Bulletin No. 1996–52

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December 23, 1996

HIGHLIGHTS

OF THIS ISSUE

These synopses are intended only as aids to the reader in

identifying the subject matter covered. They may not be relied

upon as authoritative interpretations.

INCOME TAX

Rev. Rul. 96–61, page 24.

Interest rates; underpayments and overpayments.

The rate of interest determined under section 6621 of

the Code for the calendar quarter beginning January 1,

1997, will be 8 percent for overpayments, 9 percent for

underpayments, and 11 percent for large corporate

underpayments. The rate of interest paid on the portion

of a corporate overpayment exceeding $10,000 is 6.5

percent.

T.D. 8687, page 4.

Final regulations under section 863 of the Code governs

the source of income from sales of natural resources or

other inventory produced in and sold outside the United

States.

Notice 96–68, page 30.

Definitions relating to application of exclusion under

section 127. This notice provides guidance regarding

the definitions of the terms “graduate level course” and

“courses beginning.”

EXEMPT ORGANIZATIONS

Announcement 96–131, page 32.

A list is given of organizations now classified as private

foundations.

ESTATE TAX

T.D. 8686, page 14.

Final regulations provide guidance relating to the additional requirements necessary to ensure the collection

Finding Lists begin on page 36.

Announcement of Disbarments and Suspensions begins on page 34.

of estate taxes imposed under section 2056A of the

Code with respect to taxable events involving qualified

domestic trusts (QDOTs).

EXCISE TAX

Announcement 96–130, page 32.

Effective after December 31, 1996, the tax rates for

aviation gasoline and aviation fuel taxes have changed.

The rate and base amount imposed on luxury passenger

vehicles have also changed. Ozone-depleting chemical

rates for 1997 are included in this announcement. Also,

excise taxes on transportation expire December 31,

1996.

ADMINISTRATIVE

Notice 96–65, page 28.

This notice provides guidance for certain provisions of

the Small Business Job Protection Act of 1996 (the

“Act”) dealing with the status of a trust as domestic or

foreign under sections 7701(a)(30) and 7701(a)(31) of

the Code. This notice grants taxpayers additional time to

comply with the new domestic trust criteria contained in

the Act and announces the time and manner for making

an election to apply the new trust criteria retroactively.

Also, guidance regarding the application of sections

1491 through 1494 of the Code is provided if the status

of a trust changes from domestic to foreign.

Announcement 96–132, page 33.

Orthopaedic Development Foundation, Hilton Head, SC,

no longer qualifies as an organization to which contributions are deductible under section 170 of the Code.

Mission of the Service

The purpose of the Internal Revenue Service is to

collect the proper amount of tax revenue at the least

cost; serve the public by continually improving the

quality of our products and services; and perform in a

manner warranting the highest degree of public

confidence in our integrity, efficiency and fairness.

Statement of Principles

of Internal Revenue

Tax Administration

The Service also has the responsibility of applying

and administering the law in a reasonable,

practical manner. Issues should only be raised by

examining of ficers when they have merit, never

arbitrarily or for trading purposes. At the same

time, the examining officer should never hesitate

to raise a meritorious issue. It is also important

that care be exercised not to raise an issue or to

ask a court to adopt a position inconsistent with

an established Service position.

The function of the Internal Revenue Service is to

administer the Internal Revenue Code. Tax policy

for raising revenue is determined by Congress.

With this in mind, it is the duty of the Service to

carry out that policy by correctly applying the laws

enacted by Congress; to determine the reasonable

meaning of various Code provisions in light of the

Congressional purpose in enacting them; and to

perform this work in a fair and impartial manner,

with neither a government nor a taxpayer point of view.

Administration should be both reasonable and

vigorous. It should be conducted with as little

delay as possible and with great cour tesy and

considerateness. It should never try to overreach,

and should be reasonable within the bounds of law

and sound administration. It should, however, be

vigorous in requiring compliance with law and it

should be relentless in its attack on unreal tax

devices and fraud.

At the heart of administration is interpretation of the

Code. It is the responsibility of each person in the

Service, charged with the duty of interpreting the

law, to try to find the true meaning of the statutory

provision and not to adopt a strained construction in

the belief that he or she is ‘‘protecting the revenue.’’

The revenue is properly protected only when we ascertain and apply the true meaning of the statute.

Introduction

The Internal Revenue Bulletin is the authoritative instrument of the Commissioner of Internal Revenue for

announcing official rulings and procedures of the Internal Revenue Service and for publishing Treasury Decisions, Executive Orders, Tax Conventions, legislation,

court decisions, and other items of general interest. It is

published weekly and may be obtained from the Superintendent of Documents on a subscription basis. Bulletin

contents of a permanent nature are consolidated semiannually into Cumulative Bulletins, which are sold on a

single-copy basis.

court decisions, rulings, and procedures must be considered, and Service personnel and others concerned are

cautioned against reaching the same conclusions in

other cases unless the facts and circumstances are

substantially the same.

The Bulletin is divided into four parts as follows:

Part I.—1986 Code.

This part includes rulings and decisions based on

provisions of the Internal Revenue Code of 1986.

It is the policy of the Service to publish in the Bulletin all

substantive rulings necessary to promote a uniform

application of the tax laws, including all rulings that

supersede, revoke, modify, or amend any of those

previously published in the Bulletin. All published rulings

apply retroactively unless otherwise indicated. Procedures relating solely to matters of internal management

are not published; however, statements of internal

practices and procedures that affect the rights and

duties of taxpayers are published.

Part II.—Treaties and Tax Legislation.

This part is divided into two subparts as follows:

Subpart A, Tax Conventions, and Subpart B, Legislation

and Related Committee Reports.

Part III.—Administrative, Procedural, and Miscellaneous.

To the extent practicable, pertinent cross references to

these subjects are contained in the other Parts and

Subparts. Also included in this part are Bank Secrecy

Act Administrative Rulings. Bank Secrecy Act Administrative Rulings are issued by the Department of the

Treasury’s Office of the Assistant Secretary (Enforcement).

Revenue rulings represent the conclusions of the Service on the application of the law to the pivotal facts

stated in the revenue ruling. In those based on positions

taken in rulings to taxpayers or technical advice to

Service field offices, identifying details and information

of a confidential nature are deleted to prevent unwarranted invasions of privacy and to comply with statutory

requirements.

Part IV.—Items of General Interest.

With the exception of the Notice of Proposed Rulemaking and the disbarment and suspension list included in

this part, none of these announcements are consolidated in the Cumulative Bulletins.

Rulings and procedures reported in the Bulletin do not

have the force and effect of Treasury Department

Regulations, but they may be used as precedents.

Unpublished rulings will not be relied on, used, or cited

as precedents by Service personnel in the disposition of

other cases. In applying published rulings and procedures, the effect of subsequent legislation, regulations,

The first Bulletin for each month includes an index for

the matters published during the preceding month.

These monthly indexes are cumulated on a quarterly and

semiannual basis, and are published in the first Bulletin

of the succeeding quarterly and semi-annual period,

respectively.

The contents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.

For sale by the Superintendent of Documents U.S. Government Printing Office, Washington, D.C. 20402.

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

Section 863.—Special Rules for

Determining Source

26 CFR 1.863–3: Allocation and apportionment of

income from certain sales of inventory.

T.D. 8687

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

Source of Income From Sales of

Inventory and Natural Resources

Produced in One Jurisdiction and

Sold in Another Jurisdiction

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Final and temporary regulations.

SUMMARY: This document contains

regulations governing the source of income from sales of natural resources or

other inventory produced in the United

States and sold outside the United States

or produced outside the United States

and sold in the United States. This

document affects persons who produce

natural resources or other inventory in

the United States and sell outside the

United States, or produce natural resources or other inventory outside the

United States and sell in the United

States.

EFFECTIVE DATE: December 30,

1996.

Applicability: Taxpayers may apply

these regulations for taxable years beginning after July 11, 1995, and on or

before December 30, 1996.

FOR FURTHER INFORMATION CONTACT: Anne Shelburne, (202) 622–3880

(not a toll free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in this final regulation has been

reviewed and approved by the Office of

Management and Budget in accordance

with the requirements of the Paperwork

Reduction Act (44 U.S.C. 3507) under

control number 1545–1476. Responses

to this collection of information are

mandatory.

An agency may not conduct or sponsor, and a person is not required to

respond to, a collection of information

unless the collection of information displays a valid control number.

The estimated average annual burden

per respondent is approximately 2.6

hours.

Comments concerning the accuracy of

this burden estimate and suggestions for

reducing this burden should be sent to

the Internal Revenue Service, Attn:

IRS Reports Clearance Officer, T:FP,

Washington, DC 20224, and the Office

of Management and Budget, Attn:

Desk Officer for the Department of the

Treasury, Office of Information and

Regulatory Affairs, Washington, DC,

20503.

Books or records relating to this collection of information must be retained

as long as their contents may become

material in the administration of any

internal revenue law. Generally, tax returns and tax return information are

confidential, as required by 26 U.S.C.

6103.

Background

This document contains final regulations to be added to the Income Tax

Regulations (26 CFR part 1) under

section 863 of the Internal Revenue

Code (Code). The final regulations provide rules for allocating and apportioning income between U.S. and foreign

sources from natural resources and other

inventory produced in the United States

and sold outside the United States, or

produced outside the United States and

sold in the United States.

On December 11, 1995, proposed

regulations [INTL–0003–95 (1996–1

C.B. 831)] were published in the Federal Register (60 FR 63478). The IRS

received written comments on the proposed regulations and held a public

hearing on April 10, 1996. Having considered the comments and the statements

made at the hearing, the IRS and the

Treasury Department adopt the proposed

regulations as modified by this Treasury

decision. The comments and revisions

are discussed below.

Explanation of Provisions

I. Allocation of gross income from sales

of natural resources under section 863(a)

Section 1.863–1(b) of the proposed

regulations relate to the rules governing

natural resources. The proposed regulations provide three methods for determining the amount of United States or

foreign source income from sales of

natural resources. One method (derived

from the existing regulations) sources

income in its entirety to the location of

the natural resources, and applies where

the taxpayer does not engage in substantial additional production beyond production of the natural resources. The

second method, the export terminal rule,

splits sales income at the export terminal, sourcing gross receipts equal to the

fair market value at the export terminal

to the location of the natural resources,

and gross receipts in excess of that

amount either to the place of sale or

according to the rules in § 1.863–3,

depending on the circumstances. The

third method requires taxpayers performing additional production in the

country where the natural resources are

located, to split gross receipts at the

point of the additional production,

sourcing gross receipts equal to the fair

market value prior to that point to the

location of the natural resources and

gross receipts in excess of that amount

according to the rules in § 1.863–3.

1. Implications of the Tenth Circuit’s

Order in Phillips

Section 1.863–1(b)(1)(i) of the proposed regulations sources certain income

from natural resources in its entirety to

the location of the resources. The preamble to the proposed regulations states

that Treasury and the IRS would consider the Tenth Circuit’s unpublished

opinion in its Order and Judgment in

Phillips Petroleum v. Comm’r, 97 T.C.

30 (1991), 101 T.C. 78 (1993), aff’d.

without published opinion, 70 F.3d 1282

(10th Cir., 1995), in finalizing the regulations. In Phillips, the Tax Court ruled

§ 1.863–1(b)’s natural resource regulation, generally sourcing income from

U.S. natural resources in its entirety to

the United States, invalid to the extent it

conflicted with the Court’s interpretation

of section 863(b)(2). That section provides that gains, profits and income

from the sale of inventory property

produced within and sold without the

United States (or vice versa) shall be

treated as derived partly from sources

within and partly from sources without

the United States. The Tenth Circuit

affirmed the Tax Court.

In view of Phillips, the final regulations modify the proposed regulations to

eliminate the 100 percent allocation rule,

making the determination of the source

of income subject instead to the export

terminal rule. Thus, gross receipts equal

to the fair market value of the product

at the export terminal are allocated to

the location of the farm, mine, well,

deposit or uncut timber, with the source

of gross receipts from such sales in

excess of the product’s fair market value

at the export terminal allocated to the

country of sale.

Several commentators requested that

any change to the natural resource rules

made in light of Phillips be done in

proposed form, providing opportunity to

comment on the regulations. However,

because the final regulations merely

eliminate the rule which required a

single source of income for sales of

natural resources, and because Treasury

and the IRS believe that there has been

adequate opportunity to comment on the

proposed regulations’ export terminal

rule, the natural resources rules are

issued in final form.

2. Availability of the 50/50 method for

natural resources

Several commentators wrote that there

is no basis for treating natural resources

differently than other inventory. Therefore, producers of natural resources

should be permitted to determine the

source of their income under the 50/50

method described in § 1.863–3(b)(1).

They point to legislation enacted in the

Tax Reform Act of 1986, arguing that

Congress, in enacting section 865 to

govern personal property sales, drew no

distinction between sales of natural resources and sales of other inventory.

Commentators have also pointed to section 865(b), enacted in 1993, providing

that income from sales of U.S. softwood

must be U.S. source in its entirety. They

conclude that Congress was aware of

the Tax Court’s decision in Phillips,

overruling Phillips only for softwood,

but intending that all other natural resources be sourced under the 50/50

method.

Treasury and the IRS do not believe

that Congress in the 1986 Act evidenced

an intent to source all income from sales

of natural resources under the 50/50

method. Rather, Congress merely referred to the 50/50 method to generally

describe the methods for sourcing income from certain types of inventory

sales. In addition, the legislative history

to the 1993 Act, requiring income from

softwood sales to be allocated in its

entirety to the United States, does not

suggest that Congress intended to overturn the longstanding regime governing

sales of other natural resources. Moreover, the Small Business Job Protection

Act of 1996, Public Law 104–188 (August 20, 1996) (the 1996 Act), further

clarifies that the Service is not required

to apply the 50/50 method. Prior to the

1996 Act, section 865(b) provided that

income from inventory sales was to be

sourced under sections 861(a)(6),

862(a)(6), and 863(b). The 1996 Act, in

section 1704(f)(4)(A), amended Code

section 865(b)(2) by striking 863(b) and

inserting 863. The Act makes this

amendment effective as if included in

amendments made by section 1211 of

the Tax Reform Act of 1986 (Public

Law 99–514). This technical correction

to the 1986 Act clarifies that Treasury

has broad authority to provide rules

sourcing income from sales of inventory

under section 863, and is not restricted

to any particular method.

Treasury and the IRS also believe

longstanding distinctions have been

made in the tax treatment of natural

resources and other property, both in our

tax laws and in our tax treaties. Most

treaties, for example, grant primary or

exclusive taxing jurisdiction to the country where natural resources are located.

Thus, income from sales of natural

resources is treated differently than income derived from sales of other inventory, which is normally subject to the

business profits article of a treaty. See,

e.g., Article 6 of the United States

Model Income Tax Convention (September 20, 1996), which provides that income from real property, ‘‘including

income from agriculture and forestry’’

may be taxed by the country where the

resources are located.

The legislative history to section

863’s predecessor, section 217(e) of the

Revenue Act of 1921, also reflects an

intention that natural resources be

treated differently from other property.

The House version of section 217 (H.R.

8245, 67th Cong., 1st Sess. (Aug.20,

1921)) included a provision sourcing

income from natural resources in its

entirety to the location of the resources.

However, based on testimony raising the

possibility of a case where such a single

source rule should not apply, the Senate

struck the provision that allocated all of

the income from natural resources to a

single country. (H.R. 8245 (67th Cong.,

1st Sess. (November 4, 1921)); Hearings

Before The Committee on Finance,

United States Senate, H.R. 8245, 67th

Cong., 1st Sess. (September 1 to October 1, 1921), at 309–310. A provision

similar to that considered by the House,

but with flexibility available for unusual

cases, was then added to the regulations

promulgated in 1922.

Thus, Treasury and the IRS believe

that income from natural resources

should be sourced differently than income from other sales of inventory.

3. Clarification

§ 1.863–2

language

In response to a comment, the final

regulations are modified to clarify that

the source of income from sales of

natural resources must be determined

solely under the rules set forth in

§ 1.863–1(b) of the final regulations.

Treasury and the IRS clarified this point

in corrections to the proposed regulations, published on August 27, 1996, in

the Federal Register (61 FR 44023).

4. Additional production activities

The proposed regulations define additional production activities in § 1.863–

1(b)(3)(ii) as substantial production activities performed by the taxpayer in

addition to activities relating to the

ownership or operation of any farm,

mine, oil or gas well, other natural

deposit, or timber. The proposed regulations provide that generally the principles of § 1.954–3(a)(4) apply in determining whether an activity qualifies as

such additional production. However, in

no case will activities that prepare the

natural resource itself for export, including those that are designed to facilitate

transportation of the natural resource to

or from the export terminal, be considered additional production. Thus, the

proposed regulations in an example indicate liquefaction of natural gas would

not constitute additional production activities.

Liquefaction is the process of liquefying natural gas so that it can be transported by tanker for sales abroad. Several commentators urged us to

reconsider our position, arguing that

liquefaction is an expensive, complex

activity. Treasury and the IRS, however,

continue to believe that liquefaction is

an activity preparing the natural resource itself for export within the meaning of § 1.863–1(b)(3)(ii) of the final

regulations, and that it is appropriate to

exclude such activities from the definition of additional production. Even

though liquefaction may be an expensive, complex process, liquefied natural

gas retains its character as a natural

resource, so that liquefaction should be

treated no differently than other processes that prepare natural resources for

export.

Several commentators requested that

the regulations more precisely define the

processes that constitute production of

natural resources, to better differentiate

those activities described in § 1.863–

1(b)(1) of the proposed regulations, as

being from the ownership or operation

of any farm, mine, oil or gas well, other

natural deposit, or timber, from those

that qualify as additional production

activities within the meaning of

§ 1.863–1(b)(3)(ii) of the proposed

regulations. In particular, a commentator

requested that the final regulations specifically address this issue in the case of

mining. In response to this comment,

the final regulations include an example

describing certain mining processes that

would not qualify as additional production activities in the case of copper.

5. Treatment of partnerships

The proposed regulations provide that,

in applying the rules in § 1.863–3 of

the proposed regulations, a partner

would be treated as engaged in the

production activity of its partnership.

However, that provision was not extended to § 1.863–1 of the proposed

regulations, which generally provides

rules for determining the source of income from sales of natural resources.

The final regulations provide rules for

transactions involving partners and partnerships, which apply in the same manner to sales of natural resources and to

sales of other inventory. See II. 3. of

this preamble for a discussion of those

rules.

6. Genetically-engineered agricultural

products

One commentator requested that final

regulations state that natural resources

do not include products, such as certain

seeds, where the premium value of the

product is derived from genetic traits

produced by biotechnology or traditional

methods, and the seeds themselves are

not grown for consumption. The inherent nature of products as agricultural

products, however, does not change because they may be subject to research

and development. Because they remain

natural resources, Treasury and the IRS

rejected this comment.

II. Allocation and apportionment of

income from sales of inventory other

than natural resources

Section 1.863–3 of the proposed regulations provides rules for allocating and

apportioning income from inventory

sales other than natural resources where

the taxpayer produces property in the

United States and sells outside the

United States, or produces property outside the United States and sells in the

United States (Section 863 Sales). The

proposed regulations provide three

methods: the 50/50 method, the independent factory price method, and the

books and records method.

1. Sales in international waters or in

space

Consistent with the existing regulations, the proposed regulations limit the

methods in § 1.863–3 to sales within a

foreign country. The preamble, however,

requests comments on whether the regulation should be expanded to cover sales

made in international waters or in space.

Although the statute refers to sales outside the United States, Treasury and the

IRS expressed concern in that preamble

that expanding the scope of the regulations to include all such sales could lead

to abuses where, for example, a taxpayer produced goods in the United

States, passed title to those goods outside the United States, and then sold the

goods to U.S. customers. In considering

whether to expand the scope of the final

regulations to include such sales, Treasury and the IRS requested comments

on whether to include an exception to

the title passage rule for sales of goods

produced in the United States and destined for the U.S. market.

In response to comments and consistent with the preamble to the proposed

regulations, the final regulations expand

the scope of the existing and proposed

regulations to include sales outside the

United States. Moreover, to prevent

abuse from this expanded rule, the final

regulations provide that sales of goods

wholly produced in the United States

and sold for use, consumption, or disposition in the United States, will be

considered to take place in the United

States. Income from such sales will be

treated as from U.S. sources. The final

regulations rely on rules in § 1.864–

6(b)(3)(ii) (relating to the determination

of whether foreign source income is

effectively connected with a U.S. trade

or business under section 864(c)(4)(iii)),

for determining the country of use,

consumption, or disposition. Also, property will be treated as wholly produced

in the United States for this purpose if it

is subject to no more than packaging,

repackaging, labeling, or other minor

assembly operations outside the United

States. See also § 1.861–7(c) to deter-

mine the source of income in any case

in which the sales transaction is arranged in a particular manner for the

primary purpose of tax avoidance.

Treasury and the IRS are considering

whether the rules of the final regulations

are appropriate where a product is produced in one country but is destined for

use either on the high seas or in space.

Until additional guidance is provided,

taxpayers may rely upon the general

rules of the final regulations for these

cases.

2. Segregation and aggregation of sales

Once a taxpayer selects a method

under § 1.863–3(b) for dividing gross

income derived from Section 863 Sales

between production activity and sales

activity, § 1.863–3(a) of the proposed

regulations provide that a taxpayer must

separately apply that method to Section

863 Sales in the United States and to

Section 863 Sales outside the United

States. The proposed regulations also

provide in § 1.863–3(a) that taxpayers

must determine the source of gross

income under paragraph (c) and taxable

income under paragraph (d) by aggregating all Section 863 Sales to which a

method described in paragraph (b) applies.

The final regulations clarify that the

rules of paragraphs (c) and (d) apply

separately to Section 863 Sales in the

United States and to Section 863 Sales

outside the United States, so that taxpayers are required to aggregate all

Section 863 Sales under paragraphs (c)

and (d) after the taxpayer has first

separately applied the method under

paragraph (b) to Section 863 Sales in

the United States and to Section 863

Sales outside the United States.

3. Transactions with partnerships

The proposed regulations provide in

§ 1.863–3(a) that a taxpayer’s production activity includes production activities conducted through a partnership of

which the taxpayer is a partner either

directly or through one or more partnerships. One commentator recommended

that final regulations extend the partnership rules to natural resources. However,

the commentator suggested that an aggregate approach to partnerships should

apply only in cases where the partnership, instead of selling the property and

distributing the proceeds to the partner,

distributes the property to a partner. In

response to the comments, the final

regulations modify the proposed regulations. Under the final regulations, the

aggregate approach applies to a partnership’s production or sales activity only

for two purposes. First, the aggregate

approach applies for purposes of determining the source of a partner’s distributive share of partnership income.

Thus, if a partnership engages in the

production of inventory property in the

United States and sells such property

outside the United States, a partner will

be considered to have produced and sold

that inventory property in the same

manner as the partnership when determining the source of its distributive

share of such sales income. Second, the

aggregate approach applies for purposes

of sourcing income from the sale of

inventory property that is transferred in

kind from or to a partnership. Thus, for

example, where the partnership makes

an in kind distribution of inventory

property to its partners, the source of the

partner’s income from the sale of such

property is determined based on both its

own activity and on the partnership’s

activity. Similarly, the aggregate approach applies in cases where a partner

contributes inventory produced by it to

its partnership, if the partnership then

sells the inventory (e.g., as a distributor

or after further processing).

The entity approach applies for all

other purposes. For example, where a

partnership manufactures inventory

property and sells the property to one of

its partners, the source of that partner’s

income from the resale of the property

is determined without regard to the

partnership’s manufacturing activity.

Consistent with this modification, the

final regulations also specify that assets

owned by a partnership (or a partner)

are not deemed owned by the partner

(or the partnership) unless the aggregate

approach applies to the transaction at

issue.

4. Taxable income method

In response to comments, § 1.863–

2(b) of the proposed regulations is clarified to provide that taxpayers may elect

the principles of § 1.863–3(b)(1) and (c)

to determine the source of taxable income (rather than gross income) from

sales of inventory property.

5. Independent factory price (IFP)

method

One commentator requested clarification that the sale establishing an IFP

must be sourced under the IFP method

only if a taxpayer elects the IFP method.

The proposed and final regulations intend this result. The IFP method applies

to either the sale establishing the IFP or

to a sale applying the IFP only if the

taxpayer elects the IFP method.

The proposed regulations eliminated

the provision in existing regulations permitting taxpayers to establish an IFP by

methods other than by sales to independent distributors. The preamble, however, requested comments on the continued utility of such a provision. Two

commentators recommended that the

provision be retained and expanded to

permit taxpayers to establish an IFP by

any method that is appropriate under

section 482. The commentators stated

that any evidence acceptable for proving

an arm’s length price under section 482

should be acceptable as an IFP. The

commentators also stated that taxpayers

who cannot use the IFP method must

use the 50/50 method, and that the

50/50 method may not produce an equitable result for nonresidents importing

goods into the United States.

After further consideration, Treasury

and the IRS have decided to finalize the

regulations on this point as proposed.

No convincing evidence has been presented for the need of a broad-based

rule permitting taxpayers to establish an

IFP by any method that would otherwise

be appropriate under section 482 when

they can use books and records to

demonstrate a more appropriate sourcing

result. In view of the absence of a

clearly identified benefit for taxpayers

and the availability of the books and

records method, Treasury and the IRS

believe that expansion of the IFP rule is

not justified.

6. Books and records

Under both the existing and proposed

regulations, taxpayers can request permission from the District Director to use

a taxpayer’s books and records to allocate or apportion income between U.S.

and foreign sources if this method more

clearly reflects the taxpayer’s income.

The preamble to the proposed regulations requests comments on retaining the

books and records method. Two commentators asked for retention of this

method because instances may arise

where a taxpayer does not have third

party sales, thereby making the IFP

method unavailable. In such cases, a

taxpayer may find it advantageous to

determine the source of its income on

the basis of its books and records. These

comments were accepted. The final

regulations retain the books and records

method, subject to an election and prior

approval of the method by the District

Director.

7. Determination of source of gross income from production activities

a. Definition of production assets

i. Contract manufacturing

Under the proposed regulations, production assets are limited to those

owned directly by the taxpayer that are

directly used by the taxpayer to produce

the relevant inventory. These rules are

intended to insure that taxpayers do not

attribute the assets or activities of related or unrelated parties manufacturing

under contract with the taxpayer. One

commentator asked that the definition of

production assets be expanded to include production assets owned by related or unrelated contract manufacturers. The commentator contends that by

limiting production assets to those

owned by the taxpayer, the regulations

source income differently depending

upon the form in which the taxpayer

conducts business. Treasury and the

IRS, however, believe it is appropriate

to limit production assets in the apportionment formula to assets owned by the

taxpayer and used by the taxpayer to

produce the inventory. In addition, taxpayers generally do not know the contract manufacturer’s basis in its production assets. Further, it would be very

difficult to draw a clear line between

contract manufacturers and other suppliers. Thus, Treasury and the IRS do not

believe the source of a taxpayer’s income should take into account activities

of others or assets owned by others with

whom the taxpayer has manufacturing

arrangements. The final regulations

clarify, however, that this rule does not

override the single entity rules set forth

under § 1.1502–13 (dealing with members of an affiliated group filing on a

consolidated basis), or the rules under

§ 1.863–3(g) dealing with partnerships.

ii. Accounts receivable

One commentator also asserted that

accounts receivable should be included

as a production asset. This comment

was rejected. The production formula is

intended to approximate the location of

the taxpayer’s production activity. Thus,

assets not directly involved in production should not be included.

b. Anti-abuse rule

The preamble to the proposed regulations indicated that the purpose of the

property fraction is to attribute the

source of production income to the

location of production activity. Treasury

and the IRS, however, were concerned

that taxpayers would attempt to artificially affect the location of assets to

manipulate the rules, and so solicited

comments on whether an anti-abuse rule

was needed. No comments were received that objected to such anti-abuse

rule. After further considering the issue,

Treasury and the IRS have included an

anti-abuse rule in the final regulations to

prevent taxpayers from manipulating the

property formula to achieve inappropriate results. Therefore, the anti-abuse rule

provides that if a taxpayer has entered

into or structured one or more transactions with a principal purpose of reducing its U.S. tax liability by affecting the

formula in a manner inconsistent with

the purpose of the regulation, the District Director may make appropriate adjustments so that the source of the

taxpayer’s income from production activity more clearly reflects the source of

that income. An example in the regulations demonstrates circumstances where

the anti-abuse rule may apply. In that

example, with a principal purpose of

reducing its U.S. tax liability, the taxpayer leases all of its U.S. property so

that it owns only property located in a

foreign country. The example concludes

that the District Director may ignore a

sale-leaseback transaction to more

clearly reflect the source of the taxpayer’s production income.

a statement attached to the tax return,

explaining the methodology used, the

circumstances justifying that use, the

aggregation of sales, and the amount of

income allocated. Treasury and the IRS

believe the reporting requirements in

§ 1.863–3(e) of the proposed regulations are reasonable, and serve legitimate administrative purposes.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in EO 12866.

Therefore, a regulatory assessment is not

required. It is hereby certified that these

regulations will not have a significant

economic impact on a substantial number of small entities. This certification is

based on the fact that the rules of this

section principally impact large multinationals who pay foreign taxes on substantial foreign operations and therefore

the rules will impact very few small

entities. Moreover, in those few instances where the rules of this section

impact small entities, the economic impact on such entities is not likely to be

significant. Accordingly, a regulatory

flexibility analysis is not required. Pursuant to section 7805(f) of the Internal

Revenue Code, the notice of proposed

rulemaking preceding these regulations

was submitted to the Small Business

Administration for comment on its impact on small business.

8. Determination of taxable income

One commentator requested that the

calculation of taxable income, when applying the 50/50 method along with the

research and experimental (R&E) expense allocation rules in § 1.861–17, be

clarified. The commentator suggests that

the last sentence of § 1.863–3(d) of the

proposed regulations can be read to

conflict with the R&E set aside in

§ 1.861–17. The final regulations clarify

that the R&E set aside remains available

to taxpayers using the 50/50 method.

9. Reporting requirements

The proposed regulations, in § 1.863–

3(e), require a taxpayer to fully explain

the methodology used to determine the

source of income, the circumstances

justifying use of that method, the extent

that sales are aggregated, and the

amount of income so allocated. One

commentator wrote that the reporting

requirements in § 1.863–3(e) of the proposed regulations are unnecessary and

excessively burdensome. The regulations

clarify that the requirement is limited to

Section 1.863–4 also issued under 26

U.S.C. 863.

Section 1.863–6 also issued under 26

U.S.C. 863. * * *

Par. 2. Sections 1.863–3 and

1.863–3T are redesignated as §§ 1.863–

3A and 1.863–3AT, respectively, and an

undesignated center heading is added

preceding the redesignated sections to

read as follows:

Drafting Information

The principal author of these regulations is Anne Shelburne, Office of Associate Chief Counsel (International).

However, other personnel from the IRS

and Treasury Department participated in

their development.

Adoption of Amendments to the

Regulations

Accordingly, 26 CFR parts 1 and 602

are amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for

part 1 is amended by adding entries in

numerical order to read as follows:

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

Section 1.863–2 also issued under 26

U.S.C. 863.

Section 1.863–3 also issued under 26

U.S.C. 863.

Regulations Applicable to Taxable

Years Prior to December 30, 1996

Par. 3. Section 1.863–0 is added to

read as follows:

§ 1.863–0 Table of contents.

This section lists captions contained

in §§ 1.863–1, 1.863–2, and 1.863–3.

§ 1.863–1 Allocation of gross income.

(a) In general.

(b) Natural resources.

(1) In general.

(2) Additional production prior to export terminal.

(3) Definitions.

(i) Production activity.

(ii) Additional production activities.

(iii) Export terminal.

(4) Determination of fair market

value.

(5) Determination of gross income.

(6) Tax return disclosure.

(7) Examples.

(e) Effective dates.

§ 1.863–2 Allocation and apportionment

of taxable income.

(a) Determination of taxable income.

(b) Determination of source of taxable income.

§ 1.863–3 Allocation and apportionment

of income from certain sales of inventory.

(a) In general.

(1) Scope

(2) Special rules

(b) Methods to determine income attributable to production activity and

sales activity.

(1) 50/50 method.

(i) Determination of gross income.

(ii) Example.

(2) IFP method.

(i) Establishing an IFP.

(ii) Applying the IFP method.

(iii) Determination of gross income.

(iv) Examples.

(3) Books and records method.

gross income from production activity

and sales activity.

(1) Income attributable to production

activity.

(i) Production only within the United

States or only within foreign countries.

(A) Source of income.

(B) Definition of production assets.

(ii) Production both within the United

States and within foreign countries.

(A) Source of income.

(B) Adjusted basis of production assets.

(iii) Anti-abuse rule.

(iv) Examples.

(2) Income attributable to sales activity.

(d) Determination of source of taxable income.

(e) Election and reporting rules.

(1) Elections under paragraph (b) of

this section.

(2) Disclosure on tax return.

(f) Income partly from sources within

a possession of the United States.

(g) Special rules for partnerships.

(h) Effective dates.

Par. 4. In § 1.863–1, paragraphs (a),

(b) and (c) are revised and paragraph (e)

is added to read as follows:

§ 1.863–1 Allocation of gross income.

(a) In general. Items of gross income

other than those specified in section

861(a) and section 862(a) will generally

be separately allocated to sources within

or without the United States. See

§ 1.863–2 for alternate methods to determine the income from sources within

or without the United States in the case

of items specified in § 1.863–2(a). See

also sections 865(b) and (e)(2). In the

case of sales of property involving partners and partnerships, the rules of

§ 1.863–3(g) apply.

(b) Natural resources—(1) In general. Notwithstanding any other provision, except to the extent provided in

paragraph (b)(2) of this section, gross

receipts from the sale outside the United

States of products derived from the

ownership or operation of any farm,

mine, oil or gas well, other natural

deposit, or timber within the United

States, must be allocated between

sources within and without the United

States based on the fair market value of

the product at the export terminal (as

defined in paragraph (b)(3)(iii) of this

section). Notwithstanding any other pro-

vision, except to the extent provided in

paragraph (b)(2) of this section, gross

receipts from the sale within the United

States of products derived from the

ownership or operation of any farm,

mine, oil or gas well, other natural

deposit, or timber outside the United

States must be allocated between

sources within and without the United

States based on the fair market value of

the product at the export terminal. For

place of sale, see §§ 1.861–7(c) and

1.863–3(c)(2). The source of gross receipts equal to the fair market value of

the product at the export terminal will

be from sources where the farm, mine,

well, deposit, or uncut timber is located.

The source of gross receipts from the

sale of the product in excess of its fair

market value at the export terminal

(excess gross receipts) will be determined as follows—

(i) If the taxpayer engages in additional production activities subsequent to

shipment from the export terminal and

outside the country of sale, the source of

excess gross receipts must be determined under § 1.863–3. For purposes of

applying § 1.863–3, only production assets used in additional production activity subsequent to the export terminal are

taken into account.

(ii) In all other cases, excess gross

receipts will be from sources within the

country of sale. This paragraph (b)(1)(ii)

applies to a taxpayer that engages in

additional production activities in the

country of sale, as well as to a taxpayer

that does not engage in additional production activities at all.

(2) Additional production prior to export terminal. Notwithstanding any other

provision of this section, gross receipts

from the sale of products derived by a

taxpayer who performs additional production activities as defined in paragraph (b)(3)(ii) of this section before the

relevant product is shipped from the

export terminal are allocated between

sources within and without the United

States based on the fair market value of

the product immediately prior to the

additional production activities. The

source of gross receipts equal to the fair

market value of the product immediately

prior to the additional production activities will be from sources where the

farm, mine, well, deposit, or uncut timber is located. The source of gross

receipts from the sale of the product in

excess of the fair market value immediately prior to the additional production

activities must be determined under

§ 1.863–3. For purposes of applying

§ 1.863–3, only production assets used

in the additional production activities

are taken into account.

(3) Definitions—(i) Production activity. For purposes of this section, production activity means an activity that creates, fabricates, manufactures, extracts,

processes, cures, or ages inventory. See

§ 1.864–1. Except as otherwise provided in §§ 1.1502–13 or 1.863–(g)(2),

only production activities conducted directly by the taxpayer are taken into

account.

(ii) Additional production activities.

For purposes of this section, additional

production activities are substantial production activities performed directly by

the taxpayer in addition to activities

from the ownership or operation of any

farm, mine, oil or gas well, other natural

deposit, or timber. Whether a taxpayer’s

activities constitute additional production activities will be determined under

the principles of § 1.954–3(a)(4). However, in no case will activities that

prepare the natural resource itself for

export, including those that are designed

to facilitate the transportation of the

natural resource to or from the export

terminal, be considered additional production activities for purposes of this

section.

(iii) Export terminal. Where the farm,

mine, well, deposit, or uncut timber is

located without the United States, the

export terminal will be the final point in

a foreign country from which goods are

shipped to the United States. If there is

no such final point in a foreign country

(e.g., the property is extracted and produced on the high seas), the export

terminal will be the place of production.

Where the farm, mine, well, deposit, or

uncut timber is located within the

United States, the export terminal will

be the final point in the United States

from which goods are shipped from the

United States to a foreign country. The

location of the export terminal is determined without regard to any contractual

terms agreed to by the taxpayer and

without regard to whether there is an

actual sale of the products at the export

terminal.

(4) Determination of fair market

value. For purposes of this section, fair

market value depends on all of the facts

and circumstances as they exist relative

to a party in any particular case. Where

the products are sold to a related party

in a transaction subject to section 482,

the determination of fair market value

under this section must be consistent

with the arm’s length price determined

under section 482.

(5) Determination of gross income.

To determine the amount of a taxpayer’s

gross income from sources within or

without the United States, the taxpayer’s

gross receipts from sources within or

without the United States determined

under this paragraph (b) must be reduced by the cost of goods sold properly attributable to gross receipts from

sources within or without the United

States.

(6) Tax return disclosure. A taxpayer

that determines the source of its income

under this paragraph (b) shall attach a

statement to its return explaining the

methodology used to determine fair

market value under paragraph (b)(4) of

this section, and explaining any additional production activities (as defined

in paragraph (b)(3)(ii) of this section)

performed by the taxpayer. In addition,

the taxpayer must provide such other

information as is required by § 1.863–3.

(7) Examples. The following examples illustrate the rules of this paragraph (b):

Example 1. No additional production. U.S.

Mines, a U.S. corporation, operates a copper mine

and mill in country X. U.S. Mines extracts

copper-bearing rocks from the ground and transports the rocks to the mill where the rocks are

ground and processed to produce copper-bearing

concentrate. The concentrate is transported to a

port where it is dried in preparation for export,

stored and then shipped to purchasers in the

United States. Because title to the property is

passed in the United States and, under the facts

and circumstances, none of U.S. Mine’s activities

constitutes additional production prior to the export terminal within the meaning of § 1.863–

1(b)(3)(ii), under § 1.863–1(b)(1) and (b)(1)(ii),

gross receipts equal to the fair market value of the

concentrate at the export terminal will be from

sources without the United States, and excess

gross receipts will be from sources within the

United States.

Example 2. No additional production. US Gas, a

U.S. corporation, extracts natural gas within the

United States, and transports the natural gas to a

U.S. port where it is liquified in preparation for

shipment. The liquified natural gas is then transported via freighter and sold without additional

production activities in a foreign country. Liquefaction of natural gas is not an additional production activity because liquefaction prepares the

natural gas for transportation from the export

terminal. Therefore, under § 1.863–1(b)(1) and

(b)(1)(ii), gross receipts equal to the fair market

value of the liquefied natural gas at the export

terminal will be from sources within the United

States, and excess gross receipts will be from

sources without the United States.

Example 3. Sale in third country. US Gold, a

U.S. corporation, mines gold in country X, produces gold jewelry in the United States, and sells

the jewelry in country Y. Assume that the fair

market value of the gold at the export terminal in

country X is $40, and that US Gold ultimately

sells the gold jewelry in country Y for $100.

Under § 1.863–1(b), $40 of US Gold’s gross

receipts will be allocated to sources without the

United States. Under § 1.863–1(b)(1)(i), the

source of the remaining $60 of gross receipts will

be determined under § 1.863–3. If US Gold

applies the 50/50 method described in § 1.863–3,

$20 of cost of goods sold is properly attributable

to activities subsequent to the export terminal, and

all of US Gold’s production assets subsequent to

the export terminal are located in the United

States, then $20 of gross income will be allocated

to sources within the United States and $20 of

gross income will be allocated to sources without

the United States.

Example 4. Production in country of sale. US

Oil, a U.S. corporation, extracts oil in country X,

transports the oil via pipeline to the export

terminal in country Y, refines the oil in the United

States, and sells the refined product in the United

States to unrelated persons. Assume that the fair

market value of the oil at the export terminal in

country Y is $80, and that US Oil ultimately sells

the refined product for $100. Under § 1.863–

1(b)(1), $80 of US Oil’s gross receipts will be

allocated to sources without the United States, and

under § 1.863–1(b)(1)(ii) the remaining $20 of

gross receipts will be allocated to sources within

the United States.

Example 5. Additional production prior to export. The facts are the same as in Example 1,

except that U.S. Mines also operates a smelter in

country X. The concentrate output from the mill is

transported to the smelter where it is transformed

into smelted copper. The smelted copper is exported to purchasers in the United States. Under

the facts and circumstances, all of the processes

applied to make copper concentrate are considered

mining. Therefore, under § 1.863–1(b)(2), gross

receipts equal to the fair market value of the

concentrate at the smelter will be from sources

without the United States. Under the facts and

circumstances, the conversion of the concentrate

into smelted copper is an additional production

activity in a foreign country within the meaning of

§ 1.863–1(b)(3)(ii). Therefore, the source of U.S.

Mine’s excess gross receipts will be determined

pursuant to § 1.863–1(b)(2).

The taxpayer’s taxable income from

sources within or without the United

States will be determined under the

rules of §§ 1.861–8 through 1.861–14T

for determining taxable income from

sources within the United States.

(e) Effective dates. The rules of paragraphs (a), (b) and (c) of this section

will apply to taxable years beginning

December 30, 1996. However, taxpayers

may apply the rules of this section for

taxable years beginning after July 11,

1995, and before December 30, 1996.

For years beginning before December

30, 1996, see § 1.863–1 (as contained

in 26 CFR part 1 revised as of April 1,

1996).

Par. 5. Section 1.863–2 is revised to

read as follows:

§ 1.863–2 Allocation and apportionment

of taxable income.

(a) Determination of taxable income.

Section 863(b) provides an alternate

method for determining taxable income

from sources within the United States in

the case of gross income derived from

sources partly within and partly without

the United States. Under this method,

taxable income is determined by deducting from such gross income the expenses, losses, or other deductions properly apportioned or allocated thereto and

a ratable part of any other expenses,

losses, or deductions that cannot definitely be allocated to some item or class

of gross income. The income to which

this section applies (and that is treated

as derived partly from sources within

and partly from sources without the

United States) will consist of gains,

profits, and income

(1) From certain transportation or

other services rendered partly within and

partly without the United States to the

extent not within the scope of section

863(c) or other specific provisions of

this title;

(2) From the sale of inventory property (within the meaning of section

865(i)) produced (in whole or in part)

by the taxpayer in the United States and

sold outside the United States or produced (in whole or in part) by the

taxpayer outside the United States and

sold in the United States; or

(3) Derived from the purchase of personal property within a possession of

the United States and its sale within the

United States, to the extent not excluded

from the scope of these regulations

under § 1.936–6(a)(5), Q&A 7.

(b) Determination of source of taxable income. Income treated as derived

from sources partly within and partly

without the United States under paragraph (a) of this section may be allocated to sources within and without the

United States pursuant to § 1.863–1 or

apportioned to such sources in accordance with the methods described in

other regulations under section 863. To

determine the source of certain types of

income described in paragraph (a)(1) of

this section, see § 1.863–4. To determine the source of gross income described in paragraph (a)(2) of this section, see § 1.863–1 for natural resources

and see § 1.863–3 for other inventory.

Taxpayers, at their election, may apply

the principles of § 1.863–3(b)(1) and (c)

to determine the source of taxable income (rather than gross income) from

sales of inventory property (other than

natural resources). To determine the

source of income partly from sources

within a possession of the United States,

including income described in paragraph

(a)(3) of this section, see § 1.863–3(f).

apply to taxable years beginning December 30, 1996. However, taxpayers

may apply the rules of this section for

taxable years beginning after July 11,

1995, and before December 30, 1996.

For years beginning before December

30, 1996, see § 1.863–2 (as contained

in 26 CFR part 1 revised as of April 1,

1996).

Par. 6. Section 1.863–3 is added to

read as follows:

§ 1.863–3 Allocation and apportionment

of income from certain sales of inventory.

(a) In general—(1) Scope. Paragraphs (a) through (e) of this section

apply to determine the source of income

derived from the sale of inventory property (inventory), which a taxpayer produces (in whole or in part) within the

United States and sells outside the

United States, or which a taxpayer produces (in whole or in part) outside the

United States and sells within the

United States (Section 863 Sales). A

taxpayer must divide gross income from

Section 863 Sales between production

activity and sales activity using one of

the methods described in paragraph (b)

of this section. The source of gross

income from production activity and

from sales activity must then be determined under paragraph (c) of this section. Taxable income from Section 863

Sales is determined under paragraph (d)

of this section. Paragraph (e) of this

section describes the rules for electing

the methods described in paragraph (b)

of this section and the information that a

taxpayer must disclose on a tax return.

Paragraph (f) of this section applies to

determine the source of certain income

derived from a possession of the United

States. Paragraph (g) of this section

provides special rules for partnerships

for all sales subject to §§ 1.863–1

through 1.863–3. Paragraph (h) of this

section provides effective dates for the

rules in this section.

(2) Rules of application for Section

863 Sales. Once a taxpayer has elected a

method described in paragraph (b) of

this section, the taxpayer must separately apply that method to Section 863

Sales in the United States and to Section

863 Sales outside the United States. In

addition, the taxpayer must apply the

rules of paragraphs (c) and (d) of this

section by aggregating all Section 863

Sales to which a method described in

paragraph (b) of this section applies,

after separately applying that method to

Section 863 Sales in the United States

and to Section 863 Sales outside the

United States. See section 865(i)(1) for

the definition of inventory property. See

also section 865(e)(2). See § 1.861–7(c)

and paragraph (c)(2) of this section for

the time and place of sale.

(b) Methods to determine income attributable to production activity and

sales activity—(1) 50/50 method—

(i) Determination of gross income. Generally, gross income from Section 863

Sales will be apportioned between production activity and sales activity under

the 50/50 method as described in this

paragraph (b)(1). Under the 50/50

method, one-half of the taxpayer’s gross

income will be considered income attributable to production activity and the

source of that income will be determined under the rules of paragraph

(c)(1) of this section. The remaining

one-half of such gross income will be

considered income attributable to sales

activity and the source of that income

will be determined under the rules of

paragraph (c)(2) of this section. In lieu

of the 50/50 method, the taxpayer may

elect to determine the source of income

from Section 863 Sales under the IFP

method described in paragraph (b)(2) of

this section or, with the consent of the

District Director, the books and records

method described in paragraph (b)(3) of

this section.

(ii) Example. The following example

illustrates the rules of this paragraph

(b)(1):

Example. 50/50 method. (i) P, a U.S. corporation, produces widgets in the United States. P sells

the widgets for $100 to D, an unrelated foreign

distributor, in another country. P’s cost of goods

sold is $40. Thus, P’s gross income is $60.

(ii) Pursuant to the 50/50 method, one-half of

P’s gross income, or $30, is considered income

attributable to production activity, and one-half of

P’s gross income, or $30, is considered income

attributable to sales activity.

(2) IFP method—(i) Establishing an

IFP. A taxpayer may elect to allocate

gross income earned from production

activity and sales activity using the

independent factory price (IFP) method

described in this paragraph (b)(2) if an

IFP is fairly established. An IFP is fairly

established based on a sale by the

taxpayer only if the taxpayer regularly

sells part of its output to wholly inde-

pendent distributors or other selling concerns in such a way as to reasonably

reflect the income earned from production activity. A sale will not be considered to fairly establish an IFP if sales

activity by the taxpayer with respect to

that sale is significant in relation to all

of the activities with respect to that

product.

(ii) Applying the IFP method. If the

taxpayer elects to use the IFP method,

the amount of the gross sales price

equal to the IFP will be treated as

attributable to production activity, and

the excess of the gross sales price over

the IFP will be treated as attributable to

sales activity. If a taxpayer elects to use

the IFP method, the IFP must be applied

to all Section 863 Sales of inventory

that are substantially similar in physical

characteristics and function, and are sold

at a similar level of distribution as the

inventory sold in the sale fairly establishing an IFP. The IFP will only be

applied to sales that are reasonably

contemporaneous with the sale fairly

establishing the IFP. An IFP cannot be

applied to sales in other geographic

markets if the markets are substantially

different. If the taxpayer elects the IFP

method, the rules of this paragraph will

also apply to determine the division of

gross receipts between production activity and sales activity in a Section 863

Sale that itself fairly establishes an IFP.

If the taxpayer elects to apply the IFP

method, the IFP method must be applied

to all sales for which an IFP may be

fairly established and applied for that

taxable year and each subsequent taxable year. The taxpayer will apply either

the 50/50 method described in paragraph

(b)(1) of this section or the books and

records method described in paragraph

(b)(3) of this section to any other Section 863 Sale for which an IFP cannot

be established or applied for each taxable year.

(iii) Determination of gross income.

The amount of a taxpayer’s gross income from production activity is determined by reducing the amount of gross

receipts from production activity by the

cost of goods sold properly attributable

to production activity. The amount of a

taxpayer’s gross income from sales activity is determined by reducing the

amount of gross receipts from sales

activity by the cost of goods sold (if

any) properly attributable to sales activity. The source of gross income from

production activity is determined under

the rules of paragraph (c)(1) of this

section, and the source of gross income

from sales activity will be determined

under the rules of paragraph (c)(2) of

this section.

(iv) Examples. The following examples illustrate the rules of this paragraph (b)(2):

Example 1. IFP method. (i) P, a U.S. producer,

purchases cotton and produces cloth in the United

States. P sells cloth in country X to D, an

unrelated foreign clothing manufacturer, for $100.

Cost of goods sold for cloth is $80, entirely

attributable to production activity. P does not

engage in significant sales activity in relation to its

other activities in the sales to D. Under these

facts, the sale to D fairly establishes an IFP of

$100. Assume that P elects to use the IFP method.

Accordingly, $100 of the gross sales price is

treated as attributable to production activity, and

no amount of income from this sale is attributable

to sales activity. After reducing the gross sales

price by cost of goods sold, $20 of the gross

income is treated as attributable to production

activity ($100–$80).

(ii) P also sells cloth in country X to A, a

unrelated foreign retail outlet, for $110. Because P

elected the IFP method and the cloth is substantially similar to the cloth sold to D, the IFP fairly

established in the sales to D must be used to

determine the amount attributable to production

activity in the sale to A. Accordingly, $100 of the

gross sales price is treated as attributable to

production activity and $10 ($110–$100) is attributable to sales activity. After reducing the gross

sales price by cost of goods sold, $20 of the gross

income is treated as attributable to production

activity ($100–$80) and $10 is attributable to sales

activity.

Example 2. Scope of IFP Method. (i) USCo

manufactures three dissimilar products. USCo

elects to apply the IFP method. In year 1, an IFP

can be established for sales of product X, but not

for products Y and Z. In year 2, an IFP cannot be

established for any of USCo’s products. In year 3,

an IFP can be established for products X and Y,

but not for product Z.

(ii) In year 1, USCo must apply the IFP method

to sales of product X. In year 2, although USCo’s

IFP election remains in effect, USCo is not

required to apply the IFP election to any products.

In year 3, USCo is required to apply the IFP

method to sales of products X and Y.

(3) Books and records method. A taxpayer may elect to determine the

amount of its gross income from Section

863 Sales that is attributable to production and sales activities for the taxable

year based upon its books of account if

it has received in advance the permission of the District Director having audit

responsibility over its tax return. The

taxpayer must establish to the satisfaction of the District Director that the

taxpayer, in good faith and unaffected

by considerations of tax liability, will

regularly employ in its books of account

a detailed allocation of receipts and

expenditures which clearly reflects the

amount of the taxpayer’s income from

production and sales activities. If a

taxpayer receives permission to apply

the books and records method, but does

not comply with a material condition set

forth by the District Director, the District Director may, in its discretion,

revoke permission to use the books and

records method. The source of gross

income treated as attributable to production activity under this method may be

determined under the rules of paragraph

(c)(1) of this section, and the source of

gross income attributable to sales activity will be determined under the rules of

paragraph (c)(2) of this section.

gross income from production activity

and sales activity—(1) Income attributable to production activity—(i) Production only within the United States or

only within foreign countries—

(A) Source of income. For purposes of

this section, production activity means

an activity that creates, fabricates,

manufactures, extracts, processes, cures,

or ages inventory. See § 1.864–1. Subject to the provisions in § 1.1502–13 or

paragraph (g)(2)(ii) of this section, the

only production activities that are taken

into account for purposes of §§ 1.863–

1, 1.863–2, and this section are those

conducted directly by the taxpayer.

Where the taxpayer’s production assets

are located only within the United States

or only outside the United States, the

income attributable to production activity is sourced where the taxpayer’s

production assets are located. For rules

regarding the source of income when

production assets are located both within

the United States and without the United

States, see paragraph (c)(1)(ii) of this

section.

(B) Definition of production assets.

Subject to the provisions of § 1.1502–13

and paragraph (g)(2)(ii) of this section,

production assets include only tangible

and intangible assets owned directly by

the taxpayer that are directly used by the

taxpayer to produce inventory described

in paragraph (a) of this section. Production assets do not include assets that are

not directly used to produce inventory

described in paragraph (a) of this section. Thus, production assets do not

include such assets as accounts receivables, intangibles not related to production of inventory (e.g., marketing intangibles, including trademarks and

customer lists), transportation assets,

warehouses, the inventory itself, raw

materials, or work-in-process. In addition, production assets do not include

cash or other liquid assets (including

working capital), investment assets, prepaid expenses, or stock of a subsidiary.

For purposes of this section, a tangible

production asset will be considered located where the asset is physically located. An intangible production asset

will be considered located where the

tangible production assets owned by the

taxpayer to which it relates are located.

(ii) Production both within the United

States and within foreign countries—

(A) Source of income. Where the taxpayer’s production assets are located

both within and without the United

States, income from sources without the

United States will be determined by

multiplying the income attributable to

the taxpayer’s production activity by a

fraction, the numerator of which is the

average adjusted basis of production

assets that are located outside the United

States and the denominator of which is

the average adjusted basis of all production assets within and without the

United States. The remaining income is

treated as from sources within the

United States.

(B) Adjusted basis of production assets. For purposes of paragraph

(c)(1)(ii)(A) of this section, the adjusted

basis of an asset is determined under

section 1011. The average adjusted basis

is computed by averaging the adjusted

basis of the asset at the beginning and

end of the taxable year, unless by reason

of material changes during the taxable

year such average does not fairly represent the average for such year. In this

event, the average adjusted basis will be

determined upon a more appropriate

basis. If production assets are used to

produce inventory sold in Section 863

Sales and are also used to produce other

property during the taxable year, the

portion of its adjusted basis that is

included in the fraction described in

paragraph (c)(1)(ii)(A) of this section

will be determined under any method

that reasonably reflects the portion of

the assets that produces inventory sold

in Section 863 Sales. For example, the

portion of such an asset that is included

in the formula may be determined by

multiplying the asset’s average adjusted

basis by a fraction, the numerator of

which is the gross receipts from sales of

inventory from Section 863 Sales produced by the asset, and the denominator

of which is the gross receipts from all

property produced by that asset.

(iii) Anti-abuse rule. The purpose of

this paragraph (c)(1) is to attribute the

source of the taxpayer’s production income to the location of the taxpayer’s

production activity. Therefore, if the

taxpayer has entered into or structured

one or more transactions with a princi-

pal purpose of reducing its U.S. tax

liability by manipulating the formula

described in paragraph (c)(1)(ii)(A) of

this section in a manner inconsistent

with the purpose of this paragraph

(c)(1), the District Director may make

appropriate adjustments so that the

source of the taxpayer’s income from

production activity more clearly reflects

the source of that income.

(iv) Examples. The following examples illustrate the rules of this paragraph (c)(1):

Example 1. Source of production income. (i) A,

a U.S. corporation, produces widgets that are sold

both within the United States and within a foreign

country. The initial manufacture of all widgets

occurs in the United States. The second stage of

production of widgets that are sold within a

foreign country is completed within the country of

sale. A’s U.S. plant and machinery which is

involved in the initial manufacture of the widgets

has an average adjusted basis of $200. A also

owns warehouses used to store work-in-process. A

owns foreign equipment with an average adjusted

basis of $25. A’s gross receipts from all sales of

widgets is $100, and its gross receipts from export

sales of widgets is $25. Assume that apportioning

average adjusted basis using gross receipts is

reasonable. Assume A’s cost of goods sold from

the sale of widgets in the foreign countries is $13

and thus, its gross income from widgets sold in

foreign countries is $12. A uses the 50/50 method

to divide its gross income between production

activity and sales activity.

(ii) A determines its production gross income

from sources without the United States by multiplying one-half of A’s $12 of gross income from

sales of widgets in foreign countries, or $6, by a

fraction, the numerator of which is all relevant

foreign production assets, or $25, and the denominator of which is all relevant production assets, or

$75 ($25 foreign assets + ($200 U.S. assets X $25

gross receipts from export sales/$100 gross receipts from all sales)). Therefore, A’s gross production income from sources without the United

States is $2 ($6 X ($25/$75)).

Example 2. Location of intangible property.

Assume the same facts as Example 1, except that

A employs a patented process that applies only to

the initial production of widgets. In computing the

formula used to determine the source of income

from production activity, A’s patent, if it has an

average adjusted basis, would be located in the

United States.

Example 3. Anti-abuse rule. (i) Assume the

same facts as Example 1. A sells its U.S. assets to

B, an unrelated U.S. corporation, with a principal

purpose of reducing its U.S. tax liability by

manipulating the property fraction. A then leases

these assets from B. After this transaction, under

the general rule of paragraph (c)(1)(ii) of this

section, all of A’s production income would be

considered from sources without the United States,

because all of A’s relevant production assets are

located within a foreign country. Since the leased

property is not owned by the taxpayer, it is not

included in the fraction.

(ii) Because A has entered into a transaction

with a principal purpose of reducing its U.S. tax

liability by manipulating the formula described in

paragraph (c)(1)(ii)(A) of this section, A’s income

must be adjusted to more clearly reflect the source

of that income. In this case, the District Director

may redetermine the source of A’s production

income by ignoring the sale-leaseback transactions.

(2) Income attributable to sales activity. The source of the taxpayer’s income

that is attributable to sales activity will

be determined under the provisions of

§ 1.861–7(c). However, notwithstanding

any other provision, for purposes of

section 863, the place of sale will be

presumed to be the United States if

personal property is wholly produced in

the United States and the property is

sold for use, consumption, or disposition

in the United States. See § 1.864–

6(b)(3)(ii) to determine the country of

use, consumption, or disposition. Also,

in applying this paragraph, property will

be treated as wholly produced in the

United States if it is subject to no more

than packaging, repackaging, labeling,

or other minor assembly operations outside the United States, within the meaning of § 1.954–3(a)(4)(iii)(property

manufactured or produced by a controlled foreign corporation).

(d) Determination of source of taxable income. Once the source of gross

income has been determined under paragraph (c) of this section, the taxpayer

must properly allocate and apportion

separately under §§ 1.861–8 through

1.861–14T the amounts of its expenses,

losses, and other deductions to its respective amounts of gross income from

Section 863 Sales determined separately

under each method described in paragraph (b) of this section. In addition, if

the taxpayer deducts expenses for research and development under section

174 that may be attributed to its Section

863 Sales under § 1.861–8(e)(3), the

taxpayer must separately allocate or apportion expenses, losses, and other deductions to its respective amounts of

gross income from each relevant product

category that the taxpayer uses in applying the rules of § 1.861–8(e)(3)(i)(A).

In the case of gross income from Section 863 Sales determined under the IFP

method or the books and records

method, the rules of §§ 1.861–8 through

1.861–14T must apply to properly allocate or apportion amounts of expenses,

losses and other deductions allocated

and apportioned to such gross income

between gross income from sources

within and without the United States. In

the case of gross income from Section

863 Sales determined under the 50/50

method, the amounts of expenses,

losses, and other deductions allocated

and apportioned to such gross income

must be apportioned between sources

within and without the United States pro

rata based on the relative amounts of

gross income from sources within and

without the United States determined

under the 50/50 method. Research and

experimental expenditures qualifying under § 1.861–17 are allocated under that

section, and are not allocated and apportioned pro rata under the 50/50 method.

(e) Election and reporting rules—

(1) Elections under paragraph (b) of

this section. If a taxpayer does not elect

a method specified in paragraph (b)(2)

or (3) of this section, the taxpayer must

apply the method specified in paragraph

(b)(1) of this section. The taxpayer may

elect to apply the method specified in

paragraph (b)(2) of this section by using

the method on a timely filed original

return (including extensions). A taxpayer

may elect to apply the method specified

in paragraph (b)(3) of this section by

using the method on a timely filed

original return (including extensions),

but only if the taxpayer has received

permission from the District Director to

apply that method. Once a method under

paragraph (b) of this section has been

used, that method must be used in later

taxable years unless the Commissioner

consents to a change. However, if a

taxpayer elects to change to or from the

method specified in paragraph (b)(3) of

this section, the taxpayer must obtain

permission from the District Director

instead of the Commissioner. Permission

to change methods from one year to

another year will not be withheld unless

the change would result in a substantial

distortion of the source of the taxpayer’s

income.

(2) Disclosure on tax return. A taxpayer who uses one of the methods

described in paragraph (b) of this section must fully explain in a statement

attached to the return the methodology

used, the circumstances justifying use of

that methodology, the extent that sales

are aggregated, and the amount of income so allocated.

(f) Income partly from sources within

a possession of the United States. Taxpayers with income partly from sources

within a possession of the United States

must apply the rules of § 1.863–3A(c).

(g) Special rules for partnerships—

(1) General rule. For purposes of

§ 1.863–1 and this section, a taxpayer’s

production or sales activity does not

include production and sales activities

conducted by a partnership of which the

taxpayer is a partner either directly or

through one or more partnerships, ex-

cept as otherwise provided in paragraph

(g)(2) of this section.

(2) Exceptions—(i) In general. For

purposes of determining the source of

the partner’s distributive share of partnership income or determining the

source of the partner’s income from the

sale of inventory property which the

partnership distributes to the partner in

kind, the partner’s production or sales

activity includes an activity conducted

by the partnership. In addition, the production activity of a partnership includes

the production activity of a taxpayer that

is a partner either directly or through

one or more partnerships, to the extent

that the partner’s production activity is

related to inventory that the partner

contributes to the partnership in a transaction described under section 721.

(ii) Attribution of production assets to

or from a partnership. A partner will be

treated as owning its proportionate share

of the partnership’s production assets

only to the extent that, under paragraph

(g)(2)(i) of this section, the partner’s

activity includes production activity conducted through a partnership. A partner’s

share of partnership assets will be determined by reference to the partner’s

distributive share of partnership income

for the year attributable to such production assets. Similarly, to the extent a

partnership’s activities include the production activities of a partner, the partnership will be treated as owning the

partner’s production assets related to the

inventory that is contributed in kind to

the partnership. See paragraph

(c)(1)(ii)(B) of this section for rules

apportioning the basis of assets to Section 863 Sales.

(iii) Basis. For purposes of this section, in those cases where the partner is

treated as owning its proportionate share

of the partnership’s production assets,

the partner’s basis in production assets

held through a partnership shall be determined by reference to the partnership’s adjusted basis in its assets (including a partner’s special basis

adjustment, if any, under section 743).

Similarly, a partnership’s basis in a

partner’s production assets is determined

with reference to the partner’s adjusted

basis in its assets.

(iv) Separate application of methods.

If, under paragraph (g)(2) of this section, a partner is treated as conducting

the activity of a partnership, and is

treated as owning its proportionate share

of a partnership’s production assets, a

partner must apply the method it has

elected under paragraph (b) of this sec-

tion separately to Section 863 Sales

described in this paragraph (g) and all

other Section 863 Sales.

(3) Examples. The following examples illustrate the rules of this paragraph (g):

Example 1. Distributive share of partnership

income. A, a U.S. corporation, forms a partnership

in the United States with B, a country X corporation. A and B each have a 50 percent interest in

the income, gains, losses, deductions and credits

of the partnership. The partnership is engaged in

the manufacture and sale of widgets. The widgets

are manufactured in the partnership’s plant located

in the United States and are sold by the partnership outside the United States. The partnership

owns the manufacturing facility and all other

production assets used to produce the widgets. A’s

distributive share of partnership income includes

50 percent of the sales income from these sales. In

applying the rules of section 863 to determine the

source of its distributive share of partnership

income from the export sales of widgets, A is

treated as carrying on the activity of the partnership related to production of these widgets and as

owning a proportionate share of the partnership’s

assets related to production of the widgets, based

upon its distributive share of partnership income.

Example 2. Distribution in kind. Assume the

same facts as in Example 1 except that the

partnership, instead of selling the widgets, distributes the widgets to A and B. A then further

processes the widgets and then sells them outside

the United States. In determining the source of the

income earned by A on the sales outside the

United States, A is treated as conducting the

activities of the partnership related to production

of the distributed widgets. Thus, the source of

gross income on the sale of the widgets is

determined under section 863 and these regulations. A applies the 50/50 method described in

paragraph (b)(1) of this section to determine the

source of income from the sales. In applying

paragraph (c)(1) of this section, A is treated as

owning its proportionate share of the partnership’s

production assets based upon its distributive share

of partnership income.

(h) Effective dates. The rules of this

section apply to taxable years beginning

December 30, 1996. However, taxpayers

may apply these regulations for taxable

years beginning after July 11, 1995, and

before December 30, 1996. For years

beginning before December 30, 1996,

see §§ 1.863–3A and 1.863–3AT.

Par. 7. Section 1.863–4 is amended by

revising the section heading and paragraph (a) to read as follows:

§ 1.863–5 [Removed]

Par. 8. Section 1.863–5 is removed.

PART 602—OMB CONTROL NUMBERS UNDER THE PAPERWORK

REDUCTION ACT

Par. 9. The authority citation for part

602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 10. In § 602.101, paragraph (c)

is amended by adding entries for

1.863–1 and 1.863–3A, and revising the

entry for 1.863–3 to read as follows:

§ 602.101 OMB Control numbers.

CFR part or section

where identified and

described

Current OMB

control No.

1.863–1 . . . . . . . . . . . . . . 1545–1476

1.863–3 . . . . . . . . . . . . . . 1545–1476

1.863–3A. . . . . . . . . . . . . 1545–0126

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved November 25, 1996.

Donald C. Lubick,

Acting Assistant Secretary

of Tax Policy.

(Filed by the Office of the Federal Register on

November 27, 1996, 8:45 a.m., and published in

the issue of the Federal Register for November 29,

1996, 61 F.R. 60540)

Section 1491.—Imposition of Tax

If the status of a trust changes from domestic to

foreign, what are the consequences for purposes of

the section 1491 excise tax? See Notice 96–65,

page 28.

Section 2056A.—Qualified

Domestic Trust

§ 1.863–4 Certain transportation services.

26 CFR 20.2056A–2: Requirements for qualified

domestic trusts.

(a) General. A taxpayer carrying on

the business of transportation service

(other than an activity giving rise to

transportation income described in section 863(c) or to income subject to other

specific provisions of this title) between

points in the United States and points

outside the United States derives income

partly from sources within and partly

from sources without the United States.

T.D. 8686

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 20 and 602

Requirements to Ensure Collection

of Section 2056A Estate Tax

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Final regulations.

Background

SUMMARY: This document contains

final regulations that provide guidance

relating to the additional requirements

necessary to ensure the collection of the

estate tax imposed under section

2056A(b) with respect to taxable events

involving qualified domestic trusts

(QDOTs) described in section 2056A(a).

DATES: These regulations are effective

November 29, 1996.

For dates of applicability, see

§ 20.2056A–2(d).

A notice of proposed rulemaking was

published in the Federal Register on

January 5, 1993 (58 FR 305), reflecting

amendments to the Internal Revenue

Code by the Technical and Miscellaneous Revenue Act of 1988 (Public Law

100–647), the Revenue Reconciliation

Act of 1989 (Public Law 101–239), and

the Revenue Reconciliation Act of 1990

(Public Law 101–508). The amendments

generally relate to sections 2056 and

2523, and affect the availability of the

estate and gift tax marital deduction

when the surviving spouse or the donee

spouse is not a United States citizen.

Part of the NPRM was published in the

Federal Register as final regulations, in

TD 8612, on August 22, 1995 (60 FR

43531 [1995–2 C.B. 192]). That part of

the NPRM that addressed the regulatory

requirements to ensure the collection of

the estate tax imposed by section

2056A(b)(1)(A) and (B) was published

in the Federal Register on August 22,

1995, in the form of temporary and

proposed regulations, (60 FR 43554 and

60 FR 43575, respectively) in order to

afford the public a further opportunity to

comment on these security arrangements.

On January 16, 1996, the IRS held a

hearing on the temporary and proposed

regulations. These final regulations reflect the comments received in response

to the temporary and proposed regulations.

FOR FURTHER INFORMATION CONTACT: Susan Hurwitz (202) 622–3090

(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in these final regulations has been

reviewed and approved by the Office of

Management and Budget in accordance

with the Paperwork Reduction Act (44

U.S.C. 3507) under control number

1545–1443. Responses to this collection

of information are required in order for

an estate to be eligible for the estate tax

marital deduction in cases where the

surviving spouse is not a United States

citizen.

An agency may not conduct or sponsor, and a person is not required to

respond to, a collection of information

unless the collection of information displays a valid control number.

The estimated annual burden per respondent varies from 30 minutes to 3

hours, depending on individual circumstances, with an estimated average of

1.39 hours.

Comments concerning the accuracy of

this burden estimate and suggestions for

reducing this burden should be sent to

the Internal Revenue Service, Attn:

IRS Reports Clearance Officer T:FP,

Washington, DC 20224, and to the Office of Management and Budget, Attention: Desk Officer for the Department

of the Treasury, Office of Information

and Regulatory Affairs, Washington, DC

20503.

Books or records relating to this collection of information must be retained

as long as their contents may become

material in the administration of any

internal revenue law. Generally, tax returns and tax return information are

confidential, as required by 26 U.S.C.

6103.

Explanation of Provisions

The following is a summary of the

significant comments received and the

reasons for accepting or rejecting those

comments in the final regulations.

Under the temporary regulations, a

qualified domestic trust (QDOT) that

has assets in excess of $2 million, may

alternate among the three security arrangements provided in the regulations

(U.S. bank trustee, bond or letter of

credit), provided that at all times, at

least one of the three arrangements is in

effect. A QDOT with assets of $2

million or less need not satisfy these

requirements, if, in general, the trust

holdings of foreign situs real property

are limited to 35 percent of the fair

market value of the trust corpus.

Comments were received that trusts in

actual compliance with these regulatory

requirements, but which do not explicitly include the required language, will

not qualify as a QDOT. In addition,

comments suggested that the imposition

of numerous governing instrument re-

quirements will increase the difficulty of

drafting a QDOT and result in a trust

document that will have to include detailed provisions, many of which are not

likely to be applicable. A suggestion was

made that if the governing instrument

requirement is retained in the regulations, then the required security provisions should be permitted to be incorporated by reference in a trust document.

This suggestion was adopted. However,

in order to assist taxpayers who may

wish to specify the required provisions

in the governing instrument, the IRS has

published guidance in the Internal Revenue Bulletin (see § 602.101(d)(2) of

this chapter) providing sample language

that may be used in a QDOT instrument

to satisfy the additional security requirements contained in the final regulations.

In response to comments, the language of the regulations has been modified to clarify that the QDOT may

alternate among the three arrangements

provided in the regulations as long as, at

any given time, one of the three arrangements is required to be operative.

Comments suggested that the temporary regulations may be viewed as requiring that a QDOT that initially employs the bank trustee security

alternative must, irrespective of whether

the QDOT has switched to another

security option, continue to have at least

one U.S. Bank acting as a trustee. In

response to this comment, the final

regulations clarify that, if the QDOT

changes to a different security arrangement, a U.S. bank need not continue to

act as trustee.

Under the temporary regulations, in

determining whether the value of the

assets passing to a QDOT are in excess

of, or less than, $2 million, indebtedness

with respect to the assets is not taken

into account to reduce value. Similarly,

under the temporary regulations, the

amount of the bond or letter of credit

that is furnished to the IRS must be

equal to 65 percent of the fair market

value of the trust assets determined

‘‘without regard to any indebtedness

thereon.’’ Comments suggested that indebtedness should be taken into account

in determining whether the $2 million

dollar threshold has been exceeded and

the amount of the bond or letter of

credit required. This change has not

been made. The IRS and Treasury believe that the retention of the rule that

indebtedness on the property is not

taken into account to reduce value most

effectively ensures collection of the estate tax imposed under section

2056A(b). For the limited purpose under

this section (i.e., to determine whether

the $2 million threshold is exceeded and

the amount of the bond or letter of

credit to be furnished to the IRS) the

complexity that would be involved in

drafting rules to determine which debts

qualify to be taken into account and

which do not is not warranted.

Under the temporary regulations, with

regard to the bond and letter of credit

security options, if the fair market value

of the trust assets, is ‘‘finally determined’’ to be in excess of the value of

the trust assets as originally reported,

the trustee has a reasonable period of

time (not exceeding sixty days from the

date of the final determination) to adjust

the amount of the bond or letter of

credit. The temporary regulations also

use the term ‘‘finally determined’’ in

addressing substantial undervaluations of

property passing to a QDOT and the

grace period provided to meet the security requirements when a QDOT is

determined to contain assets in excess of

$2 million. Comments were received

suggesting that the regulations provide a

definition of ‘‘finally determined’’.

Accordingly, the final regulations provide that the value of the assets will be

finally determined on the earliest to

occur of—

1. The entry of a decision, judgment,

decree, or other order by any court of

competent jurisdiction that has become

final;

2. The execution of a closing agreement made under section 7121;

3. Any final disposition by the IRS of

a claim for refund;

4. The issuance of an estate tax closing letter (if no claim for refund is

filed); or

5. The expiration of the statute of

limitations for assessment with respect

to the decedent’s estate tax liability.

In response to comments, the regulation addressing the required duration of

the bond or letter of credit has been

clarified to provide that the security

arrangement must remain in effect until

the trust ceases to function as a QDOT.

Comments have been received regarding the amount of the bond or letter of

credit that must be furnished to the IRS.

One commentator stated that, since the

purpose of the bond or letter of credit

requirement is to provide a source of

funds for the payment of the section

2056A(b) estate tax, the amount of the

required bond or letter of credit should

be based on either the maximum federal

estate tax rate, or the amount of estate

tax deferred, rather than 65% of the

value of the QDOT, as provided in the

regulations. This suggestion has not

been adopted. Generally, the regulation

requires a bond of 65 percent of the

initial fair market value of the trust

assets to ensure that the potential estate

tax liability is adequately secured if the

trust property appreciates in value.

The temporary regulations providing

that notice of failure to renew a bond or

letter of credit must be ‘‘received by the

IRS at least 60 days prior to the end of

the term of the bond or letter of credit’’

has been changed to reference the date

the notice is ‘‘mailed to’’ the IRS.

Further, under the final regulations, the

notice must also be mailed to the U.S.

Trustee of the QDOT.

Under the regulations, in the case of a

QDOT of less than $2 million, if on the

last day of a taxable year of the QDOT,

the value of foreign real property owned

by the QDOT exceeds 35 percent of the

QDOT assets because of distributions of

principal during that year, or because of

fluctuations in the value of the foreign

currency in the jurisdiction where the

real property is located, a grace period

of one year is provided to allow the

trustee to comply with the 35 percent

limit. Comments suggested that changes

in the relative value of the trust assets

would also cause the trust to fail to

satisfy the 35 percent limit, and failure

to comply due to such changes that are

beyond the control of the trustee should

also be eligible for the grace period.

Accordingly, under the final regulations,

the trustee will also be accorded the

grace period to satisfy the 35 percent

limit if, as a result of changes in the

relative values of the trust assets, more

than 35 percent of the value of the trust

consists of foreign real estate.

Under the temporary regulations, for

purposes of determining whether the $2

million threshold has been exceeded,

and for purposes of determining the

amount of the bond or letter of credit,

the executor of the decedent’s estate

may exclude up to $600,000 in value

attributable to real property wherever

situated (and related furnishings) owned

directly by the QDOT that is used by

the surviving spouse as the spouse’s

principal residence. Comments were received that the regulations should be

expanded to allow the exclusion of all

residential real property that is actually

used by the surviving spouse. Thus, a

vacation home or second home would

qualify for the exclusion. It was also

suggested that all personally used resi-

dential real property, regardless of value,

should be eligible for the exclusion. The

final regulations do not change the monetary limit of $600,000 for the exclusion. The $600,000 limit for the exclusion facilitates the reduction of the costs

associated with providing security while

adequately ensuring the collection of the

section 2056A(b) tax. This is especially

the case in situations where the residential real property is situated outside the

United States so that a significant collection risk is presented. However, under

the final regulations the exclusion has

been redesignated as a ‘‘personal residence’’ exclusion. The exclusion is now

available for the principal residence of

the surviving spouse and one additional

residence, to the extent the combined

value excluded does not exceed

$600,000. The second residence will be

eligible for the exclusion only if the

residence is used by the surviving

spouse as a personal residence and not

subject to any rental arrangement with

any person.

Under the temporary regulations, the

residence exclusion election is made by

attaching a written statement to the

estate tax return on which the QDOT

election is made. Commentators suggested that the final regulations allow

the election to be made at any time

during the term of the QDOT, and not

necessarily at the time of filing of the

decedent’s estate tax return. For example, if the bank trustee alternative is

selected by the trustee of the QDOT, but

at some future date the trustee desires to

change to the bond or letter of credit

security arrangement, the trustee should

be given the opportunity to make a

delayed election of the exclusion. In

response to these comments, the final

regulations provide that the election may

be made at any time during the term of

the QDOT. In addition, the final regulation provides for the cancellation of a

prior election.

Under the temporary regulations, the

U.S. Trustee of a QDOT is required to

file an annual statement with the IRS

containing specified items of information (including a list of all assets held

by the QDOT together with the fair

market value of each asset determined

as of the last day of the taxable year) if

the residence exclusion applies during

the taxable year. Comments were received suggesting that the cost of compliance with this annual reporting requirement will limit the utility of the

residence exclusion. In response to these

comments, annual reporting is no longer

required solely because the personal

residence exclusion was elected. However, the regulations retain the annual

reporting requirement where the residence previously subject to the exclusion is sold, or where the residence

ceases to be used as a personal residence during the taxable or calendar

year.

Under the temporary regulations, if a

residence that is subject to the exclusion

is sold during the term of the QDOT,

the exclusion will continue to apply if,

within 12 months of the date of sale, the

amount of the adjusted sales price (as

defined in section 1034(d)(1)) is used to

purchase a new residence for the spouse.

In response to comments, this provision

has been amended to provide that if a

residence ceases to be used as the

personal residence of the spouse, or if

the residence is sold during the term of

the QDOT, the exclusion may be applied to another residence that is held in

either the same QDOT or in another

QDOT, if the other residence is used as

a personal residence of the spouse. The

amount of exclusion that may be applied

to the new personal residence under

these circumstances can be up to

$600,000 (less that amount previously

allocated to a residence that continues to

qualify for the exclusion) even if the

entire $600,000 exclusion was not previously used for the initial personal residence(s).

Also, under the temporary regulations,

on the sale of a residence, if less than

the entire adjusted sales price is reinvested in a new residence, then the

amount of the exclusion initially

claimed by the QDOT is reduced proportionately. For example, if a residence

is sold for an adjusted sales price of

$1,000,000 and a new residence is acquired for $800,000, then, the original

exclusion would be reduced by

$120,000 to $480,000: $200,000 (adjusted sales price not reinvested)/

$1,000,000 (adjusted sales price) x

$600,000. Comments were received suggesting that this rule be changed to

provide that the amount of the exclusion

as adjusted not be reduced below the

amount actually reinvested (up to

$600,000). This suggestion was adopted

in the final regulations, reflecting that

two residences can now qualify for the

$600,000 exclusion.

Special Analyses

It has also 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 notice of proposed rulemaking preceding the regulations was issued prior

to March 29, 1996, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not

apply.

Drafting Information

The principal author of these regulations is Susan Hurwitz, Office of Assistant Chief Counsel (Passthroughs and

Special Industries). However, other personnel from the IRS and Treasury Department participated in their development.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 20 and

602 are amended as follows:

PART 20—ESTATE TAX; ESTATES

OF DECEDENTS DYING AFTER AUGUST 16, 1954

Paragraph 1. The authority citation for

part 20 continues to read in part as

follows:

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

Par. 2. In § 20.2056A–0, the table of

contents is amended by revising the

entry for § 20.2056A–2(d) to read as

follows:

§ 20.2056A–0 Table of contents.

§ 20.2056A–2 Requirements for qualified domestic trust.

(d) Additional requirements to ensure

collection of the section 2056A estate

tax.

(1) Security and other arrangements

for payment of estate tax imposed under

section 2056A(b)(1).

(2) Individual trustees.

(3) Annual reporting requirements.

(4) Request for alternate arrangement

or waiver.

(5) Adjustment of dollar threshold

and exclusion.

(6) Effective date and special rules.

Par. 3. In § 20.2056A–2, paragraph

(d) is added to read as follows:

§ 20.2056A–2 Requirements for qualified domestic trust.

(d) Additional requirements to ensure

collection of the section 2056A estate

tax—(1) Security and other arrange-

ments for payment of estate tax imposed

under section 2056A(b)(1)—(i) QDOTs

with assets in excess of $2 million. If

the fair market value of the assets

passing, treated, or deemed to have

passed to the QDOT (or in the form of

a QDOT), determined without reduction

for any indebtedness with respect to the

assets, as finally determined for federal

estate tax purposes, exceeds $2 million

as of the date of the decedent’s death or,

if applicable, the alternate valuation date

(adjusted as provided in paragraph

(d)(1)(iii) of this section), the trust instrument must meet the requirements of

either paragraph (d)(1)(i)(A), (B), or (C)

of this section at all times during the

term of the QDOT. The QDOT may

alternate between any of the arrangements provided in paragraphs (d)(1)(i)(A), (B), and (C) of this section provided that, at any given time, one of the

arrangements must be operative. See

paragraph (d)(1)(iii) of this section for

the definition of finally determined. The

QDOT may provide that the trustee has

the discretion to use any one of the

security arrangements or may provide

that the trustee is limited to using only

one or two of the arrangements specified in the trust instrument. A trust

instrument that specifically states that

the trust must be administered in compliance with paragraph (d)(1)(i)(A), (B),

or (C) of this section is treated as

meeting the requirements of paragraphs

(d)(1)(i)(A), (B), or (C) for purposes of

paragraphs (d)(1)(i) and, if applicable,

(d)(1)(ii) of this section.

(A) Bank Trustee. Except as otherwise provided in paragraph (d)(6)(ii) or

(iii) of this section, the trust instrument

must provide that whenever the Bank

Trustee security alternative is used for

the QDOT, at least one U.S. Trustee

must be a bank as defined in section

581. Alternatively, except as otherwise

provided in paragraph (d)(6)(ii) or (iii)

of this section, at least one trustee must

be a United States branch of a foreign

bank, provided that, in such cases, during the entire term of the QDOT a U.S.

Trustee must act as a trustee with the

foreign bank trustee.

(B) Bond. Except as otherwise provided in paragraph (d)(6)(ii) or (iii) of

this section, the trust instrument must

provide that whenever the bond security

arrangement alternative is used for the

QDOT, the U.S. Trustee must furnish a

bond in favor of the Internal Revenue

Service in an amount equal to 65 percent of the fair market value of the trust

assets (determined without regard to any

indebtedness with respect to the assets)

as of the date of the decedent’s death

(or alternate valuation date, if applicable), as finally determined for federal

estate tax purposes (and as further adjusted as provided in paragraph

(d)(1)(iv) of this section). If, after examination of the estate tax return, the

fair market value of the trust assets, as

originally reported on the estate tax

return, is adjusted (pursuant to a judicial

proceeding or otherwise) resulting in a

final determination of the value of the

assets as reported on the return, the U.S.

Trustee has a reasonable period of time

(not exceeding sixty days after the conclusion of the proceeding or other action

resulting in a final determination of the

value of the assets) to adjust the amount

of the bond accordingly. But see, paragraph (d)(1)(i)(D) of this section for a

special rule in the case of a substantial

undervaluation of QDOT assets. Unless

an alternate arrangement under paragraph (d)(1)(i)(A), (B), or (C) of this

section, or an arrangement prescribed

under paragraph (d)(4) of this section, is

provided, or the trust is otherwise no

longer subject to the requirements of

section 2056A pursuant to section

2056A(b)(12), the bond must remain in

effect until the trust ceases to function

as a QDOT and any tax liability finally

determined to be due under section

2056A(b) is paid, or is finally determined to be zero.

(1) Requirements for the bond. The

bond must be with a satisfactory surety,

as prescribed under section 7101 and

§ 301.7101–1 of this chapter (Regulations on Procedure and Administration),

and is subject to Internal Revenue Service review as may be prescribed by the

Commissioner. The bond may not be

cancelled. The bond must be for a term

of at least one year and must be automatically renewable at the end of that

term, on an annual basis thereafter,

unless notice of failure to renew is

mailed to the U.S. Trustee and the

Internal Revenue Service at least 60

days prior to the end of the term,

including periods of automatic extensions. Any notice of failure to renew

required to be sent to the Internal Revenue Service must be sent to the Estate

and Gift Tax Group in the District

Office of the Internal Revenue Service

that has examination jurisdiction over

the decedent’s estate (Internal Revenue

Service, District Director, [specify location] District Office, Estate and Gift Tax

Examination Group, [specify Street Address, City, State, Zip Code]) (or in the

case of noncitizen decedents and United

States citizens who die domiciled outside the United States, Estate Tax

Group, Assistant Commissioner (International), 950 L’Enfant Plaza, CP:IN:D:C:EX:HQ:1114, Washington, DC 20024).

The Internal Revenue Service will not

draw on the bond if, within 30 days of

receipt of the notice of failure to renew,

the U.S. Trustee notifies the Internal

Revenue Service (at the same address to

which notice of failure to renew is to be

sent) that an alternate arrangement under

paragraph (d)(1)(i)(A), (B), or (C) or

(d)(4) of this section, has been secured

and that the arrangement will take effect

immediately prior to or upon expiration

of the bond.

(2) Form of bond. The bond must be

in the following form (or in a form that

is the same as the following form in all

material respects), or in such alternative

form as the Commissioner may prescribe by guidance published in the

Internal Revenue Bulletin (see

§ 601.601(d)(2) of this chapter):

Bond in Favor of the Internal Revenue Service To Secure Payment of

Section 2056A Estate Tax Imposed Under Section 2056A(b) of the Internal

Revenue Code.

KNOW ALL PERSONS BY

THESE PRESENTS, That the under, the SURETY,

signed,

, the PRINCIPAL,

and

are irrevocably held and firmly bound to

pay the Internal Revenue Service upon

written demand that amount of any tax

up to $[amount determined under paragraph (d)(1)(i)(B) of this section], imposed under section 2056A(b)(1) of the

Internal Revenue Code (including penalties and interest on said tax) determined

by the Internal Revenue Service to be

payable with respect to the principal as

trustee for: [Identify trust and governing

instrument, name and address of

trustee], a qualified domestic trust as

defined in section 2056A(a) of the Internal Revenue Code, for the payment of

which the said Principal and said Surety,

bind themselves, their heirs, executors,

administrators, successors and assigns,

jointly and severally, firmly by these

presents.

WHEREAS, The Internal Revenue

Service may demand payment under this

bond at any time if the Internal Revenue

Service in its sole discretion determines

that a taxable event with respect to the

trust has occurred; the trust no longer

qualifies as a qualified domestic trust as

described in section 2056A(a) of the

Internal Revenue Code and the regulations promulgated thereunder, or a distribution subject to the tax imposed

under section 2056A(b)(1) has been

made. Demand by the Internal Revenue

Service for payment may be made

whether or not the tax and tax return

(Form 706–QDT) with respect to the

taxable event is due at the time of such

demand, or an assessment has been

made by the Internal Revenue Service

with respect to the tax.

NOW THEREFORE, The condition

of this obligation is such that it must not

be cancelled and, if payment of all tax

liability finally determined to be imposed under section 2056A(b) is made,

then this obligation is null and void;

otherwise, this obligation is to remain in

full force and effect for one year from

its effective date and is to be automatically renewable on an annual basis

unless, at least 60 days prior to the

expiration date, including periods of

automatic renewals, the surety mails to

the U.S. Trustee and the Internal Revenue Service by Registered or Certified

Mail, return receipt requested, notice of

the failure to renew. Receipt of this

notice of failure to renew by the Internal

Revenue Service may be considered a

taxable event. The Internal Revenue Service will not draw upon the bond if,

within 30 days of receipt of the notice

of failure to renew, the trustee notifies

the Internal Revenue Service that an

alternate security arrangement has been

secured and that the arrangement will

take effect immediately prior to or upon

expiration of the bond. The surety remains liable for all taxable events occurring prior to the date of expiration.

All notices required to be sent to the

Internal Revenue Service under this

instrument should be sent to District

Director, [specify location] District Office, Estate and Gift Tax Examination

Group, Street Address, City, State, Zip

Code. (In the case of nonresident noncitizen decedents and United States citizens who die domiciled outside the

United States, all notices should be sent

to Estate Tax Group, Assistant Commissioner (International), 950 L’Enfant

Plaza, CP:IN:D:C:EX:HQ:1114, Washington, DC 20024).

This bond shall be effective as of

. Principal

Date

Surety

Date

(3) Additional governing instrument

requirements. The trust instrument must

provide that in the event the Internal

Revenue Service draws on the bond, in

accordance with its terms, neither the

U.S. Trustee nor any other person will

seek a return of any part of the remittance until after April 15th of the calendar year following the year in which the

bond is drawn upon. After that date, any

such remittance will be treated as a

deposit and returned (without interest)

upon request of the U.S. Trustee, unless

it is determined that assessment or collection of the tax imposed by section

2056A(b)(1) is in jeopardy, within the

meaning of section 6861. If an assessment under section 6861 is made, the

remittance will first be credited to any

tax liability reported on the Form 706–

QDT, then to any unpaid balance of a

section 2056A(b)(1)(A) tax liability

(plus interest and penalties) for any

prior taxable years, and any balance will

then be returned to the U.S. Trustee.

(4) Procedure. The bond is to be

filed with the decedent’s federal estate

tax return, Form 706 or 706NA (unless

an extension for filing the bond is

granted under § 301.9100 of this chapter). The U.S. Trustee must provide a

written statement with the bond that

provides a list of the assets that will be

used to fund the QDOT and the respective values of the assets. The written

statement must also indicate whether

any exclusions under paragraph

(d)(1)(iv) of this section are claimed.

(iii) of this section, the trust instrument

must provide that whenever the letter of

credit security arrangement is used for

the QDOT, the U.S. Trustee must furnish an irrevocable letter of credit issued

by a bank as defined in section 581, a

United States branch of a foreign bank,

or a foreign bank with a confirmation

by a bank as defined in section 581. The

letter of credit must be for an amount

equal to 65 percent of the fair market

value of the trust assets (determined

without regard to any indebtedness with

respect to the assets) as of the date of

the decedent’s death (or alternate valuation date, if applicable), as finally determined for federal estate tax purposes

(and as further adjusted as provided in

paragraph (d)(1)(iv) of this section). If,

after examination of the estate tax return, the fair market value of the trust

assets, as originally reported on the

estate tax return, is adjusted (pursuant to

a judicial proceeding or otherwise) resulting in a final determination of the

value of the assets as reported on the

return, the U.S. Trustee has a reasonable

period of time (not exceeding 60 days

after the conclusion of the proceeding or

other action resulting in a final determination of the value of the assets) to

adjust the amount of the letter of credit

accordingly. But see, paragraph

(d)(1)(i)(D) of this section for a special

rule in the case of a substantial undervaluation of QDOT assets. Unless an

alternate arrangement under paragraph

(d)(1)(i)(A), (B), or (C) of this section,

or an arrangement prescribed under

paragraph (d)(4) of this section, is provided, or the trust is otherwise no longer

subject to the requirements of section

2056A

pursuant

section

2056A(b)(12), the letter of credit must

remain in effect until the trust ceases to

function as a QDOT and any tax liability finally determined to be due under

section 2056A(b) is paid or is finally

determined to be zero.

(1) Requirements for the letter of

credit. The letter of credit must be

irrevocable and provide for sight payment. The letter of credit must have a

term of at least one year and must be

automatically renewable at the end of

the term, at least on an annual basis,

unless notice of failure to renew is

mailed to the U.S. Trustee and the

Internal Revenue Service at least sixty

days prior to the end of the term,

including periods of automatic renewals.

If the letter of credit is issued by the

U.S. branch of a foreign bank and the

U.S. branch is closing, the branch (or

foreign bank) must notify the U.S.

Trustee and the Internal Revenue Service

of the closure and the notice of closure

must be mailed at least 60 days prior to

the date of closure. Any notice of failure

to renew or closure of a U.S. branch of

a foreign bank required to be sent to the

Internal Revenue Service must be sent to

the Estate and Gift Tax Group in the

District Office of the Internal Revenue

Service that has examination jurisdiction

over the decedent’s estate (Internal Revenue Service, District Director, [specify

location] District Office, Estate and Gift

Tax Examination Group, [Street Address,

City State, Zip Code]) (or in the case of

noncitizen decedents and United States

citizens who die domiciled outside the

United States, Estate Tax, Assistant

Commissioner (International), 950

L’Enfant Plaza, CP:IN:D:C:EX:HQ:1114,

Washington, DC 20024). The Internal

Revenue Service will not draw on the

letter of credit if, within 30 days of

receipt of the notice of failure to renew

or closure of the U.S. branch of a

foreign bank, the U.S. Trustee notifies

the Internal Revenue Service (at the

same address to which notice is to be

sent) that an alternate arrangement under

paragraph (d)(1)(i)(A), (B), or (C), or

(d)(4) of this section, has been secured

and that the arrangement will take effect

immediately prior to or upon expiration

of the letter of credit or closure of the

U.S. branch of the foreign bank.

(2) Form of letter of credit. The letter

of credit must be made in the following

form (or in a form that is the same as

the following form in all material respects), or an alternative form that the

Commissioner prescribes by guidance

published in the Internal Revenue Bulletin (see § 601.601(d)(2) of this chapter):

[Issue Date]

To: Internal Revenue Service

Attention: District Director, [specify

location] District Office

Estate and Gift Tax Examination

Group

[Street Address, City, State,

ZIP Code]

[Or in the case of nonresident noncitizen

decedents and United States citizens

who die domiciled outside the United

States,

To: Estate Tax Group,

Assistant Commissioner

(International)

950 L’Enfant Plaza

CP:IN:D:C:EX:HQ:1114

Washington, DC 20024].

Dear Sirs:

We hereby establish our irrevocable

in your favor

Letter of Credit No.

for drawings up to U.S. $ [Applicant

should provide bank with amount which

Applicant determined under paragraph

(d)(1)(i)(C)] effective immediately. This

Letter of Credit is issued, presentable

and payable at our office at

and expires at 3:00 p.m.

[EDT, EST, CDT, CST, MDT, MST,

at said office.

PDT, PST] on

For information and reference only,

we are informed that this Letter of

Credit relates to [Applicant should provide bank with the identity of qualified

domestic trust and governing instrument], and the name, address, and identifying number of the trustee is [Applicant should provide bank with the

trustee name, address and the QDOT’s

TIN number, if any].

Drawings on this Letter of Credit are

available upon presentation of the following documents:

1. Your draft drawn at sight on us

bearing our Letter of Credit No.

; and

2. Your signed statement as follows:

The amount of the accompanying

draft is payable under [identify bank]

irrevocable Letter of Credit No.

pursuant to section

2056A of the Internal Revenue Code

and the regulations promulgated

thereunder, because the Internal Revenue Service in its sole discretion has

determined that a ‘‘taxable event’’

with respect to the trust has occurred;

e.g., the trust no longer qualifies as a

qualified domestic trust as described

in section 2056A of the Internal Revenue Code and regulations promulgated thereunder, or a distribution

subject to the tax imposed under

section 2056A(b)(1) of the Internal

Revenue Code has been made.

Except as expressly stated herein, this

undertaking is not subject to any agreement, requirement or qualification. The

obligation of [Name of Issuing Bank]

under this Letter of Credit is the individual obligation of [Name of Issuing

Bank] and is in no way contingent upon

reimbursement with respect thereto.

It is a condition of this Letter of

Credit that it is deemed to be automatically extended without amendment for a

period of one year from the expiration

date hereof, or any future expiration

date, unless at least 60 days prior to any

expiration date, we mail to you and to

the U.S. Trustee notice by Registered

Mail or Certified Mail, return receipt

requested, or by courier to your and the

trustee’s address indicated above, that

we elect not to consider this Letter of

Credit renewed for any such additional

period. Upon receipt of this notice, you

may draw hereunder on or before the

then current expiration date, by presentation of your draft and statement as

stipulated above.

[In the case of a letter of credit issued

by a U.S. branch of a foreign bank the

following language must be added]. It is

a further condition of this Letter of

Credit that if the U.S. branch of [name

of foreign bank] is to be closed, that at

least sixty days prior to closing, we mail

to you and the U.S. Trustee notice by

Registered Mail or Certified Mail, return

receipt requested, or by courier to your

and the U.S. Trustee’s address indicated

above, that this branch will be closing.

This notice will specify the actual date of

closing. Upon receipt of the notice, you

may draw hereunder on or before the

date of closure, by presentation of your

draft and statement as stipulated above.

Except where otherwise stated herein,

this Letter of Credit is subject to the

Uniform Customs and Practice for

Documentary Credits, 1993 Revision,

ICC Publication No. 500. If we notify

you of our election not to consider this

Letter of Credit renewed and the expiration date occurs during an interruption

of business described in Article 17 of

said Publication 500, unless you had

consented to cancellation prior to the

expiration date, the bank hereby specifically agrees to effect payment if this

Letter of Credit is drawn against within

30 days after the resumption of business.

Except as stated herein, this Letter of

Credit cannot be modified or revoked

without your consent.

Authorized Signature

Date

(3) Form of confirmation. If the requirements of this paragraph (d)(1)(i)(C) are

satisfied by the issuance of a letter of

credit by a foreign bank with confirmation by a bank as defined in section 581,

the confirmation must be made in the

following form (or in a form that is the

same as the following form in all material respects), or an alternative form as

the Commissioner prescribes by guidance published in the Internal Revenue

Bulletin (see § 602.101(d)(2) of this

chapter):

[Issue Date]

To: Internal Revenue Service

Attention: District Director,

[specify location]

District Office

Estate and Gift Tax

Examination Group

[State Address, City,

State, ZIP Code]

[or in the case of nonresident noncitizen

decedents and United States citizens

who die domiciled outside the United

States,

To: Estate Tax Group,

Assistant Commissioner

(International)

950 L’Enfant Plaza

CP:IN:D:C:EX:HQ:1114

Washington, DC 20024].

Dear Sirs:

We hereby confirm the enclosed irre,

vocable Letter of Credit No.

and amendments thereto, if any, in your

[Issuing Bank]

favor by

for drawings up to U.S. $

[same amount as in initial Letter of

Credit] effective immediately. This confirmation is issued, presentable and payand

able at our office at

expires at 3:00 p.m. [EDT, EST,

CDT, CST, MDT, MST, PDT, PST] on

at said office.

For information and reference only,

we are informed that this Confirmation

relates to [Applicant should provide

bank with the identity of qualified domestic trust and governing instrument],

and the name, address, and identifying

number of the trustee is [Applicant

should provide bank with the trustee

name, address and the QDOT’s TIN

number, if any].

We hereby undertake to honor your

sight draft(s) drawn as specified in the

Letter of Credit.

Except as expressly stated herein, this

undertaking is not subject to any agreement, condition or qualification. The

obligation of [Name of Confirming

Bank] under this Confirmation is the

individual obligation of [Name of Confirming Bank] and is in no way contingent upon reimbursement with respect

thereto.

It is a condition of this Confirmation

that it is deemed to be automatically

extended without amendment for a period of one year from the expiry date

hereof, or any future expiration date,

unless at least sixty days prior to the

expiration date, we send to you and to

the U.S. Trustee notice by Registered

Mail or Certified Mail, return receipt

requested, or by courier to your and the

trustee’s addresses, respectively, indicated above, that we elect not to consider this Confirmation renewed for any

additional period. Upon receipt of this

notice by you, you may draw hereunder

on or before the then current expiration

date, by presentation of your draft and

statement as stipulated above.

Except where otherwise stated herein,

this Confirmation is subject to the Uniform Customs and Practice for Documentary Credits, 1993 Revision, ICC

Publication No. 500. If we notify you of

our election not to consider this Confirmation renewed and the expiration date

occurs during an interruption of business

described in Article 17 of said Publication 500, unless you had consented to

cancellation prior to the expiration date,

the bank hereby specifically agrees to

effect payment if this Confirmation is

drawn against within 30 days after the

resumption of business.

Except as stated herein, this Confirmation cannot be modified or revoked

without your consent.

Authorized Signature

Date

(4) Additional governing instrument

requirements. The trust instrument must

provide that if the Internal Revenue

Service draws on the letter of credit (or

confirmation) in accordance with its

terms, neither the U.S. Trustee nor any

other person will seek a return of any

part of the remittance until April 15th of

the calendar year following the year in

which the letter of credit (or confirmation) is drawn upon. After that date, any

such remittance will be treated as a

deposit and returned (without interest)

upon request of the U.S. Trustee after

the date specified above, unless it is

determined that assessment or collection

of the tax imposed by section

2056A(b)(1) is in jeopardy, within the

meaning of section 6861. If an assessment under section 6861 is made, the

remittance will first be credited to any

tax liability reported on the Form 706–

QDT, then to any unpaid balance of a

section 2056A(b)(1)(A) tax liability

(plus interest and penalties) for any

prior taxable years, and any balance will

then be returned to the U.S. Trustee.

(5) Procedure. The letter of credit

(and confirmation, if applicable) is to be

filed with the decedent’s federal estate

tax return, Form 706 or 706NA (unless

an extension for filing the letter of

credit is granted under § 301.9100 of

this chapter). The U.S. Trustee must

provide a written statement with the

letter of credit that provides a list of the

assets that will be used to fund the

QDOT and the respective values of the

assets. The written statement must also

indicate whether any exclusions under

paragraph (d)(1)(iv) of this section are

claimed.

(D) Disallowance of marital deduction for substantial undervaluation of

QDOT property in certain situations. (1)

If either—

(i) The bond or letter of credit security arrangement under paragraph

(d)(1)(i)(B) or (C) of this section is

chosen by the U.S. Trustee; or

(ii) The QDOT property as originally

reported on the decedent’s estate tax

return is valued at $2 million or less

but, as finally determined for federal

estate tax purposes, the QDOT property

is determined to be in excess of $2

million, then the marital deduction will

be disallowed in its entirety for failure

to comply with the requirements of

section 2056A if the value of the QDOT

property reported on the estate tax return is 50 percent or less of the amount

finally determined to be the correct

value of the property for federal estate

tax purposes.

(2) The preceding sentence does not

apply if—

(i) There was reasonable cause for

the undervaluation; and

(ii) The fiduciary of the estate acted

in good faith with respect to the undervaluation. For this purpose, § 1.6664–

4(b) of this chapter applies, to the extent

applicable, with respect to the facts and

circumstances to be taken into account

in making this determination.

(ii) QDOTs with assets of $2 million

or less. If the fair market value of the

assets passing, treated, or deemed to

have passed to the QDOT (or in the

form of a QDOT), determined without

reduction for any indebtedness with respect to the assets, as finally determined

for federal estate tax purposes, is $2

million or less as of the date of the

decedent’s death or, if applicable, the

alternate valuation date (adjusted as provided in paragraph (d)(1)(iv) of this

section), the trust instrument must provide that either no more than 35 percent

of the fair market value of the trust

assets, determined annually on the last

day of the taxable year of the trust (or

on the last day of the calendar year if

the QDOT does not have a taxable

year), will consist of real property located outside of the United States, or the

trust will meet the requirements prescribed by paragraph (d)(1)(i)(A), (B),

or (C) of this section. See paragraph

(d)(1)(ii)(D) of this section for special

rules in the case of principal distributions from a QDOT, fluctuations in the

value of foreign real property held by a

QDOT due to changes in value of

foreign currency, and fluctuations in the

fair market value of assets held by the

QDOT. See paragraph (d)(1)(iv) of this

section for a special rule for personal

residences. If the fair market value, as

originally reported on the decedent’s

estate tax return, of the assets passing or

deemed to have passed to the QDOT

(determined without reduction for any

indebtedness with respect to the assets)

is $2 million or less, but the fair market

value of the assets as finally determined

for federal estate tax purposes is more

than $2 million, the U.S. Trustee has a

reasonable period of time (not exceeding

sixty days after the conclusion of the

proceeding or other action resulting in a

final determination of the value of the

assets) to meet the requirements prescribed by paragraph (d)(1)(i)(A), (B),

or (C) of this section. However, see

paragraph (d)(1)(i)(D) of this section in

the case of a substantial undervaluation

of QDOT assets. See § 20.2056A–

2(d)(1)(iii) for the definition of finally

determined.

(A) Multiple QDOTs. For purposes of

this paragraph (d)(1)(ii), if more than

one QDOT is established for the benefit

of the surviving spouse, the fair market

value of all the QDOTs are aggregated

in determining whether the $2 million

threshold under this paragraph (d)(1)(ii)

is exceeded.

(B) Look-through rule. For purposes

of determining whether no more than 35

percent of the fair market value of the

QDOT assets consists of foreign real

property, if the QDOT owns more than

20% of the voting stock or value in a

corporation with 15 or fewer shareholders, or more than 20% of the capital

interest of a partnership with 15 or

fewer partners, then all assets owned by

the corporation or partnership are

deemed to be owned directly by the

QDOT to the extent of the QDOT’s pro

rata share of the assets of that corporation or partnership. For a partnership,

the QDOT partner’s pro rata share is

based on the greater of its interest in the

capital or profits of the partnership. For

purposes of this paragraph, all stock in

the corporation, or interests in the partnership, as the case may be, owned by

or held for the benefit of the surviving

spouse, or any members of the surviving

spouse’s family (within the meaning of

section 267(c)(4)), are treated as owned

by the QDOT solely for purposes of

determining the number of partners or

shareholders in the entity and the

QDOT’s percentage voting interest or

value in the corporation or capital interest in the partnership, but not for the

purpose of determining the QDOT’s pro

rata share of the assets of the entity.

entities (such as an interest in a trust)

are accorded treatment consistent with

that described in paragraph (d)(1)(ii)(B)

of this section.

(D) Special rule for foreign real

property. For purposes of this paragraph

(d)(1)(ii), if, on the last day of any

taxable year during the term of the

QDOT (or the last day of the calendar

year if the QDOT does not have a

taxable year), the value of foreign real

property owned by the QDOT exceeds

35 percent of the fair market value of

the trust assets due to: distributions of

QDOT principal during that year; fluctuations in the value of the foreign

currency in the jurisdiction where the

real estate is located; or fluctuations in

the fair market value of any assets held

in the QDOT, then the QDOT will not

be treated as failing to meet the requirements of this paragraph (d)(1). Accordingly, the QDOT will not cease to be a

QDOT within the meaning of

§ 20.2056A–5(b)(3) if, by the end of

the taxable year (or the last day of the

calendar year if the QDOT does not

have a taxable year) of the QDOT

immediately following the year in which

the 35 percent limit was exceeded, the

value of the foreign real property held

by the QDOT does not exceed 35

percent of the fair market value of the

trust assets or, alternatively, the QDOT

meets the requirements of either paragraph (d)(1)(i)(A), (B), or (C) of this

section on or before the close of that

succeeding year.

(iii) Definition of finally determined.

For purposes of § 20.2056A–2(d)(1)(i)

and (ii), the fair market value of assets

will be treated as finally determined on

the earliest to occur of—

(A) The entry of a decision, judgment, decree, or other order by any

court of competent jurisdiction that has

become final;

(B) The execution of a closing agreement made under section 7121;

refund;

(D) The issuance of an estate tax

closing letter (Form L–154 or equivalent) if no claim for refund is filed; or

(E) The expiration of the period of

assessment.

(iv) Special rules for personal residence and related personal effects—(A)

Two million dollar threshold. For purposes of determining whether the $2

million threshold under paragraphs

(d)(1)(i) and (ii) of this section has been

exceeded, the executor of the estate may

elect to exclude up to $600,000 in value

attributable to real property (and related

furnishings) owned directly by the

QDOT that is used by, or held for the

use of the surviving spouse as a personal residence and that passes, or is

treated as passing, to the QDOT under

section 2056(d). The election may be

made regardless of whether the real

property is situated within or without

the United States. The election is made

by attaching to the estate tax return on

which the QDOT election is made a

written statement claiming the exclusion.

The statement must clearly identify the

property or properties (i.e. address and

location) for which the election is being

made.

(B) Security requirement. For purposes of determining the amount of the

bond or letter of credit required when

paragraph (d)(1)(i)(B) or (C) of this

section applies, the executor of the estate may elect to exclude, during the

term of the QDOT, up to $600,000 in

value attributable to real property (and

related furnishings) owned directly by

the QDOT that is used by, or held for

the use of the surviving spouse as a

personal residence and that passes, or is

treated as passing, to the QDOT under

section 2056(d). The election may be

made regardless of whether the real

property is situated within or without

the United States. The election is made

by attaching to the estate tax return on

which the QDOT election is made a

written statement claiming the exclusion.

If an election is not made on the

decedent’s estate tax return, the election

may be made, prospectively, at any

time, during the term of the QDOT, by

attaching to the Form 706–QDT a written statement claiming the exclusion. A

statement may also be attached to the

Form 706–QDT that cancels a prior

election of the personal residence exclusion that was made under this paragraph, either on the decedent’s estate tax

return or on a Form 706–QDT.

The special rules of this paragraph

(d)(1)(iv) do not apply for purposes of

determining whether more than 35 percent of the QDOT assets consist of

foreign real property under paragraph

(d)(1)(ii) of this section.

(D) Personal residence. For purposes

of this paragraph (d)(1)(iv), a personal

residence is either the principal residence of the surviving spouse within the

meaning of section 1034 or one other

residence of the surviving spouse. In

order to be used by or held for the use

of the spouse as a personal residence,

the residence must be available at all

times for use by the surviving spouse.

The residence may not be rented to

another party, even when not occupied

by the spouse. A personal residence may

include appurtenant structures used by

the surviving spouse for residential purposes and adjacent land not in excess of

that which is reasonably appropriate for

residential purposes (taking into account

the residence’s size and location).

(E) Related furnishings. The term related furnishings means furniture and

commonly included items such as appli-

ances, fixtures, decorative items and

china, that are not beyond the value

associated with normal household and

decorative use. Rare artwork, valuable

antiques, and automobiles of any kind or

class are not within the meaning of this

term.

(F) Required statement. If one or

both of the exclusions provided in paragraph (d)(1)(iv)(A) or (B) of this section

are elected by the executor of the estate

and the personal residence is later sold

or ceases to be used, or held for use as

a personal residence, the U.S. Trustee

must file the statement that is required

under paragraph (d)(3) of this section at

the time and in the manner provided in

paragraphs (d)(3)(ii) and (iii) of this

section.

(G) Cessation of use. Except as provided in this paragraph (d)(1)(iv)(G), if

the residence ceases to be used by, or

held for the use of, the spouse as a

personal residence of the spouse, or if

the residence is sold during the term of

the QDOT, the exclusions provided in

paragraphs (d)(1)(iv)(A) and (B) of this

section cease to apply. However, if the

residence is sold, the exclusion continues to apply if, within 12 months of the

date of sale, the amount of the adjusted

sales price (as defined in section

1034(b)(1)) is reinvested to purchase a

new personal residence for the spouse.

If less than the amount of the adjusted

sales price is reinvested, the amount of

the exclusion equals the amount reinvested in the new residence plus any

amount previously allocated to a residence that continues to qualify for the

exclusion, up to a total of $600,000. If

the QDOT ceases to qualify for all or

any portion of the initially claimed

exclusions, paragraph (d)(1)(i) of this

section, if applicable (determined as if

the portion of the exclusions disallowed

had not been initially claimed by the

QDOT), must be complied with no later

than 120 days after the effective date of

the cessation. In addition, if a residence

ceases to be used by, or held for the use

of the spouse as a personal residence of

the spouse or if the personal residence is

sold during the term of the QDOT, the

personal residence exclusion may be

allocated to another residence that is

held in either the same QDOT or in

another QDOT that is established for the

surviving spouse, if the other residence

qualifies as being used by, or held for

the use of the spouse as a personal

residence. The trustee may allocate up

to $600,000 to the new personal residence (less the amount previously allo-

cated to a residence that continues to

qualify for the exclusion) even if the

entire $600,000 exclusion was not previously utilized with respect to the original personal residence(s).

(v) Anti-abuse rule. Regardless of

whether the QDOT designates a bank as

the U.S. Trustee under paragraph

(d)(1)(i)(A) of this section (or otherwise

complies with paragraph (d)(1)(i)(A) of

this section by naming a foreign bank

with a United States branch as a trustee

to serve with the U.S. Trustee), complies

with paragraph (d)(1)(i)(B) or (C) of

this section, or is subject to and complies with the foreign real property

requirements of paragraph (d)(1)(ii) of

this section, the trust immediately ceases

to qualify as a QDOT if the trust

utilizes any device or arrangement that

has, as a principal purpose, the avoidance of liability for the estate tax imposed under section 2056A(b)(1), or the

prevention of the collection of the tax.

For example, the trust may become

subject to this paragraph (d)(1)(v) if the

U.S. Trustee that is selected is a domestic corporation established with insubstantial capitalization by the surviving

spouse or members of the spouse’s

family.

(2) Individual trustees. If the U.S.

Trustee is an individual United States

citizen, the individual must have a tax

home (as defined in section 911(d)(3))

in the United States.

(3) Annual reporting requirements—

(i) In general. The U.S. Trustee must

file a written statement described in

paragraph (d)(3)(iii) of this section, if

the QDOT satisfies any one of the

following criteria for the applicable reporting years—

(A) The QDOT directly owns any

foreign real property on the last day of

its taxable year (or the last day of the

calendar year if it has no taxable year),

and the QDOT does not satisfy the

requirements of paragraph (d)(1)(i)(A),

(B), or (C) or (d)(4) of this section by

employing a bank as trustee or providing security; or

(B) The personal residence previously

subject to the exclusion under paragraph

(d)(1)(iv) of this section is sold, or that

personal residence ceases to be used, or

held for use, as a personal residence,

during the taxable year (or during the

calendar year if the QDOT does not

have a taxable year); or

(d)(1)(ii)(B) of this section, the QDOT

is treated as owning any foreign real

property on the last day of the taxable

year (or the last day of the calendar year

if the QDOT has no taxable year), and

the QDOT does not satisfy the requirements of paragraph (d)(1)(A), (B), (C)

or (d)(4) of this section by employing a

bank as trustee or providing security.

(ii) Time and manner of filing. The

written statement, containing the information described in paragraph (d)(3)(iii)

of this section, is to be filed for the

taxable year of the QDOT (calendar

year if the QDOT does not have a

taxable year) for which any of the

events or conditions requiring the filing

of a statement under paragraph (d)(3)(i)

of this section have occurred or have

been satisfied. The written statement is

to be submitted to the Internal Revenue

Service by filing a Form 706–QDT, with

the statement attached, no later than

April 15th of the calendar year following the calendar year in which or with

which the taxable year of the QDOT

ends (or by April 15th of the following

year if the QDOT has no taxable year),

unless an extension of time is obtained

under § 20.2056A–11(a). The Form

706–QDT, with attached statement, must

be filed regardless of whether the Form

706–QDT is otherwise required to be

filed under the provisions of this chapter. Failure to file timely the statement

may subject the QDOT to the rules of

paragraph (d)(1)(v) of this section.

(iii) Contents of statement. The written statement must contain the following

information—

(A) The name, address, and taxpayer

identification number, if any, of the U.S.

Trustee and the QDOT; and

(B) A list summarizing the assets

held by the QDOT, together with the

fair market value of each listed QDOT

asset, determined as of the last day of

the taxable year (December 31 if the

QDOT does not have a taxable year) for

which the written statement is filed. If

the look-through rule contained in paragraph (d)(1)(ii)(B) of this section applies, then the partnership, corporation,

trust or other entity must be identified

and the QDOT’s pro rata share of the

foreign real property and other assets

owned by that entity must be listed on

the statement as if directly owned by the

QDOT; and

subject to the exclusion under paragraph

(d)(1)(iv) of this section is sold during

the taxable year (or during the calendar

year if the QDOT does not have a

taxable year), the statement must provide the date of sale, the adjusted sales

price (as defined in section 1034(b)(1)),

the extent to which the amount of the

adjusted sales price has been or will be

used to purchase a new personal residence and, if not timely reinvested, the

steps that will or have been taken to

comply with paragraph (d)(1)(i) of this

section, if applicable; and

(D) If the personal residence ceases

to be used, or held for use, as a personal

residence by the surviving spouse during

the taxable year (or during the calendar

year if the QDOT does not have a

taxable year), the written statement must

describe the steps that will or have been

taken to comply with paragraph (d)(1)(i)

of this section, if applicable.

(4) Request for alternate arrangement

or waiver. If the Commissioner provides

guidance published in the Internal Revenue Bulletin (see § 601.601(d)(2) of

this chapter) pursuant to which a testator, executor, or the U.S. Trustee may

adopt an alternate plan or arrangement

to assure collection of the section 2056A

estate tax, and if the alternate plan or

arrangement is adopted in accordance

with the published guidance, then the

QDOT will be treated, subject to paragraph (d)(1)(v) of this section, as meeting the requirements of paragraph (d)(1)

of this section. Until this guidance is

published in the Internal Revenue Bulletin (see § 601.601(d)(2) of this chapter),

taxpayers may submit a request for a

private letter ruling for the approval of

an alternate plan or arrangement proposed to be adopted to assure collection

of the section 2056A estate tax in lieu

of the requirements prescribed in this

paragraph (d)(4).

(5) djustment of dollar threshold and

exclusion. The Commissioner may increase or decrease the dollar amounts

referred to in paragraph (d)(1)(i), (ii) or

(iv) of this section in accordance with

guidance published in the Internal Revenue Bulletin (see § 601.601(d)(2) of

this chapter).

(6) Effective date and special rules.

(i) This paragraph (d) is effective for

estates of decedents dying after February 19, 1996.

(ii) Special rule in the case of incompetency. A revocable trust or a trust

created under the terms of a will is

deemed to meet the governing instrument requirements of this paragraph (d)

notwithstanding that the requirements

are not contained in the governing instrument (or otherwise incorporated by

reference) if the trust instrument (or

will) was executed on or before November 20, 1995, and—

(A) The testator or settlor dies after

February 19, 1996;

(B) The testator or settlor is, on November 20, 1995, and at all times

thereafter, under a legal disability to

amend the will or trust instrument;

not provide the executor or the U.S.

Trustee with a power to amend the

instrument in order to meet the requirements of section 2056A; and

(D) The U.S. Trustee provides a written statement with the federal estate tax

return (Form 706 or 706NA) that the

trust is being administered (or will be

administered) so as to be in actual

compliance with the requirements of this

paragraph (d) and will continue to be

administered so as to be in actual compliance with this paragraph (d) for the

duration of the trust. This statement

must be binding on all successor trustees.

(iii) Special rule in the case of certain irrevocable trusts. An irrevocable

trust is deemed to meet the governing

instrument requirements of this paragraph (d) notwithstanding that the requirements are not contained in the

governing instrument (or otherwise incorporated by reference) if the trust was

executed on or before November 20,

1995, and:

(A) The settlor dies after February

19, 1996;

(B) The trust instrument does not

provide the U.S. Trustee with a power

to amend the trust instrument in order to

meet the requirements of section 2056A;

and

estate tax return (Form 706 or 706NA)

that the trust is being administered in

actual compliance with the requirements

of this paragraph (d) and will continue

to be administered so as to be in actual

compliance with this paragraph (d) for

the duration of the trust. This statement

must be binding on all successor trustees.

§ 20.2056A–2T [Removed]

Par. 3a. Section 20.2056A–2T is removed.

PART 602—0MB CONTROL NUMBERS UNDER THE PAPERWORK

REDUCTION ACT

Par. 4. The authority citation for part

602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 5. In § 602.101, paragraph (c) is

amended by:

1. Removing the following entry

from the table:

§ 602.101 OMB Control numbers.

CFR part or section

where identified and

described

Current OMB

control No.

20.2056A–2T(d) . . . . . . . 1545–1443

2. Adding the following entry in numerical order to the table to read as

follows:

§ 602.101 OMB Control numbers.

CFR part or section

where identified and

described

Current OMB

control No.

20.2056A–2. . . . . . . . . . . 1545–1443

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved September 19, 1996.

Donald C. Lubick,

Acting Assistant Secretary

of the Treasury.

(Filed by the Office of the Federal Register on

November 27, 1996, 8:45 a.m., and published in

the issue of the Federal Register for November 29,

1996, 61 F.R. 60551)

Section 6621.— Determination of

Interest Rate

26 CFR 301.6621–1: Interest rate

Interest rates; underpayments and

overpayments. The rate of interest determined under section 6621 of the

Code for the calendar quarter beginning

October 1, 1996, will be 8 percent for

overpayments, 9 percent for underpayments, and 11 percent for large corporate underpayments. The rate of interest

paid on the portion of a corporate

overpayment exceeding $10,000 is 6.5

percent.

Rev. Rul. 96–61

Section 6621 of the Internal Revenue

Code establishes different rates for inter-

est on tax overpayments and interest on

tax underpayments. Under § 6621(a)(1),

the overpayment rate is the sum of the

federal short-term rate plus 2 percentage

points, except the rate for the portion of

a corporate overpayment of tax exceeding $10,000 for a taxable period is the

sum of the federal short-term rate plus

0.5 of a percentage point for interest

computations made after December 31,

1994. Under § 6621(a)(2), the underpayment rate is the sum of the federal

short-term rate plus 3 percentage points.

Section 6621(c) provides that for purposes of interest payable under § 6601

on any large corporate underpayment,

the

underpayment

rate

under

§ 6621(a)(2) is determined by substituting ‘‘5 percentage points’’ for ‘‘3 percentage points.’’ See § 6621(c) and

§ 301.6621–3 of the Regulations on

Procedure and Administration for the

definition of a large corporate underpayment and for the rules for determining

the applicable rate. Section 6621(c) and

§ 301.6621–3 are generally effective for

periods after December 31, 1990.

Section 6621(b)(1) provides that the

Secretary will determine the federal

short-term rate for the first month in

each calendar quarter.

Section 6621(b)(2)(A) provides that

the federal short-term rate determined

under § 6621(b)(1) for any month applies during the first calendar quarter

beginning after such month.

Section 6621(b)(2)(B) provides that in

determining the addition to tax under

§ 6654 for failure to pay estimated tax

for any taxable year, the federal shortterm rate that applies during the third

month following such taxable year also

applies during the first 15 days of the

fourth month following such taxable

year.

Section 6621(b)(3) provides that the

federal short-term rate for any month is

the federal short-term rate determined

during such month by the Secretary in

accordance with § 1274(d), rounded to

the nearest full percent (or, if a multiple

of 1/2 of 1 percent, the rate is increased

to the next highest full percent).

Notice 88–59, 1988–1 C.B. 546, announced that, in determining the quarterly interest rates to be used for overpayments and underpayments of tax

under § 6621, the Internal Revenue Service will use the federal short-term rate

based on daily compounding because

that rate is most consistent with § 6621

which, pursuant to § 6622, is subject to

daily compounding.

Rounded to the nearest full percent,

the federal short-term rate based on

daily compounding determined during

the month of October 1996 is 6 percent.

Accordingly, an overpayment rate of 8

percent and an underpayment rate of 9

percent are established for the calendar

quarter beginning January 1, 1997. The

overpayment rate for the portion of

corporate overpayments exceeding

$10,000 for the calendar quarter beginning January 1, 1997, is 6.5 percent.

The underpayment rate for large corporate underpayments for the calendar

quarter beginning January 1, 1997, is 11

percent. These rates apply to amounts

bearing interest during that calendar

quarter.

The 9 percent rate also applies to

estimated tax underpayments for the

first calendar quarter in 1997 and for the

first 15 days in April 1997.

Interest factors for daily compound

interest for annual rates of 6.5 percent, 8

percent, 9 percent, and 11 percent are

published in Tables 18, 21, 23, and 27,

of Rev. Proc. 95–17, 1995–1 C.B. 556,

572, 575, 577, and 581.

Annual interest rates to be compounded daily pursuant to § 6622 that

apply for prior periods are set forth in the

tables accompanying this revenue ruling.

DRAFTING INFORMATION

The principal author of this revenue

ruling is Marcia Rachy of the Office of

Assistant Chief Counsel (Income Tax

and Accounting). For further information

regarding this revenue ruling, contact

Ms. Rachy on (202) 622–6232 (not a

toll-free call).

TABLE OF INTEREST RATES

PERIODS BEFORE JUL. 1, 1975—PERIODS ENDING DEC. 31, 1986

OVERPAYMENTS AND UNDERPAYMENTS

PERIOD

RATE

DAILY RATE TABLE

IN 1995-1 C.B.

Before Jul. 1, 1975

Jul. 1, 1975—Jan. 31, 1976

Feb. 1, 1976—Jan. 31, 1978

Feb. 1, 1978—Jan. 31, 1980

Feb. 1, 1980—Jan. 31, 1982

Feb. 1, 1982—Dec. 31, 1982

Jan. 1, 1983—Jun. 30, 1983

Jul. 1, 1983—Dec. 31, 1983

Jan. 1, 1984—Jun. 30, 1984

Jul. 1, 1984—Dec. 31, 1984

Jan. 1, 1985—Jun. 30, 1985

Jul. 1, 1985—Dec. 31, 1985

Jan. 1, 1986—Jun. 30, 1986

Jul. 1, 1986—Dec. 31, 1986

12%

20%

16%

11%

13%

11%

10%

Table 2, pg. 557

Table 4, pg. 559

Table 3, pg. 558

Table 2, pg. 557

Table 5, pg. 560

Table 6, pg. 560

Table 37, pg. 591

Table 27, pg. 581

Table 75, pg. 629

Table 31, pg. 585

Table 27, pg. 581

Table 25 pg. 579

Table 23, pg. 577

TABLE OF INTEREST RATES

FROM JAN. 1, 1987—PRESENT

Jan. 1, 1987—Mar. 31, 1987

Apr. 1, 1987—Jun. 30, 1987

Jul. 1, 1987—Sep. 30, 1987

Oct. 1, 1987—Dec. 31, 1987

Jan. 1, 1988—Mar. 31, 1988

Apr. 1, 1988—Jun. 30, 1988

Jul. 1, 1988—Sep. 30, 1988

Oct. 1, 1988—Dec. 31, 1988

Jan. 1, 1989—Mar. 31, 1989

Apr. 1, 1989—Jun. 30, 1989

Jul. 1, 1989—Sep. 30, 1989

Oct. 1, 1989—Dec. 31, 1989

Jan. 1, 1990—Mar. 31, 1990

Apr. 1, 1990—Jun. 30, 1990

Jul. 1, 1990—Sep. 30, 1990

Oct. 1, 1990—Dec. 31, 1990

Jan. 1, 1991—Mar. 31, 1991

Apr. 1, 1991—Jun. 30, 1991

Jul. 1, 1991—Sep. 30, 1991

OVERPAYMENTS

UNDERPAYMENTS

RATE TABLE PG 1995-1 C.B.

10%

11%

10%

11%

10%

11%

12%

11%

10%

575

577

627

625

627

579

581

579

577

579

629

627

629

581

583

581

579

TABLE OF INTEREST RATES—Continued

FROM JAN. 1, 1987—PRESENT

Oct. 1, 1991—Dec. 31, 1991

Jan. 1, 1992—Mar. 31, 1992

Apr. 1, 1992—Jun. 30, 1992

Jul. 1, 1992—Sep. 30, 1992

Oct. 1, 1992—Dec. 31, 1992

Jan. 1, 1993—Mar. 31, 1993

Apr. 1, 1993—Jun. 30, 1993

Jul. 1, 1993—Sep. 30, 1993

Oct. 1, 1993—Dec. 31, 1993

Jan. 1, 1994—Mar. 31, 1994

Apr. 1, 1994—Jun. 30, 1994

Jul. 1, 1994—Sep. 30, 1994

Oct. 1, 1994—Dec. 31, 1994

Jan. 1, 1995—Mar. 31, 1995

Apr. 1, 1995—Jun. 30, 1995

Jul. 1, 1995—Sep. 30, 1995

Oct. 1, 1995—Dec. 31, 1995

Jan. 1, 1996—Mar. 31, 1996

Apr. 1, 1996—Jun. 30, 1996

Jul. 1, 1996—Sep. 30, 1996

Oct. 1, 1996—Dec. 31, 1996

Jan. 1, 1997—Mar. 31, 1997

OVERPAYMENTS

UNDERPAYMENTS

RATE TABLE PG 1995-1 C.B.

577

623

621

619

571

573

575

577

575

623

621

623

575

10%

579

625

623

621

573

575

577

579

577

625

623

625

577

TABLE OF INTEREST RATES FOR

LARGE CORPORATE UNDERPAYMENTS

FROM JANUARY 1, 1991—PRESENT

Jan. 1, 1991—Mar. 31, 1991

Apr. 1, 1991—Jun. 30, 1991

Jul. 1, 1991—Sep. 30, 1991

Oct. 1, 1991—Dec. 31, 1991

Jan

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