Part IV. Items — Internal Revenue Bulletin 2012-21

Notice of Proposed Rulemaking

Local Lodging Expenses

REG–137589–07

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

SUMMARY: This document contains proposed regulations relating to the deductibility of expenses for lodging when not traveling away from home (local lodging). The regulations affect taxpayers who pay or incur expenses for local lodging.

DATES: Comments or a request for a public hearing must be received by July 24, 2012.

ADDRESSES: Send submissions to CC:PA:LPD:PR (REG–137589–07), room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG–137589–07), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC. Alternatively, taxpayers may submit comments electronically via the Federal eRulemaking Portal at http://www.regulations.gov (IRS REG–137589–07).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, R. Matthew Kelley, (202) 622–7900; concerning submission of comments or a request for a hearing, Funmi Taylor, (202) 622–7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

This document contains proposed amendments to 26 CFR part 1 relating to the deduction of local lodging expenses.

Section 1.262–1 of the Income Tax Regulations generally disallows a deduction for local lodging expenses. The

proposed regulations allow taxpayers to deduct local lodging expenses as ordinary and necessary business expenses in appropriate circumstances.

Business Expenses Generally

Section 162(a) of the Internal Revenue Code (Code) allows a deduction for all of the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. Whether an expense is ordinary and necessary is a question of fact. In general, a trade or business expense is ordinary if it is normal, usual, or customary in the taxpayer’s type of business. An expense is necessary if it is appropriate and helpful for the development of the taxpayer’s business. See Commissioner v. Heininger, 320 U.S. 467, 475 (1943). An expense that serves primarily to furnish the taxpayer with a social or personal benefit, and is only secondarily related to business, is not a necessary business expense under section 162(a).

Employee Expenses

An expense that an employee must bear as a condition of employment may be a deductible employee business expense. See Sibla v. Commissioner, 611 F.2d 1260 (9 ^th Cir. 1980), acq. (1985–2 C.B. viii) (contributions to firemen’s mess required as a condition of employment are deductible business expenses). However, expenses that primarily are for the employee’s personal benefit or convenience are not deductible employee business expenses. See Commissioner v. Flowers, 326 U.S. 465 (1946) (a taxpayer’s expenses for lodging near his principal work location, to avoid a long commute to and from his primary residence, were nondeductible personal expenses incurred solely because of the taxpayer’s decision to maintain his primary residence far from his work location).

Deductible Employee Expenses

The tax consequences to an employee who is reimbursed by an employer for an expense, or who receives property or services resulting from an employer’s payment of an expense, depend on whether the

expense is one that would have been deductible if paid directly by the employee.

For example, if an employee pays an expense and an employer reimburses the employee under a reimbursement or other expense allowance arrangement, the reimbursement is not includible in the employee’s income if it is made under an accountable plan. A reimbursement is treated as made under an accountable plan only if it is made for an expense that would be deductible by the employee under sections 161 through 199. See sections 62(a)(2)(A) and 62(c). Similarly, if an employer provides property or services to an employee in the course of business, the value of the benefit to the employee is excludable from the employee’s income if the benefit constitutes a working condition fringe under section 132(a)(3). A working condition fringe is defined as property or services provided to an employee to the extent that, if the employee paid for the property or services, the payment would be allowable as a deduction to the employee under section 162 or 167.

Nondeductible Personal Expenses

Section 262(a) provides that, except as otherwise provided in Chapter 1 of the Code, no deduction is allowed for personal, living, or family expenses.

Section 1.262–1(b)(5) provides, as examples of personal, living, and family expenses, that the costs of a taxpayer’s meals incurred when not traveling away from home (local meals) are generally nondeductible personal expenses. Local meal expenses may be deducted, however, if they otherwise qualify as ordinary and necessary business expenses under section 162 or as expenses for the production of income under section 212. In contrast, lodging expenses incurred when not traveling away from home (local lodging) are nondeductible personal expenses. Thus, local lodging expenses that would otherwise qualify as trade or business expenses under section 162 or as production of income expenses under section 212 are not deductible under the current general rule.

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Explanation of Provisions

These regulations propose to amend the regulations under sections 162 and 262. The proposed regulations under section 162 provide that expenses paid or incurred for local lodging may be deductible as ordinary and necessary expenses of a taxpayer’s trade or business, including the trade or business of being an employee. The proposed regulations provide a safe harbor for certain local lodging at a business meeting, conference, or other activity or function. Other local lodging expenses may be deductible as business expenses depending on the facts and circumstances.

The proposed regulations under section 262 provide that a taxpayer’s costs incurred for local lodging are personal expenses unless the expenses are deductible under section 162. Comments are specifically requested on whether the section 262 regulations should be amended to provide that local lodging expenses are not personal expenses if they are deductible under section 212.

The proposed regulations also amend the regulations under section 262 to remove references to section 217 that are obsolete. Section 217 was amended by the Revenue Reconciliation Act of 1993, Public Law 103–66 (107 Stat. 417). Under the amendments, lodging when not traveling away from home and meals are not deductible as moving expenses.

Effective/Applicability Date

The regulations are proposed to apply to expenses paid or incurred on or after the date these regulations are published as final regulations in the Federal Register . However, until these regulations are published as final regulations in the Federal Register, taxpayers may apply the proposed regulations to expenses paid or incurred in taxable years for which the period of limitation on credit or refund under section 6511 has not expired.

Effect on Other Documents

Notice 2007–47 is obsoleted as of April 25, 2012.

Special Analyses

This notice of proposed rulemaking is not a significant regulatory action as de

Local Lodging Expenses

The cost of local lodging that a taxpayer pays or incurs primarily for the taxpayer’s convenience or personal benefit is not an ordinary and necessary expense of a business or income-producing activity. Similarly, the cost of local lodging provided to an employee by an employer for the employee’s convenience or personal benefit would not be deductible by the employee if the employee paid the cost directly. Therefore, the value of the lodging under those circumstances is not excludible from the gross income of an employee as a working condition fringe under section 132(a)(3), and reimbursement for the cost of the lodging under those circumstances is not a payment under an accountable plan under §1.62–2(c). Consequently, unless excludible on another basis, the value of the lodging or the amount of reimbursement under those circumstances is includible in the employee’s income under section 61 as compensation for services. See §§1.61–21(a)(3), 1.62–2, and 1.132–1.

The cost of local lodging is for the convenience or personal benefit of an employee (or other recipient) if, for example, the lodging is provided to the employee (1) as additional compensation, such as to provide a weekend at a luxury hotel or resort; (2) to enable the employee to avoid a long-distance commute (Commissioner v. Flowers); (3) because the employee is required to work overtime (Coombs v. Commissioner, 608 F.2d 1269, 1273 (9 ^th

Cir. 1979)); (4) as housing for a recently relocated employee while the employee searches for permanent housing; or (5) for the employee’s indefinite personal use (International Artists, Ltd, v. Commissioner, 55 T.C. 94 (1970)). An employer may deduct the costs the employer incurs in providing the lodging in each of these cases under section 162(a) as compensation for services. See §§1.162–7(a) and 1.162–25T. However, because the primary purpose of the lodging is to provide the employee with a personal benefit, if the employee pays the cost of the lodging directly, the employee may not deduct the expense as an ordinary and necessary business expense under section 162(a). Therefore, a cash reimbursement of the cost is not excludible from the employee’s

gross income under section 62(c) and the value of the lodging is not excludible from the employee’s gross income under section 132(d) as a working condition fringe.

Expenditures for local lodging may qualify as deductible ordinary and necessary expenses under appropriate circumstances if all other requirements of section 162 are met. For example, an employer may require its employees to stay at a local hotel for the bona fide purpose of facilitating training or team building directly connected with the employer’s trade or business. Similarly, a professional sports team may require its employees (players and coaches) to stay at a local hotel the night before a home game to ensure physical preparedness and allow for last minute training. Under these circumstances, the cost of the lodging is primarily for the business purposes of the employer and not to provide a personal benefit to the employees. The cost of the lodging would be deductible by an employee under section 162 if the employee paid the cost directly, and thus the value of the lodging may be excluded from the employee’s gross income as a working condition fringe if other requirements are satisfied. Similarly, a payment from the employer reimbursing the employee for the cost of the lodging may be excluded from the employee’s gross income as a payment under an accountable plan if all the requirements of an accountable plan are met.

Notice 2007–47, 2007–1 C.B. 1393 (see §601.601(d)(2) of this chapter) advises taxpayers that the IRS and the Treasury Department intend to amend the treatment of the costs of a taxpayer’s local lodging under §1.262–1(b)(5). The notice provides that, pending issuance of additional published guidance, the IRS will not apply §1.262–1(b)(5) to expenses for local lodging of an employee that an employer provides to the employee or requires the employee to obtain, if: (1) the lodging is provided on a temporary basis; (2) the lodging is necessary for the employee to participate in or be available for a bona fide business meeting or function of the employer; and (3) the expenses are otherwise deductible by the employee, or would be deductible if paid by the employee, under section 162(a).

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the employees meet all other requirements (such as substantiation) for deductibility of the expense and for exclusion from income as a working condition fringe or payment under an accountable plan.

Example 1 . (i) Employer conducts training for its employees at a hotel near Employer’s main office. The training is directly connected with Employer’s trade or business. Some employees attending the training are traveling away from home and some employees are not traveling away from home. Employer requires all employees attending the training to remain at the hotel overnight for the bona fide purpose of facilitating the training. Employer pays the costs of the lodging at the hotel directly to the hotel and does not treat the value as compensation to the employees.

(ii) Employer has a noncompensatory business purpose for paying the lodging expenses. Employer is not paying the expenses primarily to provide a social or personal benefit to the employees. If the employees who are not traveling away from home had paid for their own lodging, the expenses would have been deductible under section 162(a) as ordinary and necessary business expenses of the employees. Therefore, the value of the lodging is excluded from the employees’ income as a working condition fringe under section 132(a) and (d).

(iii) Employer may deduct the lodging expenses, including lodging for employees who are not traveling away from home, as ordinary and necessary business expenses under section 162(a).

Example 2 . (i) The facts are the same as in Ex- ample 1, except that the employees pay the cost of their lodging at the hotel directly to the hotel, Employer reimburses the employees for the cost of the lodging, and Employer does not treat the reimbursement as compensation to the employees.

(ii) Employer is reimbursing the lodging expenses for a noncompensatory business purpose and not primarily to provide a social or personal benefit to the employees. The employees incur the expenses in performing services for the employer. If Employer had not reimbursed the employees who are not traveling away from home for the cost of the lodging, the expenses would have been deductible under section 162(a) as ordinary and necessary business expenses of the employees. Therefore, the reimbursements to the employees are made under an accountable plan and are excluded from the employees’ gross income.

(iii) Employer may deduct the lodging expense reimbursements, including reimbursements for employees who are not traveling away from home, as ordinary and necessary business expenses under section 162(a).

Example 3 . (i) Employer is a professional sports team. Employer requires its employees (players and coaches) to stay at a local hotel the night before a home game to conduct last minute training and ensure the physical preparedness of the players. Employer pays the lodging expenses directly to the hotel and does not treat the value as compensation to the employees.

(ii) Employer has a noncompensatory business purpose for paying the lodging expenses. Employer is not paying the lodging expenses primarily to provide a social or personal benefit to the employees. If

fined in Executive Order 12866, as supplemented by Executive Order 13563. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations and, because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, this notice of proposed rulemaking has been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Comments and Requests for a Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any comments that are submitted timely to the IRS as prescribed in this preamble under the “Addresses” heading. The Treasury Department and the IRS invite comments on all aspects of the proposed rules. All comments will be available for public inspection and copying. A public hearing may be scheduled if requested in writing by any person who timely submits comments. If a public hearing is scheduled, notice of the date, time, and place for the public hearing will be published in the Federal Register .

Drafting Information

The principal author of these regulations is R. Matthew Kelley of the Office of Associate Chief Counsel (Income Tax and Accounting). However, other personnel from the IRS and Treasury Department participated in their development.

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Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1—INCOME TAXES

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

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.162–31 is added to read as follows:

§1.162–31 Expenses paid or incurred for lodging when not traveling away from home .

(a) In general . Expenses paid or incurred for lodging when not traveling away from home (local lodging) generally are personal, living, or family expenses that are nondeductible under section 262(a). Under certain circumstances, however, expenses for local lodging may be deductible under section 162(a) as ordinary and necessary expenses paid or incurred in connection with carrying on a taxpayer’s trade or business, including a trade or business as an employee. Whether local lodging expenses are paid or incurred in carrying on a taxpayer’s trade or business is determined under all the facts and circumstances. One factor is whether the taxpayer incurs the expense because of a bona fide condition or requirement of employment imposed by the taxpayer’s employer. Expenses paid or incurred for local lodging that is lavish or extravagant under the circumstances or that primarily provides an individual with a social or personal benefit are not incurred in carrying on a taxpayer’s trade or business.

(b) Safe harbor for local lodging at business meetings and conferences . An individual’s expenses for local lodging will be treated as ordinary and necessary business expenses if—

(1) The lodging is necessary for the individual to participate fully in or be available for a bona fide business meeting, conference, training activity, or other business function;

(2) The lodging is for a period that does not exceed five calendar days and does not recur more frequently than once per calendar quarter;

(3) If the individual is an employee, the employee’s employer requires the employee to remain at the activity or function overnight; and

(4) The lodging is not lavish or extravagant under the circumstances and does not provide any significant element of personal pleasure, recreation, or benefit.

(c) Examples . The provisions of this section are illustrated by the following examples. In each example the employer and

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the employees had paid for their own lodging, the expenses would have been deductible by the employees under section 162(a) as ordinary and necessary business expenses. Therefore, the value of the lodging is excluded from the employees’ income as a working condition fringe.

(iii) Employer may deduct the expenses for lodging the players and coaches at the hotel as ordinary and necessary business expenses under section 162(a). Example 4 . (i) Employer hires Employee, who currently resides 500 miles from Employer’s business premises. Employer pays for temporary lodging for Employee near Employer’s business premises while Employee searches for a residence.

(ii) Employer is paying the temporary lodging expense primarily to provide a personal benefit to Employee by providing housing while Employee searches for a residence. Employer incurs the expense only as additional compensation and not for a noncompensatory business purpose. If Employee paid the temporary lodging expense, the expense would not be an ordinary and necessary employee business expense under section 162(a) because the lodging primarily provides a personal benefit to Employee. Therefore, the value of the lodging is includible in Employee’s gross income as additional compensation.

(iii) Employer may deduct the lodging expenses as ordinary and necessary business expenses under section 162(a) and §1.162–25T.

Example 5 . (i) Employee normally travels two hours each way between her home and her office. Employee is working on a project that requires Employee to work late hours. In order to maximize Employee’s availability to work on the project, Employer provides Employee with lodging at a hotel near the office.

(ii) Employer is paying the temporary lodging expense primarily to provide a personal benefit to Employee by relieving her of the daily commute to her residence. Employer incurs the expense only as additional compensation and not for a noncompensatory business purpose. If Employee paid the temporary lodging expense, the expense would not be an ordinary and necessary business expense under section 162(a) because the lodging primarily provides a personal benefit to Employee. Therefore, the value of the lodging is includible in Employee’s gross income as additional compensation.

(iii) Employer may deduct the lodging expenses as ordinary and necessary business expenses under section 162(a) and §1.162–25T.

Example 6 . (i) Employer requires an employee to be “on duty” each night to respond quickly to emergencies that may occur outside of normal working hours. Employees who work daytime hours each serve a “duty shift” once each month in addition to their normal work schedule. Emergencies that require the duty shift employee to respond occur regularly. Employer has no sleeping facilities on its business premises and pays for a hotel room nearby where the duty shift employee stays until called to respond to an emergency.

(ii) Employer has a noncompensatory business purpose for paying the lodging expenses. Employer is not providing the lodging to duty shift employees primarily to provide a social or personal benefit to the employees. If the employees had paid for their lodg

ing, the expenses would have been deductible by the employees under section 162(a) as ordinary and necessary business expenses. Therefore, the value of the lodging is excluded from the employees’ income as a working condition fringe.

(iii) Employer may deduct the lodging expenses as ordinary and necessary business expenses under section 162(a).

(d) Effective/applicability date . This section applies to expenses paid or incurred on or after the date these regulations are published as final regulations in the Federal Register . However, until these proposed regulations are published as final regulations in the Federal Register, taxpayers may apply the proposed regulations to local lodging expenses that are paid or incurred in taxable years for which the period of limitation on credit or refund under section 6511 has not expired.

Par. 3. In §1.262–1, paragraph (b)(5) is amended to read as follows:

§1.262–1 Personal, living, and family expenses .

- - - (b) - - (5) Expenses incurred in traveling away from home (which include transportation expenses, meals, and lodging) and any other transportation expenses are not deductible unless they qualify as expenses deductible under section 162 (relating to trade or business expenses), section 170 (relating to charitable contributions), section 212 (relating to expenses for production of income), section 213 (relating to medical expenses), or section 217 (relating to moving expenses), and the regulations under those sections. The taxpayer’s costs of commuting to his place of business or employment are personal expenses and do not qualify as deductible expenses. For expenses paid or incurred before the date these regulations are published as final regulations in the Federal Register, a taxpayer’s expenses for lodging when not traveling away from home (local lodging) are nondeductible personal expenses. For expenses paid or incurred on or after the date these regulations are published as final regulations in the Federal Register, a taxpayer’s expenses for local lodging are personal expenses and are not deductible unless they qualify as deductible expenses under section 162. However, until these regulations are published as final regulations in the Federal Register, taxpayers

may deduct local lodging expenses that qualify under section 162 and are paid or incurred in taxable years for which the period of limitation on credit or refund under section 6511 has not expired. Except as permitted under section 162 or 212, the costs of a taxpayer’s meals not incurred in traveling away from home are nondeductible personal expenses.

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

(Filed by the Office of the Federal Register on April 24, 2012, 8:45 a.m., and published in the issue of the Federal Register for April 25, 2012, 77 F.R. 24657)

Notice of Proposed Rulemaking

Certain Transfers of Property to Regulated Investment Companies (RICs) and Real Estate Investment Trusts (REITs)

REG–139991–08

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

SUMMARY: This document contains proposed amendments to regulations under section 337(d) of the Internal Revenue Code. The proposed regulations provide guidance concerning certain transfers of property from a C corporation to a Regulated Investment Company (RIC) or a Real Estate Investment Trust (REIT) and will affect the parties to such transactions. This document also invites comments from the public regarding these proposed regulations.

DATES: Written or electronic comments and requests for a public hearing must be received by July 16, 2012.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG–139991–08), room 5205, Internal Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand-delivered Monday through Friday

2012–21 I.R.B. 945 May 21, 2012

built-in gain remains subject to corporate tax in the hands of the transferor. Therefore, there would not be any circumvention of the purposes of General Utilities repeal. Section 1.337(d)–4(b)(3) provides an exception in an analogous context (where a C corporation transfers all or substantially all of its assets to a tax-exempt entity) to the extent the transaction qualifies for nonrecognition treatment under section 1031 or section 1033.

Accordingly, the proposed regulations provide an exception from the general rule of the current regulations for a transfer of property by a C corporation to a RIC or REIT to the extent that the transfer qualifies for non-recognition treatment under either section 1031 or 1033. In such a transaction, the C corporation transferor’s basis in the property it receives is derived from its basis in the transferred property, and thus reflects the built-in gain. At the same time, the basis of the transferee RIC or REIT in the converted property has no relation to the C corporation transferor’s basis therein.

Treasury and the IRS are not proposing to extend this treatment to all exchanged basis transactions, such as exchanges that would otherwise qualify for nonrecognition treatment under section 351 of the Code, out of a concern that such an exemption could create opportunities to avoid corporate-level tax on built-in gains and would give rise to administrative difficulties that could be addressed only through extensive rulemaking.

B. Transfers by Tax-Exempt Entities .

The regulations apply to property transferred by a C corporation directly to a RIC or REIT, and indirectly through a partnership to the extent of any C corporation partner’s proportionate share of the transferred property (the partnership rule). The regulations state that if the partnership elects deemed sale treatment with respect to such transfer, then any net gain recognized by the partnership on the deemed sale must be allocated to the C corporation partner.

Commentators have expressed concern that the partnership rule presents unintended effects when the partnership has multiple C corporation partners including both taxable and tax-exempt entities. If such a partnership transfers built-in gain

between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG–139991–08), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC, or sent electronically, via the Federal eRulemaking Portal at http://www.regulations.gov (IRS REG–139991–08).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, Grid Glyer (202) 622–7930 or Maury Passman (202) 622–7750 with respect to the corporate issues, and David H. Kirk (202) 622–3060 with respect to the partnership issues; concerning submissions of comments, Oluwafunmilayo Taylor (202) 622–7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

Congress repealed the General Utilities doctrine in the Tax Reform Act of 1986 (Public Law 99–514, 100 Stat. 2085), as amended by the Technical and Miscellaneous Revenue Act of 1988 (Public Law 100–647, 102 Stat. 3342), when sections 336 and 337 of the Internal Revenue Code were amended to require corporations to recognize gain or loss on the distribution of property in connection with complete liquidations other than certain subsidiary liquidations. Section 337(d)(1) directs the Secretary to prescribe regulations as may be necessary to carry out the purposes of General Utilities repeal, including rules to “ensure that such purposes may not be circumvented * * * through the use of a regulated investment company, a real estate investment trust, or tax-exempt entity * * *.”

On March 18, 2003, regulations under §1.337(d)–7 (the regulations) were published in the Federal Register (T.D. 9047, 2003–1 C.B. 676 [68 Fed. Reg. 12817]). The regulations generally provide (in paragraphs (a) and (b)(1)) that if property of a C corporation (the C corporation transferor) becomes the property of a RIC or REIT by the qualification of that C corporation as a RIC or REIT or by the transfer of assets of that C corporation to a RIC or REIT (a conversion transaction), then the RIC or REIT will be subject to tax on the net built-in gain in the converted property under the rules of section 1374 and the underlying regulations. This

treatment, however, does not apply if the C corporation transferor elects to recognize gain and loss as if it sold the converted property to an unrelated party at fair market value (deemed sale treatment).

Explanation and Summary of Comments

This preamble first discusses the proposal as it relates to net built-in gain property acquired by a RIC or REIT either in a like-kind exchange (where the C corporation transferor’s gain is not recognized by reason of section 1031) or in an involuntary conversion (where such gain is not recognized by reason of section 1033). This preamble then discusses a proposed revision to the definition of a C corporation in the regulations, which provides that a transfer of property by a tax-exempt entity to a RIC or REIT is not treated as a conversion transaction unless the tax-exempt entity would have been subject to tax if a deemed sale election had been made.

In addition, the proposed regulations also add definitions for the terms RIC, REIT, and S corporation. While these terms are not explicitly defined in the regulations, their meanings are both self-evident and unambiguous in that context. Nonetheless, for clarification and ease of use, the proposed regulations add explicit definitions.

A. Like-Kind Exchanges and Involuntary Conversions .

The current regulations generally provide that if property of a C corporation becomes the property of a RIC or REIT in a conversion transaction, then, absent a deemed sale election, the RIC or REIT will be subject to tax on the net built-in gain in the converted property under the rules of section 1374 and the underlying regulations (as modified in paragraph (b) of the regulations), as if the RIC or REIT were an S corporation.

Commentators have expressed concern that the general rule may inappropriately expose property transferred in certain exchanged basis transactions - specifically, like-kind exchanges and involuntary conversions – to this treatment. In these transactions, the C corporation transferor replaces property it transferred to a RIC or REIT with property that has an equivalent basis and built-in gain, and as a result, the

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required. Pursuant to section 7805(f) of the Code, these proposed regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Comments and Requests for a Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any written (a signed original and eight (8) copies) or electronic comments that are submitted timely to the IRS. Treasury and the IRS request comments on all aspects of the proposed rules. All comments will be available for public inspection and copying. A public hearing may be scheduled if requested in writing by any person that timely submits written or electronic comments. If a public hearing is scheduled, notice of the date, time, and place for the public hearing will be published in the Federal Register .

Drafting Information

The principal authors of these regulations are Grid Glyer and Maury Passman of the Office of Associate Chief Counsel (Corporate). Other personnel from Treasury Department and the IRS participated in their development.

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Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1—INCOME TAXES

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

Authority: 26 U.S.C. 7805 * * * Section 1.337(d)–7 is also issued under 26 U.S.C. 337(d) * * * Par. 2. Section 1.337(d)–7 is amended by:

Revising paragraphs (a)(2), (d)(1), (e) and (f).
Adding paragraph (d)(3). The revisions and addition read as follows:

property to a RIC or REIT in a conversion transaction without making a deemed sale election (that is, section 1374 treatment applies), and if the transferee RIC or REIT sells the converted property during the recognition period, then the RIC or REIT is subject to a corporate-level tax on the net built-in gain, including the portion of the net built-in gain that otherwise would have been allocated to tax-exempt C corporation partners had a deemed sale election been made. This is because the net recognized built-in gain is determined with reference to the amount of gain that would have been allocated to all C corporation partners, regardless of their taxable or tax-exempt status. In contrast, if the transferring partnership were to make a deemed sale election, the taxable C corporation partners would recognize gain that otherwise could have been deferred if section 1374 treatment had applied.

Treasury and the IRS believe that the inclusion of direct or indirect transfers by tax-exempt entities in the scope of the final regulations furthers the purposes of General Utilities repeal only to the extent that those entities would have been subject to tax had a deemed sale election been made (for example, if a deemed sale election would have generated unrelated business taxable income or would have adversely affected the entity’s tax-exempt status). Accordingly, the proposed regulations would amend the final regulations to provide that the definition of a C corporation excludes tax-exempt entities within the meaning of §1.337(d)–4(c)(2). As a result, transfers of property by a tax-exempt entity to a RIC or REIT (or by a partnership to a RIC or REIT to the extent of a tax-exempt partner’s distributive share of the gain in the transferred property) generally will not be subject to section 1374 treatment. For this purpose, however, an entity will not be considered to be tax-exempt to the extent it would be subject to tax (such as under section 511) under Title 26 of the United States Code with respect to gain (if any) resulting from a deemed sale election if such an election were made under §1.337(d)–7(c)(5) with respect to the transfer. Thus, for example, if a partnership in which a tax-exempt C corporation described in §1.337(d)–4(c)(2) is a partner transfers property to a RIC or REIT in a conversion transaction, and the tax-exempt entity would not have been subject to

unrelated business income tax under section 511 or to tax under any other provision of the Code had the partnership made a deemed sale election in connection with the transfer, the transfer would be excluded from the scope of the final regulations (and the transferee RIC or REIT will not be subject to section 1374 treatment) to the extent of the tax-exempt entity’s distributive share of the built-in gain or loss in the converted property. However, to the extent the tax-exempt partner would have been subject to unrelated business income tax under section 511 or to tax under any other provision of the Code with respect to its distributive share of the built-in gain on the property, the transferee RIC or REIT would be subject to tax on the built-in gain on the property under the rules of section 1374 as if the RIC or REIT were an S corporation unless the transferring partnership elects deemed sale treatment.

Section 1.337(d)–7(e) provides that the principles of §1.337(d)–7 apply to property transferred by a partnership to a RIC or REIT to the extent of any C corporation partner’s distributive share of the gain or loss in the transferred property. The proposed regulations provide that §1.337(d)–7(e) also applies to determine the distributive share of the gain or loss in the transferred property of a C corporation partner of a higher-tier partnership in a tiered partnership structure in which the transferor partnership is a lower-tier partnership.

Special Analyses

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866, as supplemented by Executive Order 13565. Therefore, a regulatory assessment is not required. Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6), it is hereby certified that these proposed regulations would not have a significant economic impact on a substantial number of small entities because the proposed regulations limit the situations in which these regulations apply to all businesses, including small businesses. This certification is based on the fact that these proposed regulations do not create additional obligations for, or impose an economic impact on, small entities. Therefore, a regulatory flexibility analysis is not

2012–21 I.R.B. 947 May 21, 2012

respect to the $25 net built-in gain. See paragraph (d)(3)(ii) of this section.

Example 3 . Section 1031(b) exchange . (i) Facts . The facts are the same as in Example 1, except that immediately before the Year 3 exchange Property A had a value of $92, and X transferred Property A and $8 to Y in exchange for Property B in a transaction that qualified for nonrecognition treatment under section 1031(b).

(ii) Analysis . The transfer of Property B by Y to X is a conversion transaction within the meaning of paragraph (a)(2)(ii) of this section. The conversion transaction qualified for nonrecognition treatment as to Y under section 1031(b) (resulting from the receipt of $8 in money or other property in addition to the replacement property); as a result, Y recognized $8 of its $30 gain, and did not recognize the remaining $22 of gain. Paragraph (a) of this section does not apply to the transaction to the extent of the $8 gain recognized by Y by reason of paragraph (d)(1) of this section, or to the extent of the $22 gain realized but not recognized by Y by reason of paragraph (d)(3)(i) of this section.

Example 4 . Section 1033(a) involuntary conver- sion of property held by a C corporation transferor . (i) Facts . Y owned uninsured, improved property (Property 1) that was involuntarily converted (within the meaning of section 1033(a)) in a fire. Y sold Property 1 for $100 to X, which owned an adjacent property and wanted Property 1 for use as a parking lot. Y had a $70 basis in Property 1 immediately before the sale. Y elected to defer gain recognition under section 1033(a)(2), and purchased qualifying replacement property (Property 2) for $100 from an unrelated party prior to the expiration of the period described in section 1033(a)(2)(B).

(ii) Analysis . The transfer of Property 1 by Y to X is a conversion transaction within the meaning of paragraph (a)(2)(ii) of this section. The conversion transaction (combined with Y’s purchase of Property 2) qualified for nonrecognition treatment under section 1033(a) as to Y; thus, Y did not recognize any of its $30 gain. Therefore, the conversion transaction is not subject to paragraph (a) of this section by reason of paragraph (d)(3)(i) of this section.

Example 5 . Section 1033(a) involuntary conver- sion of property held by a REIT . (i) Facts . X owned property (Property 1). On January 1, Year 2, Property 1 had a fair market value of $100 and a basis of $70, and X was not subject to section 1374 treatment with respect to Property 1. On that date, when Property 1 was under a threat of condemnation, X sold Property 1 to an unrelated party for $100 (First Transaction). X elected to defer gain recognition under section 1033(a)(2), and purchased qualifying replacement property (Property 2) for $100 from Y (Second Transaction) prior to the expiration of the period described in section 1033(a)(2)(B).

(ii) Analysis . The transfer of Property 2 by Y to X in the Second Transaction is a conversion transaction within the meaning of paragraph (a)(2)(ii) of this section. The Second Transaction (combined with the First Transaction) qualified for nonrecognition treatment under section 1033(a) as to X, but not as to Y. Assume no nonrecognition provision applied to Y; thus, Y recognized gain or loss on its sale of Property 2 in the Second Transaction, and the Second Transaction is not subject to paragraph (a) of this section by reason of paragraph (d)(3)(i) of this section.

§1.337(d)–7 Tax on property owned by a C corporation that becomes property of a RIC or REIT.

(a) - * (2) Definitions . For purposes of this section:

(i) C corporation . The term C corpo- ration has the meaning provided in section 1361(a)(2) except that the term does not include a RIC, a REIT, or a tax-exempt entity within the meaning of paragraph (a)(2)(vi) of this section.

(ii) Conversion transaction . The term conversion transaction means the qualification of a C corporation as a RIC or REIT or the transfer of property owned by a C corporation to a RIC or REIT.

(iii) RIC . The term RIC means a regulated investment company within the meaning of section 851(a).

(iv) REIT . The term REIT means a real estate investment trust within the meaning of section 856(a).

(v) S corporation . The term S corpo- ration has the meaning provided in section 1361(a)(1). (vi) Tax-exempt entity . The term tax- exempt entity, with respect to a conversion transaction, means an entity—

(A) Described in §1.337(d)–4(c)(2), and

(B) That would not be subject to tax under Title 26 of the United States Code with respect to gain (if any) resulting from a deemed sale election if such an election were made under paragraph (c)(5) of this section with respect to the conversion transaction.

- - - (d) Exceptions .— (1) Gain otherwise recognized . Paragraph (a) of this section does not apply to any conversion transaction to the extent that gain or loss otherwise is recognized on such conversion transaction by the C corporation that either qualifies as a RIC or a REIT or that transfers property to a RIC or REIT. See, for example, sections 311(b), 336(a), 351(b), 351(e), 356, 357(c), 367, 368(a)(2)(F), 1001, 1031(b), and 1033(b).
- - - (3) Special rules for like-kind ex- changes and involuntary conversions .—(i) In general . Paragraph (a) of this section does not apply to a conversion transaction to the extent that a C corporation transfers

property with a built-in gain to a RIC or REIT and the C corporation’s gain is not recognized by reason of either section 1031 or 1033. (ii) Clarification regarding exchanged property previously subject to section 1374 treatment . Notwithstanding paragraph (d)(3)(i) of this section, if, in a transaction described in paragraph (d)(3)(i) of this section, a RIC or REIT surrenders property that was subject to section 1374 treatment immediately prior to the transaction, the rules of section 1374(d)(6) will apply to continue section 1374 treatment to the replacement property acquired by the RIC or REIT in the transaction.

(iii) Examples . The rules of this paragraph (d)(3) are illustrated by the following examples. In each of the examples, X is a REIT, Y is a C corporation, and X and Y are not related.

Example 1 . Section 1031(a) exchange . (i) Facts . X owned a building that it leased for commercial use (Property A). Y owned a building leased for commercial use (Property B). On January 1, Year 3, Y transferred Property B to X in exchange for Property A in a transaction that qualified for nonrecognition treatment under section 1031(a). Immediately before the exchange, Properties A and B each had a value of $100, X had an adjusted basis of $60 in Property A, Y had an adjusted basis of $70 in Property B, and X was not subject to section 1374 treatment with respect to Property A.

(ii) Analysis . The transfer of property (Property B) by Y (a C corporation) to X (a REIT) is a conversion transaction within the meaning of paragraph (a)(2)(ii) of this section. The conversion transaction qualified for nonrecognition treatment under section 1031(a) as to Y; thus, Y did not recognize any of its $30 gain. Therefore, the conversion transaction is not subject to paragraph (a) of this section by reason of paragraph (d)(3)(i) of this section.

Example 2 . Section 1031(a) exchange of section 1374 property . (i) Facts . The facts are the same as in Example 1, except that X had acquired Property A in a conversion transaction in Year 2, and immediately before the Year 3 exchange X was subject to section 1374 treatment with respect to $25 of net built-in gain in Property A.

(ii) Analysis . The Year 3 transfer of Property B by Y to X is a conversion transaction within the meaning of paragraph (a)(2)(ii) of this section. The conversion transaction qualified for nonrecognition treatment under section 1031(a) as to Y; thus, Y did not recognize any of its $30 gain. Therefore, the Year 3 transfer is not subject to paragraph (a) of this section by reason of paragraph (d)(3)(i) of this section. However, X had been subject to section 1374 treatment with respect to $25 of net built-in gain in Property A immediately before the Year 3 transfer, and X’s basis in Property B is determined (in whole or in part) by reference to its adjusted basis in Property A. Accordingly, the rules of section 1374(d)(6) apply and X is subject to section 1374 treatment on Property B with

May 21, 2012 948 2012–21 I.R.B.

(e) Special rule for partnerships —(1) In general . The principles of this section apply to property transferred by a partnership to a RIC or REIT to the extent of any gain or loss in the converted property that would be allocated directly or indirectly, through one or more partnerships, to a C corporation if the partnership sold the converted property to an unrelated party at fair market value on the deemed sale date (as defined in paragraph (c)(3) of this section). If the partnership were to elect deemed sale treatment under paragraph (c) of this section in lieu of section 1374 treatment under paragraph (b) of this section with respect to such transfer, then any net gain recognized by the partnership on the deemed sale must be allocated to the C corporation partner, but does not increase the capital account of any partner. Any adjustment to the partnership’s basis in the RIC or REIT stock as a result of deemed sale treatment under paragraph (c) of this section shall constitute an adjustment to the basis of that stock with respect to the C corporation partner only. The principles of section 743 apply to such basis adjustment.

(2) Example . Transfer by partnership of prop- erty to REIT . (i) Facts . PRS, a partnership for Federal income tax purposes, has three partners: TE, a tax-exempt entity (within the meaning of §1.337(d)–7(a)(2)(vi)), owns 50 percent of the capital and profits of PRS; A, an individual, owns 30 percent of the capital and profits of PRS; and Y, a C corporation (within the meaning of §1.337(d)–7(a)(2)(i)), owns the remaining 20 percent. PRS owns a building that it leases for commercial use (Property 1). On January 1, Year 2, when PRS has an adjusted basis in Property 1 of $100 and Property 1 has a fair market value of $500, PRS transfers Property 1 to X, a REIT, in exchange for stock of X in an exchange described in section 351. PRS does not elect deemed sale treatment under paragraph (c) of this section.

(ii) Analysis . The transfer of Property 1 by PRS to X is a conversion transaction within the meaning of paragraph (a)(2)(ii) of this section to the extent of any gain or loss that would be allocated to any C corporation partner if PRS sold Property 1 at fair market value to an unrelated party on the deemed sale date. Y is a C corporation, but neither TE nor A is a C corporation within the meaning of paragraph (a)(2)(i) of this section. Therefore, the transfer of Property 1 by PRS to X is a conversion transaction within the meaning of paragraph (a)(2)(ii) of this section to the extent of Y’s share of any such gain of PRS in Property 1. If PRS were to sell Property 1 to an unrelated party at fair market value on the deemed sale date, PRS would allocate $80 of built-in gain to Y. Thus, X is subject to section 1374 treatment on Property 1 with respect to $80 of built-in gain.

(f) Effective/Applicability date - (1) In general . Except as provided in paragraph

(f)(2) of this section, this section applies to conversion transactions that occur on or after January 2, 2002. For conversion transactions that occurred on or after June 10, 1987, and before January 2, 2002, see §§1.337(d)–5 and 1.337(d)–6.

(2) Special rule . Paragraphs (a)(2), (d)(1), (d)(3) and (e) of this section apply to conversion transactions that occur on or after [INSERT DATE OF PUBLI- CATION OF THE TREASURY DECI- SION ADOPTING THESE RULES AS FINAL REGULATIONS IN THE FED- ERAL REGISTER] . However, taxpayers may apply paragraphs (a)(2), (d)(1), (d)(3) and (e) of this section to conversion transactions that occurred before [INSERT DATE OF PUBLICATION OF THE TREASURY DECISION ADOPTING THESE RULES AS FINAL REGULA- TIONS IN THE FEDERAL REGIS- TER] . For conversion transactions that occurred on or after January 2, 2002 and before [INSERT DATE OF PUBLICA- TION OF THE TREASURY DECI- SION ADOPTING THESE RULES AS FINAL REGULATIONS IN THE FED- ERAL REGISTER], see §1.337(d)–7 as contained in 26 CFR part 1 in effect on April 1, 2011.

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

(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, 77 F.R. 22516)

Notice of Proposed Rulemaking

Examples of Program-Related Investments

REG–144267–11

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

SUMMARY: This document contains proposed regulations that provide guidance to private foundations on program-related investments. These proposed regulations provide a series of new examples illustrating investments that qualify as program

related investments. In addition to private foundations, these proposed regulations affect foundation managers who participate in the making of program-related investments.

DATES: Comments and requests for a public hearing must be received by July 18, 2012.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG–144267–11), room 5205, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand-delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG–144267–11), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC, or sent electronically via the Federal eRulemaking Portal at http://www.regulations.gov/ (IRS REG–144267–11).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, Courtney D. Jones at (202) 622–6070; concerning submissions of comments and requests for a public hearing, Oluwafunmilayo Taylor, (202) 622–7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

Section 4944(a) of the Internal Revenue Code (Code) imposes an excise tax on a private foundation that makes an investment that jeopardizes the carrying out of any of the private foundation’s exempt purposes (a “jeopardizing investment”). Section 4944(a) also imposes an excise tax on foundation managers who knowingly participate in the making of a jeopardizing investment. Section 4944(b) imposes additional excise taxes on private foundations and foundation managers when investments are not timely removed from jeopardy.

Generally, under §53.4944–1(a)(2), a jeopardizing investment occurs when, based on the facts and circumstances at the time the investment is made, foundation managers fail to exercise ordinary business care and prudence in providing for the long- and short-term financial needs of the foundation. The determination of whether

2012–21 I.R.B. 949 May 21, 2012

Explanation of Provisions

The proposed regulations add nine new examples that illustrate that a wider range of investments qualify as PRIs than the range currently presented in §53.4944–3(b). The proposed regulations do not modify the existing regulations; rather, they provide additional examples that illustrate the application of the existing regulations. Generally, the charitable activities illustrated in the new examples are based on published guidance and on financial structures described in private letter rulings.

The new examples demonstrate that a PRI may accomplish a variety of charitable purposes, such as advancing science, combating environmental deterioration, and promoting the arts. Several examples also demonstrate that an investment that funds activities in one or more foreign countries, including investments that alleviate the impact of a natural disaster or that fund educational programs for poor individuals, may further the accomplishment of charitable purposes and qualify as a PRI. One example illustrates that the existence of a high potential rate of return on an investment does not, by itself, prevent the investment from qualifying as a PRI. Another example illustrates that a private foundation’s acceptance of an equity position in conjunction with making a loan does not necessarily prevent the investment from qualifying as a PRI, and two examples illustrate that a private foundation’s provision of credit enhancement can qualify as a PRI.

The last example demonstrates that a guarantee arrangement may qualify as a PRI. The proposed regulations address solely the impact of section 4944 on the facts described and do not address whether there is a qualifying distribution under section 4942. However, the Treasury Department and the IRS conclude that, based on the facts described in the last example, there would be no qualifying distribution under section 4942 at the time the foundation enters into the guarantee arrangement. Under certain circumstances, a private foundation may treat payments made under a guarantee arrangement as qualifying distributions.

Finally, the proposed regulations include examples illustrating that loans and capital may be provided to individuals

an investment is a jeopardizing investment is made on an investment-by-investment basis, taking into account the private foundation’s entire portfolio. In exercising the requisite standard of care and prudence, foundation managers may take into account the expected investment return, price volatility, and the need for portfolio diversification.

Section 4944(c) excepts program-related investments (“PRIs”) from treatment as jeopardizing investments. The regulations under section 4944(c) define a PRI as an investment: (1) the primary purpose of which is to accomplish one or more of the purposes described in section 170(c)(2)(B); (2) no significant purpose of which is the production of income or the appreciation of property; and (3) no purpose of which is to accomplish one or more of the purposes described in section 170(c)(2)(D) (attempting to influence legislation or participating in or intervening in any political campaign).

An investment is made primarily to accomplish one or more of the purposes described in section 170(c)(2)(B) (referred to as “charitable purposes”) if it significantly furthers the accomplishment of the private foundation’s exempt activities and would not have been made but for the relationship between the investment and the accomplishment of those exempt activities. In determining whether a significant purpose of an investment is the production of income or the appreciation of property, §53.4944–3(a)(2)(iii) provides that it shall be relevant whether investors who are engaged in the investment solely for the production of income would be likely to make the investment on the same terms as the private foundation.

The regulations under other Code sections in Chapter 42 accord special tax treatment to PRIs. For example, §53.4942(a)–2(c)(3)(ii)(d) excludes PRIs from the assets a private foundation takes into account when determining how much it must distribute under section 4942 as a “distributable amount” for the taxable year. In addition, §53.4942(a)–3(a)(2)(i) generally includes distributions that qualify as PRIs as “qualifying distributions” for purposes of meeting the distribution requirements under section 4942. Section 53.4943–10(b) excludes PRIs from being treated as business holdings for the

purpose of calculating excess business holdings subject to excise tax under section 4943. Sections 53.4945–5(b)(4) and 53.4945–6(c)(1)(i) also make clear that PRIs will not constitute taxable expenditures under section 4945, provided the private foundation exercises “expenditure responsibility” in circumstances in which it is required to do so. Among other expenditure responsibility requirements, a private foundation must require a written commitment from the recipient of the PRI that the funds received will be used only for the purposes of the program-related investment. As noted, the primary purpose of a program-related investment must be the accomplishment of a charitable purpose.

Section 53.4944–3(b) contains nine examples illustrating investments that qualify as PRIs and one example of an investment that does not qualify as a PRI. The existing examples focus on domestic situations principally involving economically disadvantaged individuals and deteriorated urban areas.

The Treasury Department and the IRS are aware that the private foundation community would find it helpful if the regulations could include additional PRI examples that reflect current investment practices and illustrate certain principles, including that: (1) an activity conducted in a foreign country furthers a charitable purpose if the same activity would further a charitable purpose if conducted in the United States; (2) the charitable purposes served by a PRI are not limited to situations involving economically disadvantaged individuals and deteriorated urban areas; (3) the recipients of PRIs need not be within a charitable class if they are the instruments for furthering a charitable purpose; (4) a potentially high rate of return does not automatically prevent an investment from qualifying as program-related; (5) PRIs can be achieved through a variety of investments, including loans to individuals, tax-exempt organizations and for-profit organizations, and equity investments in for-profit organizations; (6) a credit enhancement arrangement may qualify as a PRI; and (7) a private foundation’s acceptance of an equity position in conjunction with making a loan does not necessarily prevent the investment from qualifying as a PRI.

May 21, 2012 950 2012–21 I.R.B.

investment is to advance science. No significant purpose of the investment involves the production of income or the appreciation of property. The investment significantly furthers the accomplishment of Y’s exempt activities and would not have been made but for such relationship between the investment and Y’s exempt activities. Accordingly, the purchase of the common stock of S is a program-related investment.

Example 12 . Q, a developing country, produces a substantial amount of recyclable solid waste materials that are currently disposed of in landfills and by incineration, contributing significantly to environmental deterioration in Q. X is a new business enterprise located in Q. X’s only activity will be collecting recyclable solid waste materials in Q and delivering those materials to recycling centers that are inaccessible to a majority of the population. If successful, the recycling collection business would prevent pollution in Q caused by the usual disposition of solid waste materials. X has obtained funding from only a few commercial investors who are concerned about the environmental impact of solid waste disposal. Although X made substantial efforts to procure additional funding, X has not been able to obtain sufficient funding because the expected rate of return is significantly less than the acceptable rate of return on an investment of this type. Because X has been unable to attract additional investors on the same terms as the initial investors, Y, a private foundation, enters into an investment agreement with X to purchase shares of X’s common stock on the same terms as X’s initial investors. Although there is a high risk associated with the investment in X, there is also the potential for a high rate of return if X is successful in the recycling business in Q. Y’s primary purpose in making the investment is to combat environmental deterioration. No significant purpose of the investment involves the production of income or the appreciation of property. The investment significantly furthers the accomplishment of Y’s exempt activities and would not have been made but for such relationship between the investment and Y’s exempt activities. Accordingly, the purchase of the common stock is a program-related investment.

Example 13 . Assume the facts as stated in Exam- ple 12, except that X offers Y shares of X’s common stock in order to induce Y to make a below-market rate loan to X. X previously made the same offer to a number of commercial investors. These investors were unwilling to provide loans to X on such terms because the expected return on the combined package of stock and debt was below the expected market return for such an investment based on the level of risk involved, and they were also unwilling to provide loans on other terms X considers economically feasible. Y accepts the stock and makes the loan on the same terms that X offered to the commercial investors. Y plans to liquidate its stock in X as soon as the recycling collection business in Q is profitable or it is established that the business will never become profitable. Y’s primary purpose in making the investment is to combat environmental deterioration. No significant purpose of the investment involves the production of income or the appreciation of property. The investment significantly furthers the accomplishment of Y’s exempt activities and would not have been made but for such relationship between the

or entities that are not within a charitable class themselves, if the recipients are the instruments through which the private foundation accomplishes its exempt activities.

Proposed Effective/Applicability Date

Paragraph (b), Examples 11 through 19 of this section will be effective on the date of publication of the Treasury decision adopting these examples as final regulations in the Federal Register . Taxpayers may rely on paragraph (b), Examples 11 through 19 of this section before these proposed regulations are finalized.

Special Analyses

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

Comments and Requests for Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any comments that are submitted timely to the IRS as prescribed in this preamble under the “Addresses” heading. The IRS and the Treasury Department request comments on all aspects of the proposed rules. All comments will be available at www.regulations.gov or upon request. A public hearing will be scheduled if requested in writing by any person that timely submits written comments. If a public hearing is scheduled, notice of the date, time, and place for the public hearing will be published in the Federal Register .

Drafting Information

The principal author of these proposed regulations is Courtney D. Jones, Office of the Chief Counsel (Tax Exempt and Government Entities). However, other personnel from the Treasury Department and the IRS participated in their development.

- - - -

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 53 is proposed to be amended as follows:

Part 53—FOUNDATION AND SIMILAR EXCISE TAXES

Par. 1. The authority citation for part 53 continues to read in part as follows: Authority: 26 U.S.C. 7805 * * * Par. 2. Section 53.4944–3 is amended by adding Examples 11, 12, 13, 14, 15, 16, 17, 18, and 19 to paragraph (b) and adding paragraph (c) to read as follows:

§53.4944–3. Exception for program-related investments .

- - - (b) - * Example 11 . X is a business enterprise that researches and develops new drugs. X’s research demonstrates that a vaccine can be developed within ten years to prevent a disease that predominantly affects poor individuals in developing countries. However, neither X nor other commercial enterprises like X will devote their resources to develop the vaccine because the potential return on investment is significantly less than required by X or other commercial enterprises to undertake a project to develop new drugs. Y, a private foundation, enters into an investment agreement with X in order to induce X to develop the vaccine. Pursuant to the investment agreement, Y purchases shares of the common stock of S, a subsidiary corporation that X establishes to research and develop the vaccine. The agreement requires S to distribute the vaccine to poor individuals in developing countries at a price that is affordable to the affected population. The agreement also requires S to publish the research results, disclosing substantially all information about the results that would be useful to the interested public. S agrees that the publication of its research results will be made as promptly after the completion of the research as is reasonably possible without jeopardizing S’s right to secure patents necessary to protect its ownership or control of the results of the research. The expected rate of return on Y’s investment in S is less than the expected market rate of return for an investment of similar risk. Y’s primary purpose in making the

2012–21 I.R.B. 951 May 21, 2012

investment and Y’s exempt activities. Accordingly, the loan accompanied by the acceptance of common stock is a program-related investment.

Example 14 . X is a business enterprise located in V, a rural area in State Z. X employs a large number of poor individuals in V. A natural disaster occurs in V, causing significant damage to the area. The business operations of X are harmed because of damage to X’s equipment and buildings. X has insufficient funds to continue its business operations and conventional sources of funds are unwilling or unable to provide loans to X on terms it considers economically feasible. In order to enable X to continue its business operations, Y, a private foundation, makes a loan to X bearing interest below the market rate for commercial loans of comparable risk. Y’s primary purpose in making the loan is to provide relief to the poor and distressed. No significant purpose of the loan involves the production of income or the appreciation of property. The loan significantly furthers the accomplishment of Y’s exempt activities and would not have been made but for such relationship between the loan and Y’s exempt activities. Accordingly, the loan is a program-related investment.

Example 15 . A natural disaster occurs in W, a developing country, causing significant damage to W’s infrastructure. Y, a private foundation, makes loans bearing interest below the market rate for commercial loans of comparable risk to H and K, poor individuals who live in W, to enable each of them to start a small business. H will open a roadside fruit stand. K will start a weaving business. Conventional sources of funds were unwilling or unable to provide loans to H or K on terms they consider economically feasible. Y’s primary purpose in making the loans is to provide relief to the poor and distressed. No significant purpose of the loans involves the production of income or the appreciation of property. The loans significantly further the accomplishment of Y’s exempt activities and would not have been made but for such relationship between the loans and Y’s exempt activities. Accordingly, the loans to H and K are program-related investments.

Example 16 . X is a limited liability company treated as a partnership for federal income tax purposes. X purchases coffee from poor farmers residing in a developing country, either directly or through farmer-owned cooperatives. To fund the provision of efficient water management, crop cultivation, pest management, and farm management training to the poor farmers by X, Y, a private foundation, makes a loan to X bearing interest below the market rate for commercial loans of comparable risk. The loan agreement requires X to use the proceeds from the loan to provide the training to the poor farmers. X would not provide such training to the poor farmers absent the loan. Y’s primary purpose in making the

loan is to educate poor farmers about advanced agricultural methods. No significant purpose of the loan involves the production of income or the appreciation of property. The loan significantly furthers the accomplishment of Y’s exempt activities and would not have been made but for such relationship between the loan and Y’s exempt activities. Accordingly, the loan is a program-related investment.

Example 17 . X is a social welfare organization that is recognized as an organization described in section 501(c)(4). X was formed to develop and encourage interest in painting, sculpture and other art forms by, among other things, conducting weekly community art exhibits. X needs to purchase a large exhibition space to accommodate the demand for exhibition space within the community. Conventional sources of funds are unwilling or unable to provide funds to X on terms it considers economically feasible. Y, a private foundation, makes a loan to X at an interest rate below the market rate for commercial loans of comparable risk to fund the purchase of the new space. Y’s primary purpose in making the loan is to promote the arts. No significant purpose of the loan involves the production of income or the appreciation of property. The loan significantly furthers the accomplishment of Y’s exempt activities and would not have been made but for such relationship between the loan and Y’s exempt activities. Accordingly, the loan is a program-related investment.

Example 18 . X is a non-profit corporation that provides child care services in a low-income neighborhood, enabling many residents of the neighborhood to be gainfully employed. X meets the requirements of section 501(k) and is recognized as an organization described in section 501(c)(3). X’s current child care facility has reached capacity and has a long waiting list. X has determined that the demand for its services warrants the construction of a new child care facility in the same neighborhood. X is unable to obtain a loan from conventional sources of funds including B, a commercial bank, because X lacks sufficient credit to support the financing of a new facility. Pursuant to a deposit agreement, Y, a private foundation, deposits $h in B, and B lends an identical amount to X to construct the new child care facility. The deposit agreement requires Y to keep $h on deposit with B during the term of X’s loan and provides that if X defaults on the loan, B may deduct the amount of the default from the deposit. To facilitate B’s access to the funds in the event of default, the agreement requires that the funds be invested in instruments that allow B to access them readily. The deposit agreement also provides that Y will earn interest at a rate of t% on the deposit. The t% rate is substantially less than Y could otherwise earn on this sum of money, if Y invested it elsewhere. The loan agreement between B and X requires X to use the proceeds from the loan to

construct the new child care facility. Y’s primary purpose in making the deposit is to further its educational purposes by enabling X to provide child care services within the meaning of section 501(k). No significant purpose of the deposit involves the production of income or the appreciation of property. The deposit significantly furthers the accomplishment of Y’s exempt activities and would not have been made but for such relationship between the deposit and Y’s exempt activities. Accordingly, the deposit is a program-related investment.

Example 19 . Assume the same facts as stated in Example 18, except that instead of making a deposit of $h into B, Y enters into a guarantee agreement with B. The guarantee agreement provides that if X defaults on the loan, Y will repay the balance due on the loan to B. B was unwilling to make the loan to X in the absence of Y’s guarantee. X must use the proceeds from the loan to construct the new child care facility. At the same time, X and Y enter into a reimbursement agreement whereby X agrees to reimburse Y for any and all amounts paid to B under the guarantee agreement. The signed guarantee and reimbursement agreements together constitute a “guarantee and reimbursement arrangement.” Y’s primary purpose in entering into the guarantee and reimbursement arrangement is to further Y’s educational purposes. No significant purpose of the guarantee and reimbursement arrangement involves the production of income or the appreciation of property. The guarantee and reimbursement arrangement significantly furthers the accomplishment of Y’s exempt activities and would not have been made but for such relationship between the guarantee and reimbursement arrangement and Y’s exempt activities. Accordingly, the guarantee and reimbursement arrangement is a program-related investment.

(c) Effective/applicability date . Paragraph (b), Examples 11 through 19 of this section will be effective on the date of publication of the Treasury decision adopting these examples as final regulations in the Federal Register . Taxpayers may rely on paragraph (b), Examples 11 through 19 of this section before these proposed regulations are finalized.

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

(Filed by the Office of the Federal Register on April 18, 2012, 8:45 a.m., and published in the issue of the Federal Register for April 19, 2012, 77 F.R. 23429)

May 21, 2012 952 2012–21 I.R.B.