonment of securities —(1) In general. For purposes of section 165 and this section, a security that becomes wholly worthless includes a security described in paragraph (a) of this section that is abandoned and otherwise satisfies the requirements for a deductible loss under section 165. If the abandoned security is a capital asset and is not described in section 165(g)(3) and paragraph (d) of this section (concerning worthless securities of certain affiliated corporations), the resulting loss is treated as a loss from the sale or exchange, on the last day of the taxable year, of a capital asset. See section 165(g)(1) and paragraph (c) of this section. To abandon a security, a taxpayer must permanently surrender and relinquish all rights in the security and receive no consideration in exchange for the security. For purposes of this section, all the facts and circumstances determine whether the transaction is properly characterized as an abandonment or other type of transaction, such as an actual sale or exchange, contribution to capital, dividend, or gift.

(2) Effective/applicability date . This paragraph (i) applies to any abandonment of stock or other securities after March 12, 2008.

Linda E. Stiff, Deputy Commissioner for Services and Enforcement.

Approved March 3, 2008.

Eric Solomon, Assistant Secretary of the Treasury (Tax Policy).

(Filed by the Office of the Federal Register on March 11, 2008, 8:45 a.m., and published in the issue of the Federal Register for March 12, 2008, 73 F.R. 13124)

2008–16 I.R.B. 788 April 21, 2008

Section 168.—Accelerated Cost Recovery System

26 CFR 1.168(i)–3: Treatment of excess deferred income tax reserve upon disposition of deregulated public utility property.

T.D. 9387

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

Application of Normalization Accounting Rules to Balances of Excess Deferred Income Taxes and Accumulated Deferred Investment Tax Credits of Public Utilities Whose Assets Cease to be Public Utility Property

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final Regulations.

SUMMARY: This document contains final regulations that provide guidance on the normalization requirements applicable to public utilities that benefit (or have benefited) from accelerated depreciation methods or from the investment tax credit permitted under pre–1991 law. These regulations permit a utility whose assets cease, whether by disposition, deregulation, or otherwise, to be public utility property with respect to the utility (deregulated public utility property) to return to its ratepayers the normalization reserve for excess deferred income taxes (EDFIT) with respect to those assets and, in certain circumstances, also permit the return of part or all of the reserve for accumulated deferred investment tax credits (ADITC) with respect to those assets.

DATES: Effective Date: These regulations are effective March 20, 2008.

Applicability Date: For dates of applicability, see §1.46–6(k)(4) and §1.168(i)–3(d) of these regulations.

FOR FURTHER INFORMATION CONTACT: Patrick Kirwan, at (202) 622–3040 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background and Explanation of Provisions

This document amends the Income Tax Regulations (26 CFR Part 1) relating to the normalization requirements of sections 168(f)(2) and 168(i)(9) of the Internal Revenue Code (Code), section 203(e) of the Tax Reform Act of 1986, Public Law 99–514 (100 Stat. 2146), and former section 46(f) of the Code. Proposed regulations relating to the normalization requirements applicable to electric utilities that benefit (or have benefited) from accelerated depreciation methods or from the investment tax credit permitted under pre–1991 law (REG–104385–01, 2003–1 C.B. 634) were published in the Federal Register on March 4, 2003 (the 2003 proposed regulations) and again on December 21, 2005 (2006–1 C.B. 389, the 2005 proposed regulations). The preambles of both the 2003 proposed regulations and the 2005 proposed regulations describe the normalization method of accounting and the reserves under the normalization method for excess deferred federal income tax (EDFIT) and accumulated deferred investment tax credits (ADITC).

The 2003 proposed regulations provided that electric utilities whose generation assets become deregulated public utility property could continue to flow through EDFIT reserves associated with those assets without violating the normalization requirements. The rate of flowthrough was limited to the rate that would have been permitted under a normalization method of accounting if the assets had remained public utility property.

The 2003 proposed regulations provided similar rules under which electric utilities could continue to flow through ADITC reserves associated with generation assets that become deregulated public utility property without violating the normalization requirements. The 2003 proposed regulations addressed the treatment of these assets under former section 46(f)(2) (relating to the use of the investment credit to reduce the taxpayer’s cost of service) but did not address their treatment under former section 46(f)(1) (relating to the use of the investment credit to reduce the taxpayer’s rate base). The 2003 pro

posed regulations would have applied to public utility generation property deregulated after March 4, 2003. Utilities would have been permitted an election to apply the proposed rules to generation property that was deregulated on or before that date.

In response to the public comments and after further analysis, the 2003 proposed regulations were withdrawn and were replaced by the 2005 proposed regulations. The 2005 proposed regulations generally retain the rule of the 2003 proposed regulations regarding the return of EDFIT reserves and extend the application of the rule to all public utility property.

The 2005 proposed regulations permit flowthrough of the ADITC reserve with respect to deregulated public utility property to continue after its deregulation only to the extent the reduction in cost of service does not exceed, as a percentage of the ADITC with respect to the property at the time of deregulation, the percentage of the total stranded cost that the taxpayer is permitted to recover with respect to the property. In addition, the 2005 proposed regulations provide that the credit may not be flowed through more rapidly than the rate at which the taxpayer is permitted to recover the stranded cost with respect to the property. The 2005 proposed regulations provide similar rules for property to which former section 46(f)(1) (relating to rate base restoration) applies and extend the application of the ADITC flowthrough rules to all public utility property.

The 2005 proposed regulations generally apply to any public utility property that becomes deregulated public utility property after December 21, 2005. They do not include an election to apply the regulations retroactively. For public utility property that became deregulated public utility property on or before December 21, 2005, the preamble of the 2005 proposed regulations states that the IRS will follow the holdings set forth in the private letter rulings prohibiting flowthrough of the EDFIT and ADITC reserves associated with an asset after the asset’s disposition. The 2005 proposed regulations provide, however, that flowthrough will be permitted if it is consistent with the 2003 proposed regulations and occurs during the period beginning on March 5, 2003, and ending on the earlier of (1) the last date on which the utility’s rates are determined under the

April 21, 2008 789 2008–16 I.R.B.

the case, the term deregulated public utility property is the sole term used in the final regulations to describe property that ceases to be public utility property.

One commentator questioned whether the term deregulated public utility property includes normal retirements. The final regulations clarify that they do not apply to ordinary retirements within the meaning of section 1.167(a)–11(d)(3)(ii).

One commentator suggested that deregulated public utility property should include property that is public utility property in the hands of a transferee. The commentator further suggested that if the transferee of public utility property will continue the flowthrough of the transferor’s EDFIT and ADITC reserves, further flowthrough by the transferor should not be required. The IRS and Treasury Department agree with these suggestions. Accordingly, the final regulations provide, on a prospective basis, that they apply to a taxpayer with respect to public utility property that ceases to be public utility property with respect to the taxpayer. Thus, the regulations will apply even if the property remains regulated public utility property in the hands of a transferee. The regulations further provide an exception from the generally applicable rule permitting transferor flowthrough when the transferee will continue flowthrough of the EDFIT reserves. A similar exception was not provided for the ADITC reserve because transferor flowthrough of that reserve does not occur if the transferee, rather than the transferor, is recovering the cost of the property through ratemaking depreciation.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations and, because 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. Therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Code, the notice of proposed rulemaking preced

rate order in effect on December 21, 2005, or (2) December 21, 2007.

Written comments were received in response to the 2005 proposed regulations, and a public hearing was held on April 5, 2006. Three commentators spoke at the public hearing. After consideration of all the comments, the 2005 proposed regulations are adopted as amended by this Treasury decision. In general, the final regulations follow the approach of the 2005 proposed regulations.

A number of commentators suggested that the proposed rules should apply on an elective basis to public utility property that was deregulated prior to March 5, 2003, if regulatory proceedings for the deregulated public utility property are pending. The preamble to the 2005 proposed regulations explains that the Secretary’s authority under section 7805(b)(7) to provide for retroactive elections should not be exercised in a manner that impairs existing agreements between utilities and their regulators. Many commentators agreed with the objective of not disturbing previously settled and finalized agreements and believed that a retroactive election would likely result in taxpayers being compelled to reopen such agreements. The commentators suggested, however, that applying the regulations to regulatory proceedings that have yet to be finally decided would not impair any existing agreement, and that the final regulations should permit continued flowthrough of the EDFIT and ADITC reserves if no final order or settlement agreement prescribing the treatment of those reserves after deregulation was in effect on December 21, 2005. Other commentators suggested that the section 7805 limitations on retroactivity do not apply to these regulations because the normalization provisions were enacted before the effective date of those limitations. The IRS and Treasury Department agree that there is no statutory impediment that would prohibit the application of the regulations to previously deregulated property. Nevertheless, the IRS and Treasury Department have concluded that there is no compelling argument in this instance for frustrating the expectations of taxpayers who embarked upon deregulation of their public utility property before the publication of the new rules. Accordingly, the final regulations do not depart from the general practice of applying amendments

to the regulations without retroactive effect and retain the prospective effective date of the 2005 proposed regulations without a retroactive election. The final regulations retain the proposed transition rule under which flowthrough is permitted if it is consistent with the 2003 proposed regulations and occurs during the period beginning on March 5, 2003, and ending on the earlier of (1) the last date on which the utility’s rates are determined under the rate order in effect on December 21, 2005, or (2) December 21, 2007.

One commetator suggested that the regulations should provide guidance concerning when deregulation occurs. Under the regulations, property becomes deregulated public utility property when it ceases to be public utility property with respect to the taxpayer. This depends on the particular facts and circumstances and is more appropriately addressed on a case-by-case basis.

Some commentators suggested that the final regulations should permit flowthrough of ADITC reserves even in cases in which ratepayers do not bear the cost of the asset giving rise to the credit. The comments generally argued that this would be consistent with Congressional intent to share the benefit of the credit between ratepayers and shareholders. The IRS and Treasury Department agree that the Code provides for such sharing in the typical situation in which ratepayers ultimately bear the full cost of an asset through ratemaking depreciation. On the other hand, neither the statutory provision nor the legislative history provides any indication that Congress intended for ratepayers to share in benefits attributable to costs that they do not bear. Accordingly, for the reasons set forth in the preamble of the 2005 proposed regulations, the final regulations retain the proposed rules relating to flowthrough of the ADITC reserve and rate base restoration, including the rule allowing flowthrough consistent with the 2003 proposed regulations during the transition period.

Commentators suggested that the use of terms other than deregulated public utility property in the preamble of the 2005 proposed regulations implies that a distinction exists between property that ceases to be public utility property because of deregulation and property that ceases to be public utility property because of a disposition or other event. To clarify that this is not

2008–16 I.R.B. 790 April 21, 2008

becomes deregulated public utility property by the stranded cost of the property.

(3) Cross reference . See §1.168(i)–(3) for rules relating to the treatment of balances of excess deferred income taxes when public utility property becomes deregulated public utility property.

(4) Effective/applicability dates —(i) In general . Except as provided in paragraph (k)(4)(ii) of this section, this paragraph (k) applies to public utility property that becomes deregulated public utility property with respect to a taxpayer after December 21, 2005. (ii) Property that becomes public utility property of the transferee . This paragraph (k) does not apply to property that becomes deregulated public utility property with respect to a taxpayer on account of a transfer on or before March 20, 2008, if after the transfer the property is public utility property of the transferee.

(iii) Application of regulation project (REG–104385–01) . A reduction in the taxpayer’s cost of service will be treated as ratable if it is consistent with the proposed rules in regulation project (REG–104385–01) (68 FR 10190) March 4, 2003, and occurs during the period beginning on March 5, 2003, and ending on the earlier of—

(A) The last date on which the utility’s rates are determined under the rate order in effect on December 21, 2005; or

(B) December 21, 2007. Par. 3. Section 1.168(i)–3 is added to read as follows:

§1.168(i)–3 Treatment of excess deferred income tax reserve upon disposition of deregulated public utility property .

(a) Scope —(1) In general . This section provides rules for the application of section 203(e) of the Tax Reform Act of 1986, Public Law 99–514 (100 Stat. 2146) to a taxpayer with respect to public utility property (within the meaning of section 168(i)(10)) that ceases, whether by disposition, deregulation, or otherwise, to be public utility property with respect to the taxpayer and that is not described in paragraph (a)(2) of this section (deregulated public utility property).

(2) Exceptions . This section does not apply to the following property:

(i) Property that ceases to be public utility property with respect to the taxpayer on

ing these regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small businesses.

Drafting Information

The principal author of the regulations is Patrick S. Kirwan, Office of Associate Chief Counsel (Passthroughs & Special Industries). However, other personnel from the IRS and the Treasury Department participated in the development of the regulations.

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Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1—INCOME TAXES

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

Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.46–6 is amended by adding paragraph (k) to read as follows:

§1.46–6 Limitation in case of certain regulated companies .

- - - (k) Treatment of accumulated deferred investment tax credits upon the dereg- ulation of public utility property —(1) Scope —(i) In general . This paragraph (k) provides rules for the application of former sections 46(f)(1) and 46(f)(2) of the Internal Revenue Code to a taxpayer with respect to public utility property that ceases, whether by disposition, deregulation, or otherwise, to be public utility property with respect to the taxpayer and that is not described in paragraph (k)(1)(ii) of this section (deregulated public utility property).

(ii) Exception . This paragraph (k) does not apply to property that ceases to be public utility property with respect to the taxpayer on account of an ordinary retirement within the meaning of §1.167(a)–11(d)(3)(ii).

(2) Ratable amount —(i) Restoration of rate base reduction . A reduction in the taxpayer’s rate base on account of the credit with respect to public utility property that becomes deregulated public

utility property is restored ratably during the period after the property becomes deregulated public utility property if the amount of the reduction remaining to be restored does not, at any time during the period, exceed the restoration percentage of the recoverable stranded cost of the property at such time.

For this purpose— (A) The stranded cost of the property is the cost of the property reduced by the amount of such cost that the taxpayer has recovered through regulated depreciation expense during the period before the property becomes deregulated public utility property;

(B) The recoverable stranded cost of the property at any time is the stranded cost of the property that the taxpayer will be permitted to recover through rates after such time; and

(C) The restoration percentage for the property is determined by dividing the reduction in rate base remaining to be restored with respect to the property immediately before the property becomes deregulated public utility property by the stranded cost of the property.

(ii) Cost of service reduction . Reductions in the taxpayer’s cost of service on account of the credit with respect to public utility property that becomes deregulated public utility property are ratable during the period after the property becomes deregulated public utility property if the cumulative amount of the reduction during such period does not, at any time during the period, exceed the flowthrough percentage of the cumulative stranded cost recovery for the property at such time.

(B) The cumulative stranded cost recovery for the property at any time is the stranded cost of the property that the taxpayer has been permitted to recover through rates on or before such time; and

(C) The flowthrough percentage for the property is determined by dividing the amount of credit with respect to the property remaining to be used to reduce cost of service immediately before the property

April 21, 2008 791 2008–16 I.R.B.

account of an ordinary retirement within the meaning of §1.167(a)–11(d)(3)(ii).

(ii) Property transferred by the taxpayer if after the transfer the property is public utility property of the transferee and the taxpayer’s excess tax reserve with respect to the property (within the meaning of section 203(e) of the Tax Reform Act of 1986) is treated as an excess tax reserve of the transferee with respect to the property.

(b) Amount of reduction . If public utility property of a taxpayer becomes deregulated public utility property to which this section applies, the reduction in the taxpayer’s excess tax reserve permitted under section 203(e) of the Tax Reform Act of 1986 is equal to the amount by which the reserve could be reduced under that provision if all such property had remained public utility property of the taxpayer and the taxpayer had continued use of its normalization method of accounting with respect to such property.

(c) Cross reference . See §1.46–6(k) for rules relating to the treatment of accumulated deferred investment tax credits when utilities dispose of regulated public utility property.

(d) Effective/applicability dates —(1) In general . Except as provided in paragraph (d)(2) of this section, this section applies to public utility property that becomes deregulated public utility property after December 21, 2005.

(2) Property that becomes public util- ity property of the transferee . This section does not apply to property that becomes deregulated public utility property with respect to a taxpayer on account of a transfer on or before March 20, 2008, if after the transfer the property is public utility property of the transferee.

(3) Application of regulation project (REG–104385–01) . A reduction in the taxpayer’s excess deferred income tax reserve will be treated as ratable if it is consistent with the proposed rules in regulation project (REG–104385–01) (68 FR 10190) March 4, 2003, and occurs during the period beginning on March 5, 2003, and ending on the earlier of—

(i) The last date on which the utility’s rates are determined under the rate order in effect on December 21, 2005; or

(ii) December 21, 2007.

Linda E. Stiff, Acting Deputy Commissioner for

Services and Enforcement.

Approved March 6, 2008.

Eric Solomon, Assistant Secretary of the Treasury (Tax Policy).

(Filed by the Office of the Federal Register on March 19, 2008, 8:45 a.m., and published in the issue of the Federal Register for March 20, 2008, 73 F.R. 14934)

Section 199.—Income Attributable to Domestic Production Activities

26 CFR 1.199–3: Domestic production gross re- ceipts.

T.D. 9384

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

Qualified Films Under Section 199

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations involving the deduction for income attributable to domestic production activities under section 199. The final regulations revise certain rules and examples relating to the definitions of a qualified film produced by the taxpayer under section 199(c)(4)(A)(i)(II) and (c)(6) and an expanded affiliated group under section 199(d)(4). The final regulations affect taxpayers who produce qualified films and taxpayers who are members of expanded affiliated groups.

DATES: Effective Date: These regulations are effective March 7, 2008.

Applicability Date: For dates of applicability, see §1.199–8(i)(8) and (9).

FOR FURTHER INFORMATION CONTACT: Concerning §1.199–3(k), David McDonnell, at (202) 622–3040;

concerning §1.199–7, Ken Cohen (202) 622–7790 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

This document amends §§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). On June 7, 2007, the IRS and Treasury Department published proposed regulations under section 199 (REG–103842–07, 2007–28 I.R.B. 79 [72 FR 31478]). The proposed regulations revise certain rules and examples in T.D. 9263, 2006–25 I.R.B. 1063 [71 FR 31268] relating to qualified films produced by the taxpayer under section 199(c)(4)(A)(i)(II) and (c)(6) and expanded affiliated groups under section 199(d)(4). No comments were received responding to the notice of proposed rulemaking and no public hearing was requested or held. Therefore, the proposed regulations are adopted without change by this Treasury decision.

Explanation of Provisions

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).

2008–16 I.R.B. 792 April 21, 2008

The revised fraction in §1.199–3(k)(5) follows the statutory language in section 199(c)(6) by referencing all compensation for services related to the production as opposed to the more limited “by the taxpayer” compensation fraction in T.D. 9263 (71 FR 31268). Because taxpayers may have difficulty obtaining information related to the compensation paid by others, this Treasury decision provides a safe harbor in §1.199–3(k)(7) that treats a film as a qualified 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. 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

As discussed in the preamble to the proposed regulations published on June 7, 2007 (72 FR 31478), §1.199–7(e), Ex- ample 10, in T.D. 9263 (71 FR 31268) misapplies §1.1502–13 of the consolidated return regulations. Accordingly, §1.199–7(e), Example 10, has been revised to correctly apply the consolidated return regulations. In addition, as also discussed in the preamble to the proposed regulations published on June 7, 2007 (72 FR 31478), the section 199 closing of the books method under §1.199–7(f)(1)(ii) in T.D. 9263 (71 FR 31268) could have created a larger section 199 deduction than is warranted. Accordingly, this Treasury decision removes the section 199 closing of the books method and revises the Ex-

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).

Qualified Film Produced by the Taxpayer

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 de

fined 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. However, as discussed in the preamble to the proposed regulations published on June 7, 2007 (72 FR 31478), the “by the taxpayer” compensation fraction in §1.199–3(k)(5) in T.D. 9263 (71 FR 31268) may have resulted in a film that was produced entirely within the United States as not qualifying under section 199(c)(6) if less than 50 percent of the total compensation relating to production was paid “by the taxpayer.”

This Treasury decision revises the “by the taxpayer” compensation fraction in §1.199–3(k)(5) in T.D. 9263 (71 FR 31268) for determining the not-less-than-50-percent-of-the-total-compensation requirement under §1.199–3(k)(1). Under the revised fraction in §1.199–3(k)(5), 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.

Under §1.199–3(k)(6), 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). 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.

April 21, 2008 793 2008–16 I.R.B.

§1.199–3 Domestic production gross receipts .

- - - (k) Definition of qualified film —(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 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

ample in §1.199–7(g)(3) to apply the pro rata allocation method.

Effective/Applicability Dates

Sections 1.199–3(k) and 1.199–7(e), Example 10, (f)(1), and (g)(3) are applicable to taxable years beginning on or after March 7, 2008. A taxpayer may apply §§1.199–3(k) and 1.199–7(e), Example 10, to taxable years beginning after December 31, 2004, and before March 7, 2008. However, for taxable years beginning before June 1, 2006, a taxpayer may rely on §1.199–3(k) 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)(ii)( b )), to the taxable year.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to this regulation, and because the regulation does 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, 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 David H. 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.

- - - -

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1—INCOME TAXES

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

Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.199–0 is amended by:

Revising the entries for §1.199–3(k)(6) and (7).
Adding new entries for §§1.199–3(k)(7)(i) and (ii); (8), (9), and (10); and 1.199–8(i)(8) and (9).
Removing the entries for §1.199–7(f)(1)(i), (ii), and (iii).

The additions and revisions read as follows:

§1.199–0 Table of contents .

§1.199–3 Domestic production gross receipts .

- - - (k) - * (6) Produced by the taxpayer. (7) Qualified film produced by the taxpayer — safe harbor.

(i) Safe harbor. (ii) Determination of 50 percent. (8) Production pursuant to a contract. (9) Exception. (10) Examples.

§1.199–8 Other rules .

- - - (i) - - (8) Qualified film produced by the taxpayer.

(9) Expanded affiliated groups.

- - - Par. 3. 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 paragaphs (k)(6), (k)(7), and (k)(8).
Revising Example 6 of newly redesignated paragraph (k)(10).

The revisions and additions read as follows:

2008–16 I.R.B. 794 April 21, 2008

(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 §1.199–3(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. 4. 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 uses 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.

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-total-compensation 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 substituting 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)(3)(ii)(A) of this section includes any election under section 181.

(ii) Determination of 50 percent . The not-less-than-50-percent-of-the-total-compensation 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.

April 21, 2008 795 2008–16 I.R.B.

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 applicable to taxable years beginning on or after March 7, 2008. A taxpayer may apply §1.199–3(k) to taxable years beginning after December 31, 2004, and before March 7, 2008. However, for taxable years beginning before June 1, 2006, a taxpayer may rely on §1.199–3(k) 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, (f)(1), and (g)(3) are applicable to taxable years beginning on or after March 7, 2008. A taxpayer may apply §1.199–7(e), Example 10, to taxable years beginning after December 31, 2004, and before March 7, 2008.

Linda E. Stiff, Deputy Commissioner for Services and Enforcement.

Approved March 3, 2008.

Eric Solomon, Assistant Secretary of the Treasury (Tax Policy).

(Filed by the Office of the Federal Register on March 6, 2008, 8:45 a.m., and published in the issue of the Federal Register for March 7, 2008, 73 F.R. 12268)

Section 2036.—Transfers With Retained Life Estate

26 CFR 20.2036–1: Transfers with retained life es- tate. (Also § 2038; 20.2038–1.)

Substitution power. This ruling provides guidance regarding whether the corpus of an inter vivos trust is includible in the grantor’s gross estate under section 2036 or 2038 of the Code if the grantor retained the power, exercisable in a nonfiduciary capacity, to acquire property held in the trust by substituting other property of equivalent value. The ruling provides that, for estate tax purposes, the substitution power will not, by itself, cause the value of the trust corpus to be includible

(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 nonmember 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 minus 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 paragraph (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 joins in the filing of a consolidated Federal income tax return. Assume that X, Y, and Z each has 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 EAG’s section 199 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

- - - Par. 5. 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) In general . - - - 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

2008–16 I.R.B. 796 April 21, 2008

could not exercise the power to deplete the trust or to shift trust benefits among the beneficiaries. Accordingly, the court held that the substitution power was not a power to alter, amend, or revoke the trust within the meaning of § 2038.

In general, a trustee has a fiduciary duty to the trust and its beneficiaries. As a result, the trustee is held to a high standard of conduct with respect to the administration of the trust. A trustee is under a duty to the beneficiaries of the trust to administer the trust solely in the interest of the beneficiaries. The trustee must act fairly, justly, honestly, in the utmost good faith, and with sound judgment and prudence. 90A C.J.S. Trusts § 323 (2007). The trustee is also subject to a duty of impartiality that requires the trustee to take into account the interests of all the beneficiaries for whom the trustee is acting. Restatement (Third) of Trusts §§ 183 and 232 (2007); 76 Am. Jur. 2d Trusts § 434 (2008). A trustee must administer the trust solely in the interests of the beneficiaries. Generally, a sale, encumbrance, or other transaction involving the investment or management of trust property entered into by the trustee for the trustee’s own personal account or which is otherwise affected by a conflict between the trustee’s fiduciary and personal interests may be voidable by a beneficiary affected by the transaction. Uniform Trust Code § 802 (2005). If a trust has two or more beneficiaries, the trustee must act impartially in investing, managing, and distributing the trust property, giving due regard to the beneficiaries’ respective interests. Uniform Trust Code § 803 (2005). See also, Sallee v. Fort Knox National Bank, et. al., 286 F.3d 878, 891 (6 ^th Cir. 2002) (distinguishing between a duty of good faith and fair dealing, requiring parties to “deal fairly” with one another, and the more onerous fiduciary duty that requires a party to place the interest of the other party before one’s own interests).

In situations where the grantor of a trust holds a nonfiduciary power to replace trust assets with assets of equivalent value, the trustee has a duty to ensure that the value of the assets being replaced is equivalent to the value of the assets being substituted. If the trustee knows or has reason to believe that the exercise of the substitution power does not satisfy the terms of the trust instrument because the assets being substituted have a lesser value than the

in the grantor’s gross estate, provided the trustee has a fiduciary obligation (under local law) to ensure the grantor’s compliance with the terms of this power by satisfying itself that the properties acquired and substituted by the grantor are in fact of equivalent value and further provided that the substitution power cannot be exercised in a manner that can shift benefits among the trust beneficiaries.

Rev. Rul. 2008–22

ISSUE

Is the corpus of an inter vivos trust includible in the grantor’s gross estate under § 2036 or 2038 of the Internal Revenue Code if the grantor retained the power, exercisable in a nonfiduciary capacity, to acquire property held in the trust by substituting other property of equivalent value?

FACTS

In Year 1, D, a United States citizen, established and funded Trust. Trust is an irrevocable inter vivos trust for the benefit of D ’s descendants. T is the trustee of Trust, and D is prohibited from serving as trustee under the terms of Trust. The governing instrument provides that D has the power, exercisable at any time, to acquire any property held in Trust by substituting other property of equivalent value. The power is exercisable by D in a nonfiduciary capacity, without the approval or consent of any person acting in a fiduciary capacity. To exercise the power of substitution, D must certify in writing that the substituted property and the trust property for which it is substituted are of equivalent value. In addition, under local law, T has a fiduciary obligation to ensure that the properties being exchanged are of equivalent value. Under local law, if a trust has two or more beneficiaries, the trustee has a duty to act impartially in investing and managing the trust assets, taking into account any differing interests of the beneficiaries. Further, under local law and without restriction in the trust instrument, T has the discretionary power to acquire, invest, reinvest, exchange, sell, convey, control, divide, partition, and manage the trust property in accordance with the standards provided by law.

D dies in Year 2.

LAW AND ANALYSIS

Section 2036(a) provides that the value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in the case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, under which the decedent has retained for 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, (1) the possession or enjoyment of, or the right to the income from, the property, or (2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income from the property.

Section 2038(a)(1) provides that the value of the gross estate includes the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in the case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, where the enjoyment thereof was subject at the date of the decedent’s death to any change through the exercise of a power (in whatever capacity exercisable) by the decedent alone or by the decedent in conjunction with any other person to alter, amend, revoke, or terminate, or where any such power is relinquished during the 3-year period ending on the date of the decedent’s death.

In Estate of Jordahl v. Commissioner, 65 T.C. 92 (1975), acq. in result, 1977–2 C.B. 1, the decedent created an inter vivos trust. Under the terms of the trust, the decedent reserved the power to substitute other securities or property for those held in trust, provided the substituted property was equal in value to the property replaced. After the decedent’s death, the Service argued that the trust assets were includible in the decedent’s gross estate under § 2038 because the decedent’s power to substitute assets of equal value could be exercised to alter the beneficial interests in the trust. The court determined, however, that because the decedent was bound by fiduciary standards and was therefore accountable in equity to the succeeding income beneficiary and remaindermen, the decedent

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respective interests of the beneficiaries, such as when the trust is administered as a unitrust (under local law or the trust instrument) or when distributions from the trust are limited to discretionary distributions of principal and income.

DRAFTING INFORMATION

The principal author of this revenue ruling is Mayer Samuels of the Office of the Associate Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling, contact Mr. Samuels at (202) 622–3090 (not a toll-free call).

Section 2038.—Revocable Transfers

26 CFR 20.2038–1: Revocable transfers.

Is the corpus of an inter vivos trust includible in the grantor’s gross estate under section 2036 or 2038 of the Internal Revenue Code if the grantor retained the power, exercisable in a nonfiduciary capacity, to acquire property held in the trust by substituting other property of equivalent value. See Rev. Rul. 2008-22, page 796.

trust assets being replaced, the trustee has a fiduciary duty to prevent the exercise of the power. See Restatement (Third) of Trusts § 75 (2007) and Uniform Trust Code §§ 801 and 802 (2005).

In the instant case, unlike the situation presented in Estate of Jordahl, the trust instrument expressly prohibits D from serving as trustee and states that D ’s power to substitute assets of equivalent value is held in a nonfiduciary capacity. Thus, D is not subject to the rigorous standards attendant to a power held in a fiduciary capacity. However, under the terms of the trust, the assets D transfers into the trust must be equivalent in value to the assets D receives in exchange. In addition, T has a fiduciary obligation to ensure that the assets exchanged are of equivalent value. Thus, D cannot exercise the power to substitute assets in a manner that will reduce the value of the trust corpus or increase D ’s net worth. Further, in view of T ’s ability to reinvest the assets and T ’s duty of impartiality regarding the trust beneficiaries, T must prevent any shifting of benefits between or among the beneficiaries that could otherwise result from a substitution of property by D . Under these circumstances, D ’s retained power will not cause

the value of the trust corpus to be included in D ’s gross estate under § 2036 or 2038.

HOLDING

A grantor’s retained power, exercisable in a nonfiduciary capacity, to acquire property held in trust by substituting property of equivalent value will not, by itself, cause the value of the trust corpus to be includible in the grantor’s gross estate under § 2036 or 2038, provided the trustee has a fiduciary obligation (under local law or the trust instrument) to ensure the grantor’s compliance with the terms of this power by satisfying itself that the properties acquired and substituted by the grantor are in fact of equivalent value, and further provided that the substitution power cannot be exercised in a manner that can shift benefits among the trust beneficiaries. A substitution power cannot be exercised in a manner that can shift benefits if: (a) the trustee has both the power (under local law or the trust instrument) to reinvest the trust corpus and a duty of impartiality with respect to the trust beneficiaries; or (b) the nature of the trust’s investments or the level of income produced by any or all of the trust’s investments does not impact the

2008–16 I.R.B. 798 April 21, 2008