Part I. Rulings — Internal Revenue Bulletin 2012-18

Section 267.—Losses, Expenses, and Interest With Respect to Transactions Between Related Taxpayers

26 CFR 1.267(f)–1: Controlled groups.

T.D. 9583

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

Guidance Under Section 267(f); Deferral of Loss on Transactions between Members of a Controlled Group

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations concerning the deferral of losses on the sale or exchange of property between members of a controlled group and provides guidance as to the time for taking into account those losses. These regulations affect corporations that are members of a controlled group.

DATES: Effective Date: These regulations are effective on April 16, 2012.

FOR FURTHER INFORMATION CONTACT: Amie Colwell Breslow (202) 622–7530 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

Section 267(a)(1) provides that no deduction shall be allowed for any loss on the sale or exchange of property between certain related persons. Section 267(f)(2) contains an exception for a loss on the sale or exchange of property between members of a controlled group. For this purpose, “controlled group” has the meaning given to such term in section 1563(a) except that “more than 50 percent” is substituted for

“at least 80 percent” each place it appears. In the case of a sale or exchange of loss property between members of a controlled group, the loss is deferred rather than disallowed. Under section 267(f)(2)(B), the loss is deferred until the property is transferred outside of the controlled group and there would be recognition of loss under consolidated return principles or until such other time as may be prescribed in regulations.

The regulations under section 267(f) provide that the timing principles for intercompany sales or exchanges between members of a consolidated group (see generally §1.1502–13(c)(2)) apply to sales or exchanges of property at a loss between members of a controlled group. See §1.267(f)–1(a)(2). The attribute redetermination rules applicable to transactions between members of a consolidated group (see §1.1502–13(c)(1)), however, do not apply to sales or exchanges between members of a controlled group.

Although the attribute redetermination rule generally does not apply to sales or exchanges between members of a controlled group, §1.267(f)–1(c)(1)(iv) contains a special rule with respect to losses that would have been redetermined to be a noncapital, nondeductible amount if the consolidated return attribute redetermination rule did apply. Under §1.267(f)–1(c)(1)(iv), if an intercompany loss between members of a consolidated group would have been redetermined to be a noncapital, nondeductible amount as a result of the attribute redetermination rule applicable to consolidated groups, but is not redetermined because the sale or exchange occurred between members of a controlled group (to which the attribute redetermination rule does not apply), then the loss will be deferred. The loss is taken into account when the selling member (S) and buying member (B) are no longer in a controlled group relationship.

On April 21, 2011, the IRS and Treasury Department published a notice of proposed rulemaking (REG–118761–09, 2011–21 I.R.B. 803) in the Federal Reg- ister (76 FR 22336). The notice included proposed regulations under section 267(f) providing guidance concerning the Federal

income tax treatment of deferred losses on the sale or exchange of property between members of a controlled group, including transactions in which the member acquiring the property subsequently recognizes a corresponding gain with respect to the property. The proposed regulations provided that certain losses on the sale or exchange of property between members of a controlled group, which have been deferred, are taken into account upon the occurrence of either of two events. The deferred loss is taken into account to the extent of any corresponding gain that the member acquiring the property recognizes with respect to the property. Alternatively, the deferred loss is taken into account when the parties to the transaction cease to be in a controlled group relationship. The proposed regulations also provided that for purposes of determining whether the loss is redetermined to be a noncapital, nondeductible amount under the principles of §1.1502–13, stock held by S, stock held by B, and stock held by all members of the consolidated group that includes S, as well as stock held by any member of a controlled group of which S is a member that was acquired from a member of S’s consolidated group, must be taken into account. A public hearing was requested and held on August 3, 2011. The IRS received one formal comment in response to the notice of proposed rulemaking. The comment raised several questions with certain recommendations, which are discussed in the following paragraphs of this preamble.

The commentator suggested that the final regulations incorporate a model that allows a loss to be taken into account based on the arm’s length principles contained in section 482 and the regulations thereunder. Specifically, the commentator noted that if the transaction is arm’s length in nature and has substance from a business perspective, the loss should be taken into account immediately. The IRS and Treasury Department do not agree with this comment. In a transaction described in these regulations, it is assumed that the parties are acting at arm’s length. Section 267(f) serves a different purpose, namely, to determine the timing of when a loss should be taken into account on a sale or exchange of

2012–18 I.R.B. 866 April 30, 2012

as a partnership for Federal income tax purposes.

Under these final regulations, the T stock issued by T to FS is taken into account for purposes of determining whether, upon the conversion of T, P’s deferred loss would be treated under the principles of §1.1502–13 as a noncapital, nondeductible amount.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866, as supplemented by Executive Order 13563. Therefore, a regulatory assessment is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to this regulation. Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6), it is hereby certified that this rule will not have a significant economic impact on a substantial number of small entities. This certification is based on the fact that these regulations primarily affect controlled groups of corporations which tend to be larger businesses. 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 their impact on small business. No comments were received.

Drafting Information

The principal author of this regulation is Amie Colwell Breslow, Office of Associate Chief Counsel (Corporate). However, other personnel from the IRS and Treasury Department participated in its 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. - * *

property between members of a controlled group. Accordingly, the final regulations retain the model contained in the proposed regulations.

The commentator also suggested that the proposed regulations do not clearly state how to establish whether a recognized loss is redetermined to be a noncapital, nondeductible amount under the principles of §1.1502–13. Specifically, the commentator noted that it is unclear whether the proposed regulations, as written, are intended to direct taxpayers to a §1.1502–34 type of analysis in determining whether the loss is redetermined to be a noncapital, nondeductible amount. Under the rule, stock held by S, stock held by B, and stock held by all members of the consolidated group that includes S, as well as stock held by any member of a controlled group of which S is a member that was acquired from a member of S’s consolidated group must be taken into account. After considering the comment, the IRS and Treasury Department believe that the rules in the proposed regulations, as written, are clear in that they expressly list the corporations the stock holdings of which must be taken into account. Furthermore, the IRS and Treasury Department believe that the proposed regulation is appropriately broader than the stock aggregation rule of §1.1502–34 to account for, among other considerations, the fact that the controlled group definition is broader than the definition of a consolidated group.

In addition, the commentator questioned whether the proposed regulations were consistent with the holdings in Gran- ite Trust v. United States, 238 F.2d 670 (1st Cir. 1956), and other applicable case law. The IRS and Treasury Department believe that the rules contained in the proposed regulations and these final regulations are consistent with applicable case law. These rules are intended to address the timing for taking into account a loss on a sale of property between members of a controlled group, and do not relate to whether a liquidation otherwise results in the recognition of a loss.

Explanation of Provisions

These final regulations retain the rules of the proposed regulations, but make one revision to clarify the interaction of section 267(f) and §1.1502–13 principles. The fi

nal regulations also make one modification to ensure that taxpayers cannot circumvent the purposes of the proposed regulation through issuances of target corporation stock to controlled group members.

The proposed regulations provided that a deferred loss is taken into account to the extent of any corresponding gain that the member acquiring the property recognizes with respect to the property. For example, assume S sells 30 percent of T’s stock to B (a member of S’s controlled group) at a loss (in a transaction that is treated as a sale or exchange for Federal income tax purposes). If T’s stock appreciates after the sale and before a subsequent event that results in B’s recognition of gain, the proposed regulations provided that S’s deferred loss may be taken into account to the extent that B recognizes a corresponding gain.

Questions have been raised concerning whether this rule is necessary because the relevant consolidated return provisions currently allow the loss to be taken into account to the extent of the corresponding gain. The IRS and Treasury Department agree that an explicit rule is unnecessary because the timing of taking the loss into account in these circumstances is provided for under §1.1502–13. Accordingly, the rule in the proposed regulations has been removed from the final regulations and an example has been added to §1.267(f)–1(j) to illustrate the interaction of these final regulations and the consolidated return regulations.

In addition to this clarification, these final regulations provide that stock issued to a member of the controlled group by a target corporation is taken into account for purposes of determining whether a loss would be treated as noncapital, nondeductible amount if the rules of §1.1502–13 applied. For example, assume FP is a foreign corporation that owns all the stock of FS, a foreign subsidiary, and all the stock of P, a domestic corporation. P owns all the stock of T. In Year 1, FS contributes cash to T in exchange for newly issued stock of T that constitutes 40 percent of T’s outstanding stock. In Year 2, when the value of the T stock owned by P is less than its basis in P’s hands, P sells all of its T stock to FP. In Year 3, in a transaction unrelated to the issuance of the T stock in Year 1, T converts under state law to a limited liability company that is treated

April 30, 2012 867 2012–18 I.R.B.

the T stock from P and a member of P’s controlled group) is taken into account. Accordingly, under the principles of §1.1502–13 the deemed liquidation of T resulting from the conversion of T would be treated as a liquidation qualifying under section 332, and P’s loss would be redetermined to be a noncapital, nondeductible amount. Thus, under paragraph (c)(1)(iv), P’s loss continues to be deferred until P and FP are no longer in a controlled group relationship.

- - - (l) - -
- - - (3) Effective/applicability date. Paragraph (c)(1)(iv) of this section applies to a loss that continues to be deferred pursuant to that paragraph if the event that would cause the loss to be redetermined as a noncapital nondeductible amount under the principles of §1.1502–13 occurs on or after April 16, 2012.

Steven T. Miller, Deputy Commissioner for Services and Enforcement.

Approved April 9, 2012.

Emily S. McMahon, Acting Assistant Secretary of the Treasury (Tax Policy).

(Filed by the Office of the Federal Register on April 13, 2012, 8:45 a.m., and published in the issue of the Federal Register for April 16, 2012, 76 F.R. 22480)

Section 642.—Special Rules for Credits and Deductions

26 CFR 1.642(c)–3: Adjustments and other special rules for determining unlimited charitable contribu- tions deductions.

T.D. 9582

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

Guidance Under Sections 642 and 643 (Income Ordering Rules)

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final Regulations.

Section 1.267(f)–1 is also issued under 26 U.S.C. 267. Par. 2. Section 1.267(f)–1 is amended as follows:

Paragraph (c)(1)(iv) is revised.
Adding Example 9 to paragraph (j).
Adding Example 10 to paragraph (j).
Paragraph (l)(3) is redesignated as paragraph (l)(4) and a new paragraph (l)(3) is added.

The additions and revision read as follows:

§1.267(f)–1 Controlled Groups.

- - - (c) - - (1) - - (iv) B’s item is excluded from gross in- come or noncapital and nondeductible . To the extent S’s loss would be redetermined to be a noncapital, nondeductible amount under the principles of §1.1502–13, but is not redetermined under paragraph (c)(2) of this section (which generally renders the attribute redetermination rule inapplicable to sales between members of a controlled group), S’s loss continues to be deferred. For purposes of this paragraph, stock held by S, stock held by B, stock held by all members of S’s consolidated group, stock held by any member of a controlled group of which S is a member that was acquired from a member of S’s consolidated group, and stock issued by T to a member of the controlled group must be taken into account in determining whether a loss would be redetermined to be a noncapital, nondeductible amount under the principles of §1.1502–13. If the loss remains deferred, it is taken into account when S and B (including their successors) are no longer in a controlled group relationship. (If, however, the property is transferred to certain related persons, paragraph (c)(1)(iii) of this section will cause the loss to be permanently disallowed.) For example, if S sells all of the T stock to B at a loss (in a transaction that is treated as a sale or exchange for Federal income tax purposes), and T subsequently liquidates in an unrelated transaction that qualifies under section 332, S’s loss is deferred until S and B are no longer in a controlled group relationship. Similarly, if S owns all of the T stock and sells 30 percent of T’s stock to B at a loss (in a transaction that is treated as a sale or exchange for Federal income tax

purposes), and T subsequently liquidates, S’s loss on the sale is deferred until S and B (including their successors) are no longer in a controlled group relationship.

- - - (j) - - Example 9. Sale of stock by consolidated group member to controlled group member. (a) Facts . P1, a domestic corporation, owns 75% of the outstanding stock of P, the common parent of a consolidated group. P owns all of the outstanding stock of subsidiaries M and S, which are members of P’s consolidated group. M and S each own 50% of the only class of stock of L, a nonmember life insurance company. On January 1 of Year 1, S sells 25% of L’s stock to P1 for $50 cash. At the time of the sale, S’s aggregate basis in the L shares transferred to P1 was $80, and S recognizes a $30 loss. On February 18 of Year 3, at a time when the L shares held by P1 are worth $60, L liquidates. As a result of the liquidation, P1 recognizes a $10 gain.

(b) Timing . Under paragraph (a)(2) of this section, S’s loss on the sale of the L stock to P1 is deferred. Under paragraph (c)(1)(iv) of this section, upon the liquidation of L, to the extent S’s loss would be redetermined to be a noncapital, nondeductible amount under the principles of §1.1502–13, S’s loss continues to be deferred. Under the principles of §1.1502–13, S’s loss is not redetermined to be a noncapital, nondeductible amount to the extent of P1’s $10 of gain recognized. Accordingly, S takes into account $10 of loss as a result of the liquidation. In determining whether the remainder of S’s $20 loss would be redetermined to be a noncapital, nondeductible amount, under paragraph (c)(1)(iv) of this section, stock held by P1, stock held by M, and stock held by S is taken into account. Accordingly, under the principles of §1.1502–13, the liquidation of L would be treated as a liquidation qualifying under section 332, and the remainder of S’s loss would be redetermined to be a noncapital, nondeductible amount. Thus, under paragraph (c)(1)(iv), S’s remaining $20 loss continues to be deferred until S and P1 are no longer in a controlled group relationship.

Example 10. Issuance of stock to controlled group member. (a) Facts. FP is a foreign corporation that owns all the stock of FS, a foreign corporation, and all the stock of P, a domestic corporation. P owns all of the single class of outstanding common stock of T. In Year 1, FS contributes cash to T in exchange for newly issued stock of T that constitutes 40 percent of T’s outstanding stock. In Year 2, when the value of the T stock owned by P is less than its basis in P’s hands, P sells all of its T stock to FP. In Year 3, in a transaction unrelated to the issuance of the T stock in Year 1, T converts under state law to a limited liability company that is treated as a partnership for Federal income tax purposes.

(b) Timing. Under paragraph (a)(2) of this section, P’s loss on the sale of its T stock is deferred. Under paragraph (c)(1)(iv) of this section, upon the conversion of T, to the extent P’s loss would be redetermined to be a noncapital, nondeductible amount under the principles of §1.1502–13, P’s loss continues to be deferred. In determining whether the loss would be redetermined to be a noncapital, nondeductible amount, stock held by FS (which was acquired from T) and stock held by FP (the buyer of

2012–18 I.R.B. 868 April 30, 2012

tors. The IRS and Treasury Department continue to believe that the position clarified in the proposed regulations, requiring that a specific provision of the governing instrument or a provision under local law have economic effect independent of income tax consequences in order to be respected for Federal tax purposes, is the proper interpretation of the relevant Code provisions and is a principle that applies throughout Subchapter J.

The general rule provided in Subchapter J, which mandates that the tax character of distributions to beneficiaries consists of a pro rata portion of all types of a trust’s income, appears in section 652(b) and in several different sections of the regulations under the subchapter. The only regulatory exception to this pro rata rule is for a specific provision in a governing instrument or a provision under local law that provides as to the tax character of distributions to beneficiaries. This exception to the pro rata rule must have the same meaning throughout the Subchapter J regulations. The chain of regulatory references from §§1.642(c)–3(b) and 1.643(a)–5(b), detailed in the preamble to the proposed regulations, incorporates into each of those provisions, by cross-reference to §1.662(b)–2, “the principles contained” in §1.652(b)–1 and, in turn, §1.652(b)–2(a) and –2(b), which require a specific provision to have economic effect independent of income tax consequences in order to be respected. The proposed regulations confirm this uniform principle by inserting the terms of §§1.652(b)–1 and 1.652(b)–2(a) and –2(b) explicitly into §§1.642(c)–3(b) and 1.643(a)–5(b).

Moreover, section 643(a)(7) grants express regulatory authority to “prescribe such regulations as may be necessary or appropriate to carry out the purposes of this part, including regulations to prevent avoidance of such purposes.”

Income Ordering Provisions and Economic Effect Independent of Income Tax Consequences

A commentator suggested that income ordering provisions in CLTs have economic effect independent of income tax consequences because disregarding an income ordering provision could increase a CLT’s tax liability, thereby reducing the value of the trust and in turn reducing the

SUMMARY: This document contains final regulations under Internal Revenue Code (Code) section 642(c) with regard to the Federal tax consequences of an ordering provision in a trust, a will, or a provision of local law that attempts to determine the tax character of the amounts paid to a charitable beneficiary of the trust or estate. The final regulations also make conforming amendments to the regulations under section 643(a)(5). The final regulations affect estates, charitable lead trusts (CLTs), and other trusts making payments or permanently setting aside amounts for a charitable purpose.

DATES: Effective Date: These regulations are effective on April 16, 2012.

FOR FURTHER INFORMATION CONTACT: Melissa Liquerman, at (202) 622–3060 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background and Explanation of Provisions

On June 18, 2008, proposed regulations (REG–101258–08, 2008–2 C.B. 111) were published in the Federal Register [73 FR 34670]. The proposed regulations contain proposed amendments to the Income Tax Regulations 26 CFR part 1, confirming that a provision in a trust, a will, or a provision of local law that specifically indicates the source out of which amounts are to be paid, permanently set aside, or used for a purpose specified in section 642(c) must have economic effect independent of income tax consequences in order to be respected for Federal tax purposes. If such provision does not have economic effect independent of income tax consequences, income distributed for a purpose specified in section 642(c) will consist of the same proportion of each class of the items of income as the total of each class bears to the total of all classes. The proposed regulations also make conforming changes in the corresponding language in the Income Tax Regulations under section 643(a)(5). The trusts and estates that are the subject of the proposed regulations include, without limitation, charitable lead trusts (CLTs) and trusts and estates making payments or permanently setting aside amounts for a charitable purpose.

The proposed regulations are based on the structure and provisions of Subchapter J (of Chapter 1, Subtitle A, of the Code) as a whole, as well as on an analysis of the existing regulations with their interrelated cross-references. The IRS and Treasury Department believe that the current regulations under §§1.642(c)–3(b) and 1.643(a)–5(b) require that a specific provision of the governing instrument or a provision under local law have economic effect independent of income tax consequences in order to be respected for Federal income tax purposes. To make this clearer, the proposed regulations add the principle of economic effect directly to the regulations under sections 642(c) and 643(a), rather than leaving this principle to be reached by cross-reference to other regulations.

Finally, the proposed regulations remove §1.642(c)–3(b)(4) because the provisions of section 116 referenced therein were repealed by the Tax Reform Act of 1986 (Public Law 99–514). Written comments were received on the proposed regulations. Because there were no requests to speak at the scheduled public hearing, the public hearing was cancelled. The proposed regulations, with certain changes made in response to the written comments received, are adopted as final regulations.

Summary of Comments and Explanation of Provisions

Specific Provisions Must Have Economic Effect Independent of Income Tax Consequences

Commentators suggested that the clarification in the proposed regulations, that a specific provision in a governing instrument or in local law that identifies the source(s) of the amounts to be paid, permanently set aside, or used for a purpose specified in section 642(c) must have economic effect independent of income tax consequences in order for the specific provision in the governing instrument or in local law to be respected for Federal tax purposes, is an interpretation contrary to the clear language of section 642(c) and 643(a)(5) and the existing regulations.

The IRS and Treasury Department have carefully considered these arguments and the analyses suggested by the commenta

April 30, 2012 869 2012–18 I.R.B.

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 preceding this regulation was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business, and no comments were received.

Drafting Information

The principal author of these proposed regulations is Melissa Liquerman, Office of the Associate Chief Counsel (Passthroughs and Special Industries).

- - - -

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 1.642(c)–3 is amended by:

Revising the heading of paragraph (b) and adding a heading for (b)(1).
Revising paragraph (b)(2).
Adding a heading to paragraph (b)(3).
Removing paragraph (b)(4). The revisions and addition read as follows:

§1.642(c)–3 Adjustments and other special rules for determining unlimited charitable contributions deduction .

- - - (b) Determination of amounts de- ductible under section 642(c) and the character of such amounts —(1) Reduction of charitable contributions deduction by amounts not included in gross income .
- (2) Determination of the character of an amount deductible under section 642(c) . In determining whether the amounts of income so paid, permanently set aside, or used for a purpose specified in section

annual unitrust payments to the charitable beneficiaries and increasing the risk that the trust’s assets will be depleted before the end of the trust term. Although the general pro rata allocation rule may increase a trust’s tax liability and thereby reduce the value of the trust’s corpus, the effect of the payment of the trust’s income tax liability is not an economic effect independent of income tax consequences as described in these regulations. Any possible reduction in the unitrust amount subsequently paid to the charitable beneficiary would be the direct result of the payment of income taxes by the unitrust. The use of an income ordering rule in a CLT, directing the tax characteristics of the unitrust or annuity payments to the charity, is primarily, if not exclusively, an attempt to minimize the tax liabilities of the trust and its remainder beneficiaries. The only effects of the use of an ordering rule are in fact dependent solely upon tax consequences: specifically, the reduced amount of tax paid and the trust’s retention of the income tax savings.

Ordering provisions in CLTs will never have economic effect independent of their tax consequences because the amount paid to the charity is not dependent upon the type of income it is allocated. An annuity payment is a fixed amount from year to year, and although a unitrust amount may fluctuate annually, the amount is based upon a predetermined percentage of the trust’s value.

Permitting an ordering rule with no economic effect independent of income tax consequences to supersede the pro rata allocation rule generally applicable under Subchapter J would, in effect, permit taxpayers to deviate at will from the general rule imposed throughout Subchapter J in the case of all kinds of complex trusts.

Encouragement of Charitable Gifts

A commentator suggested that the proposed regulations are contrary to the Federal government’s long standing policy to encourage charitable gifts and to benefit and protect charities.

The IRS and Treasury Department have carefully considered the merits and implications of this suggestion. The IRS and Treasury Department believe, however, that the proper interpretation of the relevant Code sections does not permit the

creation of a special rule for CLTs. A CLT is treated and taxed in the same way as any other complex trust under Subchapter J. Subchapter J does not differentiate between a CLT and a different type of complex trust, and there is no provision of Subchapter J that applies exclusively and expressly to CLTs. Thus, any income tax rule applicable to a CLT will apply in the same way to every other complex trust.

Principal/Income Ordering Rules

A commentator requested that the proposed regulations be expanded to provide that trusts that make distributions to both charitable and noncharitable beneficiaries in the same taxable year must allocate the distributions equally to principal and income as between charitable and noncharitable beneficiaries, unless there is a provision that has economic effect independent of income tax consequences.

This request is beyond the scope of the proposed regulations and might implicate other well settled income tax rules applicable to complex trusts. Section 662 and the regulations thereunder provide the rules for distributions by complex trusts with a charitable beneficiary, and sufficiently address the commentator’s concern. If the commentator believes that further guidance is needed or would be helpful to taxpayers, a request for additional guidance may be submitted for consideration to be added to the Priority Guidance Plan.

Economic Effect Independent of Income Tax Consequences Example

A commentator requested an example of a provision in a governing instrument that would have economic effect independent of income tax consequences. Such an example has been added to the final regulations as Example 2 .

Special Analyses

2012–18 I.R.B. 870 April 30, 2012

642(c)(1), (2), or (3) include particular items of income of an estate or trust, whether or not included in gross income, a provision in the governing instrument or in local law that specifically provides the source out of which amounts are to be paid, permanently set aside, or used for such a purpose controls for Federal tax purposes to the extent such provision has economic effect independent of income tax consequences. See §1.652(b)–2(b). In the absence of such specific provisions in the governing instrument or in local law, the amount to which section 642(c) applies is deemed to consist of the same proportion of each class of the items of income of the estate or trust as the total of each class bears to the total of all classes. See §1.643(a)–5(b) for the method of determining the allocable portion of exempt income and foreign income. This paragraph (b)(2) is illustrated by the following examples:

Example 1 . A charitable lead annuity trust has the calendar year as its taxable year, and is to pay an annuity of $10,000 annually to an organization described in section 170(c). A provision in the trust governing instrument provides that the $10,000 annuity should be deemed to come first from ordinary income, second from short-term capital gain, third from fifty percent of the unrelated business taxable income, fourth from long-term capital gain, fifth from the balance of unrelated business taxable income, sixth from tax-exempt income, and seventh from principal. This provision in the governing instrument does not have economic effect independent of income tax conse

quences, because the amount to be paid to the charity is not dependent upon the type of income from which it is to be paid. Accordingly, the amount to which section 642(c) applies is deemed to consist of the same proportion of each class of the items of income of the trust as the total of each class bears to the total of all classes.

Example 2 . A trust instrument provides that 100 percent of the trust’s ordinary income must be distributed currently to an organization described in section 170(c) and that all remaining items of income must be distributed currently to B, a noncharitable beneficiary. This income ordering provision has economic effect independent of income tax consequences because the amount to be paid to the charitable organization each year is dependent upon the amount of ordinary income the trust earns within that taxable year. Accordingly, for purposes of section 642(c), the full amount distributed to charity is deemed to consist of ordinary income.

(3) Other examples . - * *

- - - Par. 3. Section 1.643(a)–5 is amended by revising paragraph (b) to read as follows:

§1.643(a)–5 Tax-exempt interest.

- - - (b) If the estate or trust is allowed a charitable contributions deduction under section 642(c), the amounts specified in paragraph (a) of this section and §1.643(a)–6 are reduced by the portion deemed to be included in income paid, permanently set aside, or to be used for the purposes specified in section 642(c).

If the governing instrument or local law specifically provides as to the source out of which amounts are paid, permanently set aside, or to be used for such charitable purposes, the specific provision controls for Federal tax purposes to the extent such provision has economic effect independent of income tax consequences. See §1.652(b)–2(b). In the absence of such specific provisions in the governing instrument or local law, an amount to which section 642(c) applies is deemed to consist of the same proportion of each class of the items of income of the estate or trust as the total of each class bears to the total of all classes. For illustrations showing the determination of the character of an amount deductible under section 642(c), see Examples 1 and 2 of §1.662(b)–2 and §1.662(c)–4(e).

Linda M. Kroening, (Acting) Deputy Commissioner for

Services and Enforcement.

Approved April 9, 2012.

Emily M. McMahon, (Acting) Assistant Secretary of the Treasury (Tax Policy).

(Filed by the Office of the Federal Register on April 13, 2012, 8:45 a.m., and published in the issue of the Federal Register for April 16, 2012, 76 F.R. 22483)

April 30, 2012 871 2012–18 I.R.B.