# Bulletin No. 1997–48

> Briefs, arguments, decisions, and more.

URL: https://www.frixlaw.com/law-library/documents/agency%3Airs%3A3752627821654745

## Record

- **Collection:** Agency decision
- **Document type:** Agency decision

## Text

Internal Revenue

bulletin

Bulletin No. 1997–48
December 1, 1997

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

EMPLOYEE PLANS

Rev. Rul. 97–49, page 4.

Notice 97–69, page 12.

1997 base period T-bill rate. The “base period T-bill rate”
for the period ending September 30, 1997, is published, as
required by section 995(f)(4) of the Code.

REG–105162–97, page 13.
Proposed regulations under section 7701 of the Code describe how elective changes in entity classification will be
treated for Federal tax purposes. A public hearing will be
held on February 24, 1998.

REG–251985–96, page 18.

Weighted average interest rate update. Guidelines are
set forth for determining for November 1997 the weighted
average interest rate and the resulting permissible range of
interest rates used to calculate current liability for purposes
of the full funding limitation of section 412(c)(7) of the Code
as amended by the Omnibus Budget Reconciliation Act of
1987 and by the Uruguay Round Agreements Act (GATT).

EXEMPT ORGANIZATIONS

Proposed regulations under section 863 of the Code relate
to the source of income from sales of inventory produced in
the United States and sold in a U.S. possession or produced
in a U.S. possession and sold in the United States. A public
hearing will be held on January 29, 1998.

Announcement 97–116, page 25.

Notice 97–66, page 8.

Notice 97–61, page 8.

Securities lending transaction notice. Guidance is provided to payors of substitute interest payments made after
November 13, 1997, and before January 1, 1999, to comply with the statement requirement of section 871(h)(5) of
the Code in order to qualify the payments as portfolio interest payments for purposes of the tax imposed under sections 871 and 881 of the Code. Guidance is also provided to
determine the amount of tax imposed and withheld on substitute dividend payments made by one foreign person to another foreign person.

This notice informs the public of the Service’s Year 2000
Date Standard Policy.

Notice 97–68, page 11.
This notice informs taxpayers that the rules in sections
1.664–2(a)(1)(i) and 1.664–3(a)(1)(i)(e) of the proposed Income Tax regulations, published in REG–209823–96,
1997–18 I.R.B. 47, will not be effective for certain charitable remainder trusts for the 1997 tax year.

Finding Lists begin on page 28.
Index for July–November begins on page 30.

Department of the Treasury
Internal Revenue Service

A list is provided of organizations now classified as private
foundations.

ADMINISTRATIVE

Notice 97–67, page 10.
Accounting method requests for grace period interest.
This notice informs taxpayers that the Service will issue
guidance that provides the procedures for a taxpayer to
automatically change its method of accounting to comply
with section 1004 of the Taxpayer Relief Act of 1997 for the
taxpayer’s first taxable year beginning after August 5, 1997.
The notice provides that the Service will not grant any
requests filed on or after August 5, 1997, to change to a
method of accounting for grace period interest other than
the method required by section 1004 of the Act.

Mission of the Service
ucts and services; and perform in a manner warranting
the highest degree of public confidence in our integrity, efficiency, and fairness.

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 prod-

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 officers 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 courtesy 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.

2

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.

dures 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, court decisions, rulings, and proce-

The first Bulletin for each month includes a cumulative index
for the matters published during the preceding months.
These monthly indexes are cumulated on a quarterly and
semiannual basis, and are published in the first Bulletin of the
succeeding quarterly and semiannual 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, DC 20402.

3

Part I. Rulings and Decisions Under the Internal Revenue Code of 1986
Section 861.—Income From
Sources Within the United
States
26 CFR 1.861–2: Interest.
Guidance is provided to the payors of U.S. source
substitute interest payments made after November
13, 1997, and before January 1, 1999, for complying
with the statement requirement of § 871(h)(5) in
order to qualify as portfolio interest. See Notice
97–66, page 8.

26 CFR 1.861–3: Dividends.
Guidance is provided on the determination of the
amount of tax imposed under §§ 871 and 881 on
U.S. source substitute dividend payments which are
made by a foreign person to another foreign person
(“foreign-to-foreign” payments).

Section 864.—Definitions and
Special Rules
26 CFR 1.864–5: General provisions relating to
withholding agent.
A general election to defer the effective date of
final securities lending regulations (published October 14, 1997, TD 8735, 62 FR 53498) for substitute
payments made after November 13, 1997, to January 1, 1999, does not apply for substitute interest
and substitute dividend payments received that are
foreign source effectively connected income under
§ 1.864–5(b)(2) of the final regulations. Notice
97–66, page 8.

Section 871.—Tax on
Nonresident Alien Individuals
26 CFR 1.871–7: Taxation of nonresident alien individuals not engaged in U.S. business.
Guidance is provided as to the amount of tax to
be imposed under § 1.871–7(b)(2) with respect to
substitute interest or substitute dividend payments
made by one foreign person to another foreign person. See Notice 97–66, page 8.

26 CFR 1.871–14: Rules relating to repeal of tax on
interest of nonresident alien individuals and foreign
corporations received from certain portfolio debt investments.
Guidance is provided to payors of substitute interest payments made after November 13, 1997, and
before January 1, 1999, i.e., prior to the effective
date of §1.871–14, for complying with the statement
requirement of § 871(h)(5) in order to qualify the
payments as portfolio interest payments for purposes of the tax imposed under §§ 871 and 881. See
Notice 97–66, page 8.

Section 881.—Tax on Income
of Foreign Corporations Not

December 1, 1997

Connected With United States
Business
26 CFR 1.881–2: Income of foreign corporations
treated as effectively connected with U.S. business.
Guidance is provided as to the amount of tax to
be imposed under § 1.881–2(b)(2) with respect to
substitute interest or substitute dividend payments
made by one foreign person to another foreign person. See Notice 97–66, page 8.

Section 995.—Taxation of DISC
Income to Shareholders
1997 base period T-bill rate. The
“base period T-bill rate” for the period
ending September 30, 1997, is published,
as required by section 995(f)(4) of the
Code.

Rev. Rul. 97–49
Section 995(f)(l) of the Internal Revenue Code provides that a shareholder of
a DISC shall pay interest each taxable
year in an amount equal to the product of
the shareholder’s DISC-related deferred
tax liability for the year and the “base period T-bill rate.” Under section 995(f)(4),
the base period T-bill rate is the annual
rate of interest determined by the Secretary to be equivalent to the average investment yield of United States Treasury
bills with maturities of 52 weeks which
were auctioned during the one-year period ending on September 30 of the calendar year ending with (or of the most recent calendar year ending before) the
close of the taxable year of the shareholder. The base period T-bill rate for the
period ending September 30, 1997, is
5.68 percent.
Pursuant to section 6622 of the Code,
interest must be compounded daily. The
table below provides factors for compounding the base period T-bill rate daily
for any number of days in the shareholder’s taxable year (including a 52–53
week accounting period) for the 1997
base period T-bill rate. To compute the
amount of the interest charge for the
shareholder’s taxable year, multiply the
amount of the shareholder’s DISC-related
deferred tax liability (as defined in section
995(f)(2)) for that year by the base period
T-bill rate factor corresponding to the
number of days in the shareholder’s tax-

4

able year for which the interest charge is
being computed. Generally, one would
use the factor for 365 days. One would
use a different factor only if the shareholder’s taxable year for which the interest charge being determined is a short taxable year, if the shareholder uses the
52-53 week taxable year, or if the shareholder’s taxable year is a leap year.
For the base period T-bill rates for the
periods ending in prior years, see: Rev.
Rul. 86–132, 1986–2 C.B. 137; Rev. Rul.
87–129, 1987–2 C.B. 196; Rev. Rul.
88–94, 1988–2 C.B. 301; Rev. Rul.
89–116, 1989–2 C.B. 197; Rev. Rul.
90–96, 1990–2 C.B. 188; Rev. Rul.
91–59, 1991–2 C.B. 347; Rev. Rul.
92–98, 1992–2 C.B. 201; Rev. Rul.
93–77, 1993–2 C.B. 253; Rev. Rul.
94–68, 1994–2 C.B. 177; Rev. Rul.
95–77, 1995–2 C.B. 122; and Rev. Rul.
96–55, 1996–2 C.B. 57.
DRAFTING INFORMATION
The principal author of this revenue
ruling is David Bergkuist of the Office of
the Associate Chief Counsel (International). For further information about this
revenue ruling, contact Mr. Bergkuist on
(202) 622-3850 (not a toll-free call).
1997 ANNUAL RATE,
COMPOUNDED DAILY
DAYS

5.68 PERCENT
FACTOR

1
2
3
4
5

.000155616
.000311257
.000466922
.000622611
.000778324

6
7
8
9
10

.000934062
.001089824
.001245610
.001401420
.001557255

11
12
13
14
15

.001713113
.001868996
.002024904
.002180835
.002336791

16
17
18

.002492771
.002648775
.002804804

1997–48 I.R.B.

1997 ANNUAL RATE,
COMPOUNDED DAILY

1997 ANNUAL RATE,
COMPOUNDED DAILY

1997 ANNUAL RATE,
COMPOUNDED DAILY

DAYS

5.68 PERCENT
FACTOR

DAYS

5.68 PERCENT
FACTOR

DAYS

5.68 PERCENT
FACTOR

19
20

.002960857
.003116934

64
65

.010008430
.010165604

109
110

.017105524
.017263803

21
22
23
24
25

.003273036
.003429161
.003585312
.003741486
.003897685

66
67
68
69
70

.010322802
.010480025
.010637272
.010794544
.010951840

111
112
113
114
115

.017422106
.017580433
.017738786
.017897162
.018055564

26
27
28
29
30

.004053908
.004210155
.004366426
.004522722
.004679043

71
72
73
74
75

.011109161
.011266506
.011423876
.011581270
.011738689

116
117
118
119
120

.018213990
.018372441
.018530916
.018689417
.018847941

31
32
33
34
35

.004835387
.004991756
.005148149
.005304567
.005461009

76
77
78
79
80

.011896132
.012053600
.012211092
.012368608
.012526150

121
122
123
124
125

.019006491
.019165065
.019323664
.019482287
.019640936

36
37
38
39
40

.005617475
.005773966
.005930481
.006087020
.006243584

81
82
83
84
85

.012683715
.012841306
.012998920
.013156560
.013314223

126
127
128
129
130

.019799609
.019958306
.020117028
.020275775
.020434547

41
42
43
44
45

.006400172
.006556784
.006713421
.006870082
.007026768

86
87
88
89
90

.013471912
.013629625
.013787362
.013945124
.014102911

131
132
133
134
135

.020593343
.020752165
.020911010
.021069881
.021228776

46
47
48
49
50

.007183478
.007340212
.007496971
.007653754
.007810561

91
92
93
94
95

.014260722
.014418557
.014576418
.014734302
.014892212

136
137
138
139
140

.021387696
.021546641
.021705610
.021864604
.022023623

51
52
53
54
55

.007967393
.008124249
.008281130
.008438035
.008594965

96
97
98
99
100

.015050146
.015208104
.015366087
.015524095
.015682127

141
142
143
144
145

.022182667
.022341736
.022500829
.022659947
.022819089

56
57
58
59
60

.008751919
.008908897
.009065900
.009222927
.009379979

101
102
103
104
105

.015840184
.015998265
.016156371
.016314502
.016472657

146
147
148
149
150

.022978257
.023137449
.023296666
.023455908
.023615174

61
62
63

.009537055
.009694155
.009851280

106
107
108

.016630837
.016789042
.016947271

151
152
153

.023774466
.023933782
.024093123

1997–48 I.R.B.

5

December 1, 1997

1997 ANNUAL RATE,
COMPOUNDED DAILY

1997 ANNUAL RATE,
COMPOUNDED DAILY

1997 ANNUAL RATE,
COMPOUNDED DAILY

DAYS

5.68 PERCENT
FACTOR

DAYS

5.68 PERCENT
FACTOR

DAYS

5.68 PERCENT
FACTOR

154
155

.024252489
.024411879

199
200

.031449673
.031610183

244
245

.038697430
.038859068

156
157
158
159
160

.024571294
.024730734
.024890199
.025049689
.025209204

201
202
203
204
205

.031770719
.031931279
.032091865
.032252475
.032413111

246
247
248
249
250

.039020732
.039182420
.039344134
.039505873
.039667638

161
162
163
164
165

.025368743
.025528307
.025687896
.025847510
.026007149

206
207
208
209
210

.032573771
.032734457
.032895167
.033055902
.033216663

251
252
253
254
255

.039829427
.039991242
.040153081
.040314946
.040476836

166
167
168
169
170

.026166813
.026326501
.026486214
.026645953
.026805716

211
212
213
214
215

.033377448
.033538259
.033699094
.033859955
.034020841

256
257
258
259
260

.040638752
.040800692
.040962658
.041124649
.041286665

171
172
173
174
175

.026965503
.027125316
.027285154
.027445016
.027604903

216
217
218
219
220

.034181751
.034342687
.034503648
.034664633
.034825644

261
262
263
264
265

.041448706
.041610773
.041772864
.041934981
.042097124

176
177
178
179
180

.027764816
.027924753
.028084715
.028244702
.028404713

221
222
223
224
225

.034986680
.035147741
.035308827
.035469938
.035631074

266
267
268
269
270

.042259291
.042421484
.042583702
.042745945
.042908213

181
182
183
184
185

.028564750
.028724812
.028884898
.029045010
.029205146

226
227
228
229
230

.035792236
.035953422
.036114633
.036275870
.036437131

271
272
273
274
275

.043070507
.043232826
.043395170
.043557539
.043719934

186
187
188
189
190

.029365307
.029525493
.029685704
.029845940
.030006201

231
232
233
234
235

.036598418
.036759730
.036921067
.037082428
.037243816

276
277
278
279
280

.043882354
.044044799
.044207270
.044369766
.044532287

191
192
193
194
195

.030166487
.030326798
.030487134
.030647495
.030807880

236
237
238
239
240

.037405228
.037566665
.037728127
.037889615
.038051128

281
282
283
284
285

.044694833
.044857405
.045020002
.045182624
.045345272

196
197
198

.030968291
.031128727
.031289187

241
242
243

.038212666
.038374229
.038535817

286
287
288

.045507945
.045670643
.045833366

December 1, 1997

6

1997–48 I.R.B.

1997 ANNUAL RATE,
COMPOUNDED DAILY
DAYS

5.68 PERCENT
FACTOR

289
290

.045996115
.046158889

291
292
293
294
295

.046321689
.046484514
.046647364
.046810240
.046973140

296
297
298
299
300

.047136067
.047299018
.047461995
.047624998
.047788025

301
302
303
304
305

.047951078
.048114157
.048277260
.048440390
.048603544

306
307
308
309
310

.048766724
.048929929
.049093160
.049256416
.049419698

311
312
313
314
315

.049583005
.049746337
.049909695
.050073078
.050236487

316

.050399921

Section 1441.—Withholding of
Tax on Nonresident Aliens
26 CFR 1.1441–7: Requirement for the deduction
and withholding of tax on payments to foreign
persons.
Guidance is provided to payors of substitute interest and dividend concerning their obligations as
withholding agents on payments made to foreign
beneficial owners that are individuals. See Notice
97–66, page 8.

1997–48 I.R.B.

1997 ANNUAL RATE,
COMPOUNDED DAILY
DAYS

5.68 PERCENT
FACTOR

317
318
319
320

.050563380
.050726865
.050890376
.051053912

321
322
323
324
325

.051217473
.051381060
.051544672
.051708309
.051871972

326
327
328
329
330

.052035661
.052199375
.052363115
.052526880
.052690670

331
332
333
334
335

.052854486
.053018327
.053182194
.053346087
.053510005

336
337
338
339
340

.053673948
.053837917
.054001912
.054165932
.054329977

341
342
343
344
345

.054494048
.054658145
.054822267
.054986415
.055150588

Section 1442.—Withholding of
Tax on Nonresident
Corporations

1997 ANNUAL RATE,
COMPOUNDED DAILY
DAYS

5.68 PERCENT
FACTOR

346
347
348
349
350

.055314787
.055479011
.055643261
.055807537
.055971838

351
352
353
354
355

.056136164
.056300516
.056464894
.056629297
.056793726

356
357
358
359
360

.056958181
.057122661
.057287166
.057451698
.057616255

361
362
363
364
365

.057780837
.057945445
.058110079
.058274738
.058439423

366
367
368
369
370

.058604134
.058768870
.058933632
.059098419
.059263232

371

.059428071

beneficial owners that are corporations. See Notice
97–66, page 8.

26 CFR 1.1441–7: Requirement for the deduction
and withholding of tax on payments to foreign persons.
Guidance is provided to payors of substitute interest and dividend concerning their obligations as
withholding agents on payments made to foreign

7

December 1, 1997

Part III. Administrative, Procedural, and Miscellaneous
Notice 97–61
The Internal Revenue Service has undertaken a large-scale effort to address
the year 2000 issue. The Year 2000 Conversion Project’s primary goal is to make
all current and future IRS information
systems year 2000 compliant. That is,
ensure that all computer systems function correctly before and after January 1,
2000.
The Internal Revenue Service has
adopted a standard for the year representation and date representation. This standard will be used in all data exchanges
with external trading partners (ETPs),
Federal, state and local governments as
well as the private sector. The standard
is:
—
an 8-position year when using
the Gregorian data format; the 8 characters (YYYYMMDD) must be contiguous
and the 4-position year field must be at
the beginning of the date field;
—
a four-position year when using
the Julian date format; the date field
would be represented as YYYYDDD;
—
a four-position year when using
the Epock/Offset date format where the
Epoch (year field) contains four characters and the Offset is a time element determined by the system owner; and,
—
a four-position year will be used
in conjunction with all other date formats and the other elements of the date
field.
The IRS said it will be contacting its
external trading partners to inform them
of the date by which data exchanges will
be converted. The trading partners will
be expected to certify that they will be
ready to receive the data and that they
will provide any related exchanges to the
IRS as specified in the standard.
External Trading Partners who provide data in accord with specifications
generally issued in Revenue Procedures
will continue to be informed of the date
requirements through Revenue Procedures. Others, with whom IRS has
agreements for specific exchanges, such
as with state revenue departments involved in tax administration, will be contacted individually by the IRS.

December 1, 1997

Certain Payments Made
Pursuant to a Securities
Lending Transaction

ments. The Treasury and the Service request comments on the treatment of foreign-to-foreign payments provided in this
Notice.

Notice 97–66

SECTION 2. SUBSTITUTE INTEREST
PAYMENTS

SECTION 1. SUMMARY
On October 14, 1997, final regulations
were published in the Federal Register
[T.D. 8735], RIN 1545-AP71, (the “final
regulations”) which source substitute interest and substitute dividend payments
that are made pursuant to a securities
lending or sale-repurchase transaction by
reference to the income that would be
earned with respect to the underlying
transferred debt security or stock. The
final regulations also provide that substitute interest and dividend payments that
are U.S. source under the regulations are
also characterized as interest and dividends for purposes of determining the
fixed or determinable annual or periodical
income of foreign resident individuals
and corporations subject to tax under sections 871, 881, 4948(a) and Chapter 3 of
the Internal Revenue Code and for purposes of granting tax treaty benefits with
respect to interest and dividends. As promulgated, the final regulations were made
applicable in all respects for substitute interest (as defined in § 1.861–2(a)(7) of
the income tax regulations) and substitute
dividend payments (as defined in §
1.861–3(a)(6)) made after November 13,
1997.
This Notice provides guidance on complying with the statement requirement of
section 871(h)(5) for substitute interest
payments made after November 13, 1997,
and before January 1, 1999. In addition,
the Treasury and the Service intend to
propose new regulations to provide specific guidance on how substitute dividend
payments made by one foreign person to
another foreign person (“foreign-to-foreign payments”) are to be treated. Until
the proposed regulations are promulgated,
this Notice clarifies how the amount of
the tax imposed under §§ 1.871–7(b)(2)
and 1.881–2(b)(2) will be determined
with respect to foreign-to-foreign pay-

8

Substitute interest payments made by a
foreign person that are U.S. source interest under the final regulations must satisfy
the statement requirement of section
871(h)(5) to qualify as portfolio interest.
The final regulations refer taxpayers to §
1.871–14(c) for this purpose, but those
regulations are not generally applicable
until January 1, 1999. Under this Notice,
the statement requirement of section
871(h)(5) will be satisfied with respect to
substitute interest payments made after
November 13, 1997 and before January 1,
1999, if any written, electronic, or oral
statement that reasonably establishes that
the payee is a foreign person is given or
made to the payor prior to, or within a
reasonable period of time after, the payment. The statement requirement of the
preceding sentence is deemed to be satisfied if the payor is subject to, and satisfies
with respect to the payee, the regulatory
rules in the jurisdiction in which the payor
is operating regarding establishing the
identity of a customer (i.e., “know your
customer” rules). Also, if a taxpayer
makes an election under § 1.14411(f)(2)(ii), such election will be effective,
pursuant to this Notice, to allow a withholding agent to apply retroactively
the documentation requirements of
§ 1.871–14(c) with respect to one or more
substitute interest payments made
after November 13, 1997. Treas. Reg.
§ 1.871–14(c)(3) allows a withholding
agent to collect a certificate or documentary evidence at any time until the expiration of the beneficial owner’s period of
limitation for claiming a refund of tax
with respect to portfolio interest.
SECTION 3. SUBSTITUTE DIVIDEND
PAYMENTS
The final regulations were adopted to
eliminate unjustifiable differences between the taxation of similar economic investments. It has been brought to the at-

1997–48 I.R.B.

tention of the Treasury and the Service,
however, that, in certain circumstances,
the total U.S. withholding tax paid with
respect to a securities loan or sale-repurchase transaction, or series of such transactions, could be excessive due to the application of the final regulations. The
Treasury and the Service believe that taxpayers can avoid such excessive withholding taxes in the vast majority of cases
by structuring their transactions appropriately. In some circumstances, however,
such structuring may be difficult or impossible.
To address these concerns, under this
Notice, the amount of U.S. withholding tax
to be imposed under §§ 1.871–7(b)(2) and
1.881–2(b)(2) with respect to a foreign-toforeign payment will be the amount of the
underlying dividend multiplied by a rate
equal to the excess of the rate of U.S. withholding tax that would be applicable to
U.S. source dividends paid by a U.S. person directly to the recipient of the substitute
payment over the rate of U.S. withholding
tax that would be applicable to U.S. source
dividends paid by a U.S. person directly to
the payor of the substitute payment. This
amount may be reduced or eliminated to
the extent that the total U.S. tax actually
withheld on the underlying dividend and
any previous substitute payments is greater
than the amount of U.S. withholding tax
that would be imposed on U.S. source dividends paid by a U.S. person directly to the
payor of the substitute payment. The recipient of a substitute payment may not, however, disregard the form of its transaction in
order to reduce the U.S. withholding tax.
Therefore, a recipient of a foreign-to-foreign payment will not be entitled to a refund or tax credit against any other U.S. tax
liability to reflect the fact that the rate of
U.S. withholding tax that would be applicable to a U.S. source dividend paid by a U.S.
person directly to such recipient is less than
the rate of U.S. withholding tax that would
be applicable to a U.S. source dividend
paid by a U.S. person directly to the payor
of the substitute payment (or any payor of a
previous substitute payment or the underlying dividend).
As a result of this formula, substitute
payments with respect to foreign-to-foreign securities loans and sale-repurchase
transactions that do not reduce the overall U.S. withholding tax generally will
not be subject to withholding tax. For

1997–48 I.R.B.

example, no withholding tax is required
in situations where transactions are entered into between residents of the same
country. The Treasury and the Service
believe that this Notice adequately addresses the concerns of those foreign
persons who are required by their local
regulators to enter into transactions only
with residents of the same country.
Conversely, to the extent a foreign-toforeign securities loan or sale-repurchase
transaction would reduce the overall
U.S. withholding tax, an incremental
amount of U.S. withholding tax is imposed on the substitute payment.
SECTION 4. LIABILITY OF
WITHHOLDING AGENTS
Each person who makes a foreign-toforeign payment shall be treated as a
withholding agent under section 1.1441–7
with respect to such payment. If a U.S.
withholding agent withholds the highest
rate of tax which would be imposed on all
foreign recipients of dividends and substitute payments in a chain of such payments, each foreign withholding agent
will be treated as having satisfied its withholding obligation under §1.1441–7.
SECTION 5. EXAMPLES
The following examples illustrate the
principles of this Notice:
Example 1. Same Country Securities Loan. FP, a
pension fund resident in Country X, owns stock issued by USCo, a corporation resident in the United
States. An income tax treaty between Country X
and the United States limits the U.S. withholding tax
on gross dividends to 15 percent. USBroker, a U.S.
broker-dealer, needs to borrow the stock owned by
FP. Under Country X rules intended to safeguard
the interests of workers, however, FP is required to
deal only with Country X residents in connection
with its investment activities. Accordingly, FP enters into a securities loan with FBroker, a brokerdealer also resident in Country X. FBroker then enters into a securities loan with USBroker. USCo
pays a dividend of $100 on March 15, 1998. USBroker is the shareholder of record with respect to
the dividend. Since USBroker is a U.S. person,
USCo does not withhold on the dividend. USBroker
makes a substitute payment of $100 to FBroker from
which USBroker withholds $15. The rate of withholding tax that would be applicable to a U.S. source
dividend payment made by a U.S. person directly to
FP is the same as the rate of withholding tax that
would be applicable to a U.S. source dividend payment made by a U.S. person directly to FBroker.
Accordingly, no U.S. withholding tax is imposed
under § 1.871–7(b)(2) or § 1.881–2(b)(2) on the
substitute payments made by FBroker to FP.
Example 2. Non-Same Country Securities Loan.

9

A, a resident of Country X, owns shares of USCo, a
U.S. resident corporation. Country X has a treaty
with the United States which limits the United States
tax on gross dividends to 15 percent. A enters into a
securities loan with B, a resident of Country Y,
whose treaty with the United States also limits the
United States tax on gross dividends to 15 percent.
USCo pays a dividend of $100 on March 15, 1998.
B is the shareholder of record with respect to the
dividend. USCo withholds $15 and pays B a net
dividend of $85. B makes a substitute payment of
$85 to A. The rate of withholding tax that would be
applicable to a U.S. source dividend payment made
by a U.S. person directly to A is the same as the rate
of withholding tax that would be applicable to a U.S.
source dividend payment made by a U.S. person directly to B. Accordingly, no U.S. withholding tax is
imposed under § 1.871–7(b)(2) or § 1.881–2(b)(2)
on the substitute payments made by B to A.
Example 3. Increased Treaty Benefits. The facts
are the same as in example 2, except that Country X
has no treaty with the United States. Since a dividend payment made by a U.S. person directly to A
would have been subject to a 30-percent withholding tax, B must withhold an additional $15 ((30 percent - 15 percent) x $100) on the substitute payment
it makes to A. Alternatively, USCo could have withheld 30 percent from the dividend payment made to
B, thereby satisfying B’s withholding liability under
§ 1.1441–7.
Example 4. Multiple Country Securities Loans.
A, a resident of Country W, owns shares of USCo, a
U.S. resident corporation. Country W has an income tax treaty with the United States that limits the
United States tax on gross dividends to 15 percent.
B, a resident of Country X, enters into a securities
loan with A. Country X does not have an income tax
treaty with the United States. C, a resident of Country Y, enters into a securities loan with B. Country Y
has an income tax treaty with the United States
which limits the United States tax on gross dividends to 10 percent. D, a resident of country Z, enters into a securities loan with C. Country Z has an
income tax treaty with the United States which limits the United States tax on gross dividends to 15
percent.
USCo pays a dividend of $100 on March 15,
1998. D is the shareholder of record with respect to
the dividend. USCo withholds $15 and pays D a net
dividend of $85. D makes a substitute payment of
$85 to C. The rate of withholding tax that would be
applicable to a U.S. source dividend payment made
by a U.S. person directly to C is less than the rate of
withholding tax that would be applicable to a U.S.
source dividend payment made by a U.S. person directly to D. Accordingly, no U.S. withholding tax is
imposed under § 1.871–7(b)(2) or § 1.881–2(b)(2)
on the substitute payments received by C. However,
C is not entitled to a refund or tax credit against any
other U.S. tax liability for the additional 5-percent
tax reflected in its substitute payment from D over
the amount to which C would have been subject had
C received a dividend directly from USCo.
C makes a substitute payment of $85 to B from
which C withholds $15. Since a dividend payment
made by a U.S. person directly to B would have
been subject to a 30-percent withholding tax, C generally would be required to withhold an additional
$20 ((30 percent - 10 percent) x $100) on the substitute payment it makes to B. However, because $15

December 1, 1997

actually was withheld with respect to a $100 gross
dividend paid to D, C may reduce by $5 ((15 percent
- 10 percent) x $100) the $20 withholding obligation
on its substitute payment to B.
B makes a substitute payment of $70 to A. The
rate of withholding tax that would be applicable to a
U.S. source dividend payment made by a U.S. person directly to A is less than the rate of withholding
tax that would be applicable to a U.S. source dividend payment made by a U.S. person directly to B.
Accordingly, no U.S. withholding tax is imposed
under § 1.871–7(b)(2) or § 1.881–2(b)(2) on the
substitute payment received by A. However, A is
not entitled to a refund or tax credit against any
other U.S. tax liability for the additional 15-percent
tax reflected in its substitute payment from B over
the amount to which A would have been subject had
A received a dividend directly from USCo.
Alternatively, USCo could have withheld 30 percent from the dividend payment made to D, thereby
satisfying C’s withholding obligation under §
1.1441–7.

SECTION 6. EFFECTIVE DATE OF
REGULATIONS
The provisions of this Notice are effective for purposes of applying the final
regulations as of November 14, 1997, the
effective date of those regulations. Because some withholding agents may require additional time to adjust their business practices to implement the
provisions of the final regulations and
this Notice, a withholding agent can
elect to defer the application of the final
regulations, other than Treas. Reg. §
1.864–5(b)(2)(ii), and this Notice until
January 1, 1998. A withholding agent
makes such an election by attaching a
statement to such effect to a timely filed
tax return (Form 1042) for the period
that includes November 14, 1997, or if
no such return is otherwise required for
the period including that date, on a
timely filed return (Form 1042) for the
period that includes January 1, 1998.
Withholding agents making this election
must apply the provisions of the final
regulations and this Notice for substitute
payments made after December 31,
1997.
SECTION 7. REQUEST FOR
COMMENTS
Treasury and the Service invite
comments on the guidance provided
by this Notice. Written comments should
be submitted by January 12, 1998,
to the Internal Revenue Service, P.O.
Box 7604 Ben Franklin Station, Atten-

December 1, 1997

tion: CC:CORP:T:R: (Notice 97-66)
Room 5228, Washington, DC 20044. Alternatively, comments may be
submitted via the internet at:
http://www.irs.ustreas.gov/prod/tax_regs/
comments.html. The comments submitted
will be available for public inspection and
copying.
SECTION 8. PAPERWORK
REDUCTION ACT
The collections of information contained in this Notice have 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 1545–1566.
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 collections of information contained in this Notice are in Sections 2 and
6. The information is required to qualify
substitute interest payments as portfolio
interest and to defer, on election by the
taxpayer, the effective date of this Notice
and the final securities lending regulations (T.D. 8735, 62 FR 53498) for substitute payments made after December 31,
1997. The information will be used for
the same purpose described in the preceding sentence. The collections of information are required to obtain a benefit. The
likely respondents are businesses or other
for-profit institutions.
The estimated total annual reporting
and/or recordkeeping burden is 61,750
hours.
The estimated annual burden per respondent/recordkeeper varies from 1
minute to 15 minutes, depending on individual circumstances, with an estimated
average of 10 minutes. The estimated
number of respondents and/or recordkeepers is 377,500.
The estimated frequency of responses
(used for reporting requirements only) is
once.
Books or records relating to a 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.

10

SECTION 9. CONTACT
INFORMATION
The principal author of this Notice is
Paul Epstein of the Office of the Associate Chief Counsel (International) within
the Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue,
NW, Washington, DC 20224. For further
information regarding this Notice contact
Milton Cahn or Paul Epstein at 202-6223870 (not a toll-free call).

Grace Period Interest
Notice 97–67
Many credit card agreements provide
for a grace period during which the credit
card issuer does not charge interest for a
billing cycle if the credit card holder pays
off its account balance by a specified date.
Under section 1004 of the Taxpayer Relief
Act of 1997 (the “Act”), Pub. L. No.
105–34, 111 Stat. 788, 911, if a taxpayer
holds a pool of credit card receivables, the
taxpayer must accrue interest and original
issue discount on the receivables based on
a reasonable assumption regarding the
timing of the payments by the obligors of
the receivables in the pool. Thus, the taxpayer is not permitted to assume that all of
its credit card holders will pay their balances by the date specified in the grace period provision of the credit card agreement
and, based on this assumption, defer the
inclusion of grace period interest. Section
1004 of the Act is effective for taxable
years beginning after August 5, 1997. The
Internal Revenue Service will issue guidance that provides the procedures for a
taxpayer to automatically change its
method of accounting to comply with section 1004 for the taxpayer’s first taxable
year beginning after August 5, 1997.
The Service will process requests by
taxpayers to change their methods of accounting for grace period interest that
were pending with the Service on August
4, 1997. For any requests filed on or
after August 5, 1997 (the date of enactment of the Act), the Service will exercise its discretion to deny requests to
change to a method of accounting for
grace period interest other than the
method required by section 1004 of the
Act. See § 446(e) of the Internal Revenue Code. See also H.R. Conf. Rep. No.

1997–48 I.R.B.

220, 105th Cong., 1st Sess. 523 (1997);
H.R. Rep. No. 148, 105th Cong., 1st
Sess. 457 (1997).
For further information about this notice, contact William E. Blanchard of the
Office of Assistant Chief Counsel (Financial Institutions and Products) at (202)
622-3950, or Wendy MacDonald of the
Office of Assistant Chief Counsel (Income Tax and Accounting), at (202) 6226299 (not toll-free numbers).

Guidance on Making Payments
for Charitable Remainder Trusts
Notice 97–68
This notice informs taxpayers that the
rules in §§ 1.664–2(a)(1)(i) and
1.664–3(a)(1)(i)(e) of the proposed Income Tax Regulations, published in a Notice of Proposed Rulemaking on April 18,
1997 (62 Fed. Reg. 19072), will not be effective for certain charitable remainder
trusts (CRTs) for the 1997 taxable year.
BACKGROUND
Generally, a CRT is a trust that provides for a specified distribution at least
annually over a specified period to one or
more noncharitable beneficiaries and
holds an irrevocable remainder interest in
the trust for a charitable organization.
Section 664 of the Internal Revenue Code
provides for two types of CRTs: a charitable remainder annuity trust (CRAT) and a
charitable remainder unitrust (CRUT). A
CRAT pays a fixed annuity amount at
least annually to the noncharitable beneficiary or beneficiaries. A CRUT pays a
fixed percentage of the fair market value
of the assets held by the trust as of the annual valuation date (the unitrust amount)
at least annually to the noncharitable beneficiary or beneficiaries.
Section 664(d) provides that to qualify
as a CRT, the trust must pay the annuity
or unitrust amount at least annually to the
noncharitable beneficiaries. As an administrative convenience, §§ 1.664–2(a)(1)
and 1.664–3(a)(1) of the Income Tax Regulations have allowed CRTs to pay the annuity or unitrust amount within a reasonable time after the close of the tax year in
which it is due without the timing of the
payment causing the trust to fail to function exclusively as a CRT.

1997–48 I.R.B.

PROPOSED REGULATIONS
REGARDING PAYING ANNUITY
OR UNITRUST AMOUNT
The proposed amendments to
§§ 1.664–2(a)(1)(i) and 1.664–3(a)(1)(i)(e) of the proposed regulations (the
proposed timing amendments) would require a CRT to pay the annuity amount or
the unitrust amount under the fixed percentage method of § 664(d)(2) by the
close of the tax year in which the payment
is due in order to function exclusively as a
CRT. Under the effective date in the proposed regulations, once final, the proposed timing amendments would apply to
taxable years ending after April 18, 1997,
the date the proposed regulations were
published in the Federal Register.
The Service and Treasury issued the
proposed timing amendments in response
to abuses associated with the use of accelerated CRTs described in Notice 94–78,
1994–2 C.B. 555. Taxpayers using accelerated CRTs characterize the payment of
the annuity or unitrust amount as a distribution of trust corpus that is not subject to
tax by delaying the required payment
until after the end of the tax year in which
it is due.
Since publishing the proposed regulations, the Service and Treasury have received a significant number of comments
expressing concern that the proposed
timing amendments will place a significant burden on many trusts that are not
engaging in abuses. Some commentators
observed that for many CRTs the character of the annuity or unitrust amount is
not affected by the time at which the payment is made. Because these trusts have
accumulated sufficient income in the ordinary, capital gains, and other income
categories of § 664(b)(1), (2), and (3), no
portion of the annuity or unitrust amount
distributed will be characterized as trust
corpus under § 664(b)(4) irrespective of
whether the amount is paid before or
after the close of the tax year for which it
is due. The commentators add that being
required to pay the annuity or unitrust
amount by the close of the calendar year
would create a hardship if the trustee is
relying on end-of-the-year dividends and
similar income, which may not arrive
until January of the following year, to
make the annuity or unitrust payment.
The commentators also argue that the

11

proposed timing amendments would create a hardship for trustees of CRUTs that
have a December 31 valuation date because such a trustee would be forced to
value the assets in the trust and make a
payment of the unitrust amount after the
close of business and before midnight on
that date.
In light of the enactment of the Taxpayer Relief Act of 1997 (the Act) on August 5, 1997, other commentators have argued that the proposed timing
amendments are no longer necessary to
stop the abuses created by accelerated
CRTs. The Act amended the definition of
a CRT to include a maximum allowable
percentage of 50 percent for calculating
the annuity amount or unitrust amount
and a minimum 10 percent present value
for the charitable remainder interest. Taxpayer Relief Act of 1997, Pub. L. No.
105–34, § 1089, 111 Stat. 960, 961. We
note that the Senate Finance Committee
explicitly stated that it did not intend for
the Act to “limit or alter the validity of the
regulations proposed by the Treasury Department on April 18, 1997, or the Treasury Department’s authority to address
this or other abuses of the rules governing
the taxation of charitable remainder trusts
or their beneficiaries.” S. Rep. No. 33,
105th Cong., 1st Sess. 201 (1997).
Several commentators have asked for
relief from the effective date for the proposed timing amendments while their
comments are considered and before the
regulations are finalized.
APPLICATION OF PROPOSED
TIMING AMENDMENTS
The Service and Treasury recognize
that complying with the proposed timing
amendments in 1997 may create an unnecessary burden on those trusts for
which the potential for abuse is minimal.
Therefore, when the proposed regulations
are adopted as final regulations under a
Treasury Decision, the Service and Treasury intend to provide that for the taxable
year 1997 a CRT created before January
1, 1998, will not be made subject to the
rules stated in §§ 1.664–2(a)(1)(i) and
1.664–3(a)(1)(i)(e) of the proposed regulations if in 1997 the trust is:
(1) A CRAT under which the sum certain to be paid each year to one or more
persons is 15 percent or less of the initial

December 1, 1997

net fair market value of all property
placed in the trust, or
(2) A CRUT under which the fixed percentage of the net fair market value of the
unitrust’s assets to be paid each year to one
or more persons is 15 percent or less, or
(3) A CRAT or CRUT from which all
of the annuity amounts or unitrust
amounts paid for 1997 are characterized
in the hands of the beneficiary as income
from the categories described in §
664(b)(1), (2), and (3), and not as trust
corpus. Thus, a CRT created before January 1, 1998, that meets any one of these
three exceptions may pay its annuity
amount or unitrust amount for the taxable
year 1997 within a reasonable period of
time after the close of the tax year under
§§ 1.664–2(a)(1)(i) and 1.664–3(a)(1)(i)
of the Income Tax Regulations.

The Service and Treasury will continue
to consider the comments submitted on
the proposed regulations before deciding
whether to adopt an amended version of
the proposed regulations as final regulations.
For further information regarding this
notice, please call Mary Beth Collins or
Jeff Erickson of the Office of the Assistant Chief Counsel (Passthroughs and
Special Industries) on (202) 622-3070
(not a toll-free call).

Weighted Average Interest Rate
Update

Notice 88–73 provides guidelines for
determining the weighted average interest

Month

Year

November

1997

6.81

vision. For further information regarding
this notice, call (202) 622-6076 between

December 1, 1997

DRAFTING INFORMATION

Notice 97–69

Weighted
Average

rate and the resulting permissible range of
interest rates used to calculate current liability for the purpose of the full funding
limitation of § 412(c)(7) of the Internal
Revenue Code as amended by the Omnibus Budget Reconciliation Act of 1987
and as further amended by the Uruguay
Round Agreements Act, Pub. L. 103–465
(GATT).
The average yield on the 30-year Treasury Constant Maturities for October
1997 is 6.33 percent.
The following rates were determined
for the plan years beginning in the month
shown below.

90% to 107%
Permissible
Range

90% to 110%
Permissible
Range

6.13 to 7.29

6.13 to 7.49

2:30 and 3:30 p.m. Eastern time (not a
toll-free number). Ms. Prestia’s number

12

The principal author of this notice is
Donna Prestia of the Employee Plans Di-

is (202) 622-7377 (also not a toll-free
number).

1997–48 I.R.B.

Part IV. Items of General Interest
Notice of Proposed Rulemaking
and Notice of Public Hearing
Treatment of Changes in
Elective Entity Classification

sues, Philip Tretiak or Ronald M.
Gootzeit, (202) 622-3860 (not a toll free
number); concerning submissions and the
hearing, Evangelista Lee, (202) 622-7190
(not a toll-free number).

REG–105162–97

SUPPLEMENTARY INFORMATION:

AGENCY: Internal Revenue Service
(IRS), Treasury.

Background

ACTION: Notice of proposed rulemaking and notice of public hearing.
SUMMARY: This document contains
proposed regulations addressing elective
changes in entity classification. The proposed regulations describe how elective
changes in classification will be treated
for federal tax purposes. The proposed
regulations would affect business entities
and their members. This document also
contains a notice of public hearing on
these proposed regulations.
DATES: Written comments must be received by January 26, 1998. Requests to
speak (with outlines of oral comments) at
the public hearing scheduled for February
24, 1998, must be submitted by January
26, 1998.
ADDRESSES: Send submissions to:
CC:DOM:CORP:R (REG-105162–97),
room 5228, Internal Revenue Service,
POB 7604, Ben Franklin Station, Washington, DC 20044. In the alternative, submissions may be hand delivered between
the hours of 8 a.m. and 5 p.m. to:
CC:DOM:CORP:R (REG–105162–97),
Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue NW,
Washington, DC. Alternatively, taxpayers
may submit comments electronically
via the Internet by selecting the “Tax
Regs” option of the IRS Home Page, or
by submitting comments directly to the
IRS Internet site at: http://www.irs.ustreas.gov/prod/tax_regs/comments.html.
The public hearing will be held in room
2615, Internal Revenue Building, 1111
Constitution Avenue, NW, Washington,
DC.
FOR FURTHER INFORMATION
CONTACT: Concerning the regulations,
Jeff Erickson, (202) 622-3070 (not a tollfree number); concerning international is-

1997–48 I.R.B.

This document proposes to amend the
current Income Tax Regulations (26 CFR
Parts 1 and 301) relating to the classification of entities for federal tax purposes.
On December 18, 1996, the IRS and Treasury published final regulations under
section 7701 (final regulations), replacing
the former classification rules with an
elective regime. See T.D. 8697 (1997–2
I.R.B. 11).
Under the final regulations, a business
entity that is not specifically classified as
a corporation in the final regulations (an
eligible entity) can elect its classification
for federal tax purposes under certain circumstances. An eligible entity with at
least two members can elect to be classified as a partnership or as an association
taxable as a corporation. An eligible entity with a single member can elect to be
classified as an association or as an entity
that is disregarded as an entity separate
from its owner. An eligible entity may
also elect to change its classification, except that an election may not be made
more than once in any sixty month period.
An eligible entity that does not make an
election is classified under certain default
provisions.
Explanation of Provisions
Characterization of Elective Changes in
Classification
The proposed regulations describe how
elective changes in an entity’s classification will be treated for federal tax purposes. Under the final regulations, there
are four possible changes in classification
by election: (i) a partnership elects to be
an association; (ii) an association elects to
be a partnership; (iii) an association elects
to be a disregarded entity; and (iv) a disregarded entity elects to be an association.
There are two other possible ways in
which an entity’s classification could
change (a partnership converts to a disre-

13

garded entity or a disregarded entity converts to a partnership) but these changes
occur only as a result of a change in the
number of members, not as the result of
an elective change. The proposed regulations do not address the form of these two
possible types of changes.
The proposed regulations provide a
specific characterization for each of the
four possible elective changes. In each
case, the characterization provided in the
proposed regulations attempts to minimize the tax consequences of the change
in classification and achieve administrative simplicity. The proposed regulations
provide that if an association elects to be
classified as a partnership, the association
is deemed to liquidate by distributing its
assets and liabilities to its shareholders.
Then, the shareholders are deemed to
contribute all of the distributed assets and
liabilities to the partnership. This characterization of an elective change from an
association to a partnership is consistent
with Rev. Rul. 63–107 (1963–1 C.B. 71).
If a partnership elects to be classified as
an association, the partnership is deemed
to contribute all of its assets and liabilities
to the association in exchange for stock in
the association. Then, the partnership is
deemed to liquidate by distributing stock
in the association to its partners. The proposed regulations do not affect the holdings in Rev. Rul. 84–111 (1984–2 C.B.
88), in which the IRS ruled that it would
respect the particular form undertaken by
the taxpayers when a partnership converts
to a corporation.
If an association elects to be disregarded as an entity separate from its
owner, the association is deemed to liquidate by distributing its assets and liabilities to its sole owner. Conversely, if an eligible entity that is disregarded as an
entity separate from its owner elects to be
classified as an association, the owner of
the eligible entity is deemed to contribute
all of the assets and liabilities of that entity to the association in exchange for
stock of the association.
The proposed regulations also provide
that the tax treatment of an elective
change in classification is determined
under all relevant provisions of the Internal Revenue Code and general principles
of tax law, including the step transaction

December 1, 1997

doctrine. This provision in the proposed
regulations is intended to ensure that the
tax consequences of an elective change
will be identical to the consequences that
would have occurred if the taxpayer had
actually taken the steps described in the
proposed regulations. The IRS and Treasury request comments on the application
of general principles of tax law to the
transactions that are deemed to occur on
an elective change in classification.
Change in Number of Members of Entity
The proposed regulations address the
effect of a change in the number of members on the classification of an entity.
Under the proposed regulations, if there
is a change in the number of members of
an association, the classification of the
entity is not affected. If an eligible entity classified as a partnership subsequently has only one member (and is still
treated as an entity under local law), the
entity will be disregarded as an entity
separate from its owner. If a single
member entity that is disregarded as an
entity separate from its owner subsequently has more than one member, the
entity is classified as a partnership as of
the date the entity has more than one
member. The classifications provided in
the proposed regulations can be changed
by election, assuming that the entity is
not subject to the sixty month limitation
on elections.
Timing of Elective Changes in
Classification
The proposed regulations provide that
an election to change the classification of
an entity is treated as occurring at the start
of the day for which the election is effective. Any transactions that are deemed to
occur as a result of the change in classification are treated as occurring immediately before the close of the day before
the effective date of the election. For example, if an election is made to convert
from an association to a partnership effective on January 1, the entity is treated as a
partnership on January 1, and the deemed
transactions specified in the proposed regulations are treated as occurring immediately before the close of December 31.
As a result, the last day of the association’s taxable year will be December 31
and the first day of the partnership’s taxable year will be January 1.

December 1, 1997

Treatment of Foreign Eligible Entities
Any eligible entity, including a foreign
eligible entity whose classification is not
relevant for federal tax purposes, may
elect to change its classification. The IRS
and Treasury request comments on the appropriateness of allowing such a foreign
eligible entity to make a classification
election, and comments on what the federal tax consequences of such an election
should be (e.g., with respect to the basis
of property held by the entity).
Foreign Per Se Entities
The final regulations provide a list of
the names of certain foreign business entities that are treated as corporations for
federal tax purposes. In most cases, the
name by which an entity will be known is
provided by the statutory corporate law of
the relevant jurisdiction. In certain cases,
however, the corporate law does not provide a statutory name. In these jurisdictions, taxpayers and practitioners often
fill the statutory void with a name derived
from a number of the statutory characteristics of the entity. In an effort to make
the list of foreign per se corporations
more accessible, the final regulations use
the commonly used non-statutory term in
certain cases where the statute does not
provide a defined name. To minimize any
uncertainty, however, the provisions of
§301.7701–2(b)(8)(iii) and (iv) were included in the final regulations to address
this issue. In response to comments from
taxpayers, these subsections of the final
regulations are clarified to provide guidance on the terms used in the final regulations. Furthermore, the regulations clarify that the term Berhad used with regard
to Malaysia does not include a “Sendirian
Berhad” (the equivalent of a private limited company). The regulations also clarify that, in relation to Mexico, the term
Sociedad Anonima includes a Sociedad
Anonima that chooses to apply the variable capital provision of Mexican corporate law (Sociedad Anonima de Capital
Variable). The fact that capital may be
varied does not make this a different type
of entity from a Sociedad Anonima that
does not choose to apply the variable capital provision. These clarifications are not
intended to change the interpretation of
the final regulations.
The proposed regulations also clarify

14

the treatment of the Finnish, Maltese, and
Norwegian entities specified in the final
regulations. Effective January 1, 1996,
Maltese and Norwegian corporate law
recognized a distinction between public
and private companies, and the proposed
regulations reflect this change. The proposed regulations also provide that the
rules of the final regulations with regard
to the Maltese and Norwegian entities
may be applied (when these proposed regulations are finalized) as though the entities specified in the proposed regulations
had been included in the final regulations
issued on December 18, 1996. Thus, a
Maltese or Norwegian entity that is no
longer treated as a per se corporation
under the regulations would be able to
make an election within 75 days of the
date these proposed regulations are finalized, and such election could be effective
as of January 1, 1997. Finnish law, since
September 1, 1997, has recognized a similar distinction between public and private
companies. It is proposed that a Finnish
entity that is no longer treated as a per se
corporation under the regulations would
be able to make an election within 75
days of the date these proposed regulations are finalized, and such election
could be effective as of September 1,
1997.
Special Basis Adjustments Under
Section 743
Section 743 provides that the basis of
partnership property is not adjusted as the
result of a transfer of an interest in the
partnership by sale or exchange unless the
partnership has made an election under
section 754. If a section 754 election is
made, the transferee partner is treated as
having a special basis adjustment with respect to partnership property. This adjustment constitutes an adjustment to the
basis of partnership property with respect
to the transferee partner only. Some uncertainty has remained as to the treatment
of this special basis adjustment upon the
contribution of the partnership property to
a corporation in a section 351 exchange,
and because the proposed regulations provide for a deemed contribution by the
partnership to a corporation in an elective
conversion to an association, the proposed regulations address this uncertainty.
The proposed regulations provide that a

1997–48 I.R.B.

corporate transferee’s basis in property
transferred by a partnership in a transfer
described in section 351 includes any special basis adjustment under section 743.
The special basis adjustment is also taken
into account in determining the partner’s
basis in the stock received in the exchange. For example, assume a partnership owns Property X, which has a common basis of $100 for the partnership and
in which Partner A has a $5 special basis
adjustment under section 743(b). Subsequently, the partnership validly elects to
be classified as an association. The partnership is deemed to contribute all of its
assets and liabilities to the association in
exchange for stock in the association, and
immediately thereafter, the partnership
liquidates by distributing the stock of the
association to its partners. If the transfer
of the assets to the association would be a
transfer described in section 351, then
under the proposed regulations, the association’s basis in Property X includes
Partner A’s $5 special basis adjustment.
Thus, the association has a $105 basis in
Property X (Partner A’s $5 special basis
adjustment plus the partnership’s $100
common basis). Partner A’s basis in the
association’s stock will reflect the $5 special basis adjustment previously on Property X.
The proposed regulations also provide,
however, that the amount of gain, if any,
recognized by the partnership on the
transfer is determined without reference
to any special basis adjustment. The partner with the special basis adjustment can
then use the special basis adjustment to
reduce its share of any gain recognized by
the partnership. This approach of determining gain at the partnership level and
allowing the partner to use the special
basis adjustment as an offset is similar to
the treatment of a sale of property with a
special basis adjustment.
Proposed Effective Date
Except as otherwise specified, these
regulations are proposed to apply as of the
date the final regulations are published in
the Federal Register.
Special Analyses
It has been determined that this notice
of proposed rulemaking is not a signifi-

1997–48 I.R.B.

cant regulatory action as defined in EO
12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C.
chapter 5) does not apply to these regulations, and because these regulations do
not impose on small entities a collection
of information requirement, the Regulatory Flexibility Act (5 U.S.C. chapter 6)
does not apply. Therefore, a Regulatory
Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal
Revenue Code, this notice of proposed
rulemaking will be submitted to the Chief
Counsel for Advocacy of the Small Business Administration for comment on its
impact on small business.
Comments and Public Hearing
Before these proposed regulations are
adopted as final regulations, consideration will be given to any written comments (preferably a signed original and
eight (8) copies) that are submitted timely
to the IRS. All comments will be available for public inspection and copying.
A public hearing has been scheduled
for February 24, 1998, at 10 a.m., in room
2615, Internal Revenue Building, 1111
Constitution Avenue NW, Washington,
DC. Because of access restrictions, visitors will not be admitted beyond the Internal Revenue Building lobby more than 15
minutes before the hearing starts.
The rules of 26 CFR 601.601(a)(3)
apply to the hearing.
Persons that wish to present oral comments at the hearing must submit timely
written comments and an outline of the
topics to be discussed and the time to be
devoted to each topic by (preferably a
signed original and eight (8) copies) January 26, 1998.
A period of 10 minutes will be allotted
to each person for making comments.
An agenda showing the scheduling of
the speakers will be prepared after the
deadline for receiving outlines has
passed. Copies of the agenda will be
available free of charge at the hearing.
Drafting Information
The principal authors of these regulations are Ann M. Veninga, Office of Chief
Counsel (Passthroughs and Special Indus-

15

tries) and Philip Tretiak, Office of Associate Chief Counsel (International). However, other personnel from the IRS and
Treasury Department participated in their
development.
*

*

*

*

*

Proposed Amendments to the Regulations
Accordingly, 26 CFR parts 1 and 301
are proposed to be amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 continues to read in part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.743-2 is added under
the undesignated centerheading “Transfer
of Interests in a Partnership” to read as
follows:
§1.743-2 Transfer of property
to a corporation.
(a) Basis in transferred property. A
corporation’s adjusted tax basis in property transferred to the corporation by a
partnership in a transfer described in section 351 is determined with reference to
any special basis adjustment to the property under section 743(b) (other than any
special basis adjustment that reduces a
partner’s gain under paragraph (b) of this
section).
(b) Partnership gain. The amount of
gain, if any, recognized by a partnership
on a transfer of property by the partnership to a corporation in a transfer described in section 351 is determined without reference to any special basis
adjustment to the transferred property
under section 743(b). The amount of
gain, if any, recognized by the partnership
on the transfer that is allocated to a partner with a special basis adjustment in the
transferred property is adjusted to reflect
the partner’s special basis adjustment in
the transferred property.
(c) Basis in stock. The partnership’s
adjusted tax basis in stock received from a
corporation in a transfer described in section 351 is determined without reference
to the special basis adjustment in property
transferred to the corporation in the section 351 exchange. A partner with a special basis adjustment in property transferred to the corporation, however, has a
special basis adjustment in the stock re-

December 1, 1997

ceived by the partnership in the section
351 exchange in an amount equal to the
partner’s special basis adjustment in the
transferred property, reduced by any special basis adjustment that reduced the
partner’s gain under paragraph (b) of this
section.
(d) Effective date. This section applies
to transfers that occur on or after the date
final regulations are published in the Federal Register.
PART 301—PROCEDURE AND
ADMINISTRATION
Par. 3. The authority citation for part
301 continues to read in part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 4. Section 301.6109-1 is amended
as follows:
1. Paragraph (d)(2)(ii) is removed and
reserved.
2. Paragraph (h) is redesignated as
paragraph (i) and the first sentence of
newly designated paragraph (i)(1) is
amended by removing the language
“paragraph (h)” and adding “paragraph
(i)” in its place.
3. A new paragraph (h) is added.
The addition reads as follows:
§301.6109-1 Identifying numbers.
*

*

*

*

*

(h) Special rules for certain entities
under §301.7701–3—(1) General rule.
Any entity that has an employer identification number (EIN) will retain that EIN
if its federal tax classification changes
under §301.7701–3.
(2) Special rules for entities that are
disregarded as entities separate from
their owners—(i) When an entity becomes
disregarded as an entity separate from its
owner. Except as otherwise provided in
regulations or other guidance, a single
owner entity that is disregarded as an entity separate from its owner under
§301.7701–3, must use its owner’s taxpayer identifying number (TIN) for federal tax purposes.
(ii) When an entity that was disregarded as an entity separate from its
owner becomes recognized as a separate
entity. If a single owner entity’s classification changes so that it is recognized as a
separate entity for federal tax purposes,
and that entity had an EIN, then the entity
must use that EIN and not the TIN of the

December 1, 1997

single owner. If the entity did not already
have its own EIN, then the entity must acquire an EIN and not use the TIN of the
single owner.
(3) Effective date. This paragraph (h)
applies to changes in classification that
occur on or after the date on which these
regulations are published as final regulations in the Federal Register.
Par. 5. Section 301.7701–2 is amended
as follows:
1. Paragraph (b)(8)(i) is amended by
revising the entries for Finland, Malta,
and Norway.
2. Paragraph (b)(8)(ii)(A) is redesignated as paragraph (b)(8)(ii)(A)(1) and
the language “and” at the end of the paragraph is removed.
3. Paragraph (b)(8)(ii)(B) is redesignated as paragraph (b)(8)(ii)(A)(2) and
the period at the end of the paragraph is
removed and the language “; and “ is
added in its place.
4. Paragraph (b)(8)(ii) heading and introductory text are redesignated as paragraph (b)(8)(ii)(A) heading and introductory text, and a new paragraph heading is
added for paragraph (b)(8)(ii).
5. Paragraphs (b)(8)(ii)(A)(3) and
(b)(8)(ii)(B) are added.
6. Paragraphs (b)(8)(iii), (b)(8)(iv),
and (e) are revised.
The revisions and additions read as follows:
§301.7701-2 Business entities;
definitions.
*

*

*

*

*

(b) * * *
(8) * * *
(i) * * *
Finland, Julkinen Osakeyhtio/Publikt Aktiebolag
*

*

*

*

*

Malta, Public Limited Company
*

*

*

*

*

Norway, Allment Aksjeselskap
*

*

*

*

*

(ii) Clarification of list of corporations
in paragraph (b)(8)(i) of this section—
(A) Exceptions in certain cases. * * *
*

*

*

*

*

(3) With regard to Malaysia, a
Sendirian Berhad.

16

(B) Inclusions in certain cases. With
regard to Mexico, the term Sociedad
Anonima includes a Sociedad Anonima
that chooses to apply the variable capital
provision of Mexican corporate law (Sociedad Anonima de Capital Variable).
(iii) Public companies. For purposes of
paragraph (b)(8)(i) of this section, with
regard to Cyprus, Hong Kong, Jamaica,
and Trinidad and Tobago, the term Public
Limited Company includes any Limited
Company that is not defined as a private
company under the corporate laws of
those jurisdictions. In all other cases,
where the term Public Limited Company
is not defined, that term shall include any
Limited Company defined as a public
company under the corporate laws of the
relevant jurisdiction.
(iv) Limited companies. For purposes
of this paragraph (b)(8), any reference to
a Limited Company includes, as the case
may be, companies limited by shares and
companies limited by guarantee.
*

*

*

*

*

(e) Effective date. Except as otherwise
provided in this paragraph (e), the rules of
this section apply as of January 1, 1997.
The reference to the Finnish, Maltese, and
Norwegian entities in paragraph (b)(8)(i)
of this section is applicable on the date the
final regulations are published in the Federal Register. Any Maltese or Norwegian entity that becomes an eligible entity
as a result of paragraph (b)(8)(i) of this
section in effect on the date final regulations are published in the Federal Register may elect (within 75 days of the date
final regulations are published in the Federal Register) to be classified for federal
tax purposes as an entity other than a corporation retroactive to any period from
and including January 1, 1997. Any
Finnish entity that becomes an eligible
entity as a result of paragraph (b)(8)(i) of
this section in effect on the date final regulations are published in the Federal
Register may elect (within 75 days of the
date final regulations are published in the
Federal Register) to be classified for federal tax purposes as an entity other than a
corporation retroactive to any period from
and including September 1, 1997.
Par. 6. Section 301.7701–3 is amended
as follows:
1. A sentence is added at the end of
paragraph (c)(1)(iv).

1997–48 I.R.B.

2. Paragraph (c)(2)(iii) is added.
3. A heading is added to paragraph
(d)(1).
4. Paragraph (f) is redesignated as
paragraph (h) and newly designated paragraph (h)(1) is revised.
5. Paragraphs (f) and (g) are added.
The revision and additions read as follows:
§301.7701–3 Classification of certain
business entities.
*

*

*

*

*

(c) * * *
(1) * * *
(iv) Limitation. * * * An election by a
newly-formed eligible entity that is effective on the date of formation is not considered a change for purposes of this paragraph (c)(1)(iv).
*

*

*

*

*

(2) * * *
(iii) Changes in classification. For purposes of paragraph (c)(2)(i) of this section, if an election under paragraph
(c)(1)(i) of this section is made to change
the classification of an entity, each person
who was an owner on the date that any
transactions under paragraph (g) of this
section are deemed to occur, and who is
not an owner at the time the election is
filed, must also sign the election. This
paragraph (c)(2)(iii) applies to elections
filed on or after the date final regulations
are published in the Federal Register.
(d) Special rules for foreign eligible entities—(1) Definition of relevance. * * *
*

*

*

*

*

(f) Changes in number of members of
an entity—(1) Associations. The classification of an eligible entity as an association is not affected by any change in the
number of members of the entity.
(2) Partnerships and single member
entities. An eligible entity classified as a
partnership is disregarded as an entity
separate from its owner as of the date the
entity has only one member. A single
member entity disregarded as an entity
separate from its owner is classified as a
partnership as of the date the entity has
more than one member.
(3) Effect on sixty month limitation. A
change in the number of members of an
entity does not result in the creation of a

1997–48 I.R.B.

new entity for purposes of the sixty month
limitation on elections under paragraph
(c)(1)(iv) of this section.
(4) Examples. The following examples
illustrate the application of this paragraph
(f):
Example 1. (i) On April 1, 1998, A and B, U.S.
persons, form X, a foreign eligible entity. X is
treated as an association under the default provisions
of paragraph (b)(2)(i) of this section, and X does not
make an election to be classified as a partnership. A
subsequently purchases all of B’s interest in X.
(ii) Under paragraph (f)(1) of this section, X continues to be classified as an association. X, however, can subsequently elect to be disregarded as an
entity separate from A. The sixty month limitation
of paragraph (c)(1)(iv) of this section does not prevent X from making an election because X has not
made a prior election under paragraph (c)(1)(i) of
this section.
Example 2. (i) On April 1, 1998, A and B, U.S.
persons, form X, a foreign eligible entity. X is
treated as an association under the default provisions
of paragraph (b)(2)(i) of this section, and X does not
make an election to be classified as a partnership.
On January 1, 1999, X elects to be classified as a
partnership effective on that date. Under the sixty
month limitation of paragraph (c)(1)(iv) of this section, X cannot elect to be classified as an association
until January 1, 2004 (i.e., sixty months after the effective date of the election to be classified as a partnership).
(ii) On June 1, 1999, A purchases all of B’s interest in X. After A’s purchase of B’s interest, X can no
longer be classified as a partnership because X has
only one member. Under paragraph (f)(2) of this
section, X is disregarded as a separate entity as of
the date A becomes the only member of X. X, however, is not treated as a new entity for purposes of
paragraph (c)(1)(iv) of this section. As a result, the
sixty month limitation of paragraph (c)(1)(iv) of this
section continues to apply to X and X cannot elect to
be classified as an association until January 1, 2004
(i.e., sixty months after January 1, 1999, the effective date of the election by X to be classified as a
partnership).

(5) Effective date. This paragraph (f)
applies as of the date the final regulations
are published in the Federal Register.
(g) Elective changes in classification—
(1) Deemed treatment of elective
change—(i) Partnership to association. If
an eligible entity classified as a partnership elects under paragraph (c)(1)(i) of
this section to be classified as an association, the following is deemed to occur:
The partnership contributes all of its assets and liabilities to the association in exchange for stock in the association, and
immediately thereafter, the partnership
liquidates by distributing the stock of the
association to its partners.
(ii) Association to partnership. If an
eligible entity classified as an association
elects under paragraph (c)(1)(i) of this

17

section to be classified as a partnership,
the following is deemed to occur: The association distributes all of its assets and liabilities to its shareholders in liquidation
of the association, and immediately thereafter, the shareholders contribute all of the
distributed assets and liabilities to a newly
formed partnership.
(iii) Association to disregarded entity.
If an eligible entity classified as an association elects under paragraph (c)(1)(i) of
this section to be disregarded as an entity
separate from its owner, the following is
deemed to occur: The association distributes all of its assets and liabilities to its
single owner in liquidation of the association.
(iv) Disregarded entity to an association. If an eligible entity that is disregarded as an entity separate from its
owner elects under paragraph (c)(1)(i) of
this section to be classified as an association, the following is deemed to occur:
The owner of the eligible entity contributes all of the assets and liabilities of
the entity to the association in exchange
for stock of the association.
(2) Effect of elective changes. The tax
treatment of a change in the classification
of an entity for federal tax purposes by
election under paragraph (c)(1)(i) of this
section is determined under all relevant
provisions of the Internal Revenue Code
and general principles of tax law, including the step transaction doctrine.
(3) Timing of election. An election
under paragraph (c)(1)(i) of this section
that changes the classification of an eligible entity for federal tax purposes is
treated as occurring at the start of the day
for which the election is effective. Any
transactions that are deemed to occur
under this paragraph (g) as a result of a
change in classification are treated as occurring immediately before the close of
the day before the election is effective.
For example, if an election is made to
change the classification of an entity from
an association to a partnership effective
on January 1, the deemed transactions
specified in paragraph (g)(1)(ii) of this
section (including the liquidation of the
association) are treated as occurring immediately before the close of December
31 and must be reported by the owners of
the entity on December 31. As a result,
the last day of the association’s taxable
year will be December 31 and the first

December 1, 1997

day of the partnership’s taxable year will
be January 1.
(4) Effective date. This paragraph (g)
applies to elections that are filed on or
after the date the final regulations are
published in the Federal Register.
(h) Effective date—(1) In general. Except as otherwise provided in this section,
the rules of this section are applicable as
of January 1, 1997.
*

*

*

*

*

Michael P. Dolan,
Acting Commissioner of
Internal Revenue.
(Filed by the Office of the Federal Register on October 27, 1997, 8:45 a.m., and published in the issue of
the Federal Register for October 28, 1997, 62 F.R.
55768)

Notice of Proposed Rulemaking
and Notice Of Public Hearing
Source of Income From Sales of
Inventory Partly From Sources
Within a Possession of the United
States; Also, Source of Income
Derived From Certain Purchases
From a Corporation Electing
Section 936
REG–251985–96
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Notice of proposed rulemaking and notice of public hearing.
SUMMARY: This document contains
proposed regulations under section 863
governing the source of income from
sales of inventory produced in the United
States and sold in a possession of the
United States or produced in a possession
of the United States and sold in the
United States. It also contains proposed
regulations under section 863 governing
the source of income from sales of inventory purchased in a possession of the
United States and sold in the United
States. This document affects persons
who produce (in whole or in part) inventory in the United States and sell in a possession, or produce (in whole or in part)

December 1, 1997

inventory in a possession and sell in the
United States, as well as persons who
purchase inventory in a possession and
sell in the United States. This document
also contains proposed regulations under
section 936 governing the source of income of a taxpayer from the sale in the
United States of property purchased from
a corporation that has an election under
section 936 in effect. This document also
provides notice of a public hearing on
these proposed regulations.
DATES: Comments and outlines of oral
comments to be presented at the public
hearing scheduled for January 29, 1998,
at 10 a.m. must be received by January 8,
1998.
ADDRESSES: Send submissions to:
CC:DOM:CORP:R (INTL–0003–95),
room 5228, Internal Revenue Service,
POB 7604, Ben Franklin Station, Washington, DC 20044. In the alternative, submissions may be hand delivered between
the hours of 8 a.m. and 5 p.m. to:
CC:DOM:CORP:R (REG–251985–96),
Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue NW,
Washington, DC, or electronically, via the
IRS Internet site at: http://www.irs
ustreas.gov/prod/tax_regs/comments.html.
The public hearing will be held in room
2615, Internal Revenue Building, 1111
Constitution Avenue, NW, Washington,
DC.
FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Anne
Shelburne, (202) 622-3880; concerning
submissions and the hearing, Ms. Evangelista Lee, (202) 622-7190 (not toll-free
numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information contained in this notice of proposed rulemaking has been submitted to the Office of
Management and Budget (OMB) for review in accordance with the Paperwork
Reduction Act of 1995 (44 U.S.C.
3507(d)).
Comments on the collection of information should be sent to the Office of
Management and Budget, Attn: Desk
Officer for the Department of Treasury,
Office of Information and Regulatory Af-

18

fairs, Washington, DC 20503, with
copies to the Internal Revenue Service,
Attn: IRS Reports Clearance Officer,
T:FP, Washington, DC 20224. Comments on the collection of information
should be received by December 9, 1998.
Comments are specifically requested concerning:
Whether the proposed collection of information is necessary for the proper performance of the functions of the IRS, including whether the information will have
practical utility;
The accuracy of the estimated burden associated with the proposed collection of
information (see below);
How the quality, utility, and clarity of the
information to be collected may be enhanced;
How the burden of complying with the
proposed collection of information may
be minimized, including through the application of automated collection techniques or other forms of information technology; and
Estimates of capital or start-up costs and
costs of operation, maintenance, and purchase of services to provide information.
The collection of information requirements are in proposed §1.863–3(f)(6).
This information is required by the IRS
to monitor compliance with the federal
tax rules for determining the source of
income from the sale of inventory produced in the United States and sold in a
possession of the United States or produced in a possession of the United
States and sold in the United States, or
from the sale of inventory purchased in a
possession of the United States and sold
in the United States. The likely respondents are taxpayers who produce inventory in the United States and sell in a
possession, or who produce inventory in
a possession and sell in the United
States, or who purchase inventory in a
possession and sell in the United States.
Responses to this collection of information are required to properly determine
the source of a taxpayer’s income from
such sales.
Books or records relating to a 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.

1997–48 I.R.B.

Estimated total annual reporting burden:
500 hours. The estimated annual burden
per respondent varies from 1 hour to 5
hours, depending on individual circumstances, with an estimated average of 2.5
hours.
Estimated number of respondents: 200
Estimated annual frequency of responses:
One time per year.
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 assigned by the Office of
Management and Budget.

vember 29, 1996 (61 F.R. 60540), and the
prior regulations were renumbered
§§1.863–3A and 1.863–3AT. The new
regulations retain the prior rules for Section 863 Possession Sales by providing in
paragraph §1.863–3(f) that taxpayers
must apply the rules of §1.863–3A(c) in
allocating and apportioning income derived from sources partly within the
United States and partly within a possession of the United States. These proposed
regulations would modify the existing
rules for allocating and apportioning income between the United States and a
possession.

Background

1. Property produced and sold

These proposed regulations contain
rules under section 863 relating to the
source of income from cross-border sales
of certain property. These regulations
also contain rules under section 936 relating to the source of income of a taxpayer
from the sale in the United States of property purchased from a corporation that has
an election under section 936 in effect.
These regulations are proposed to be effective for taxable years beginning 30
days after publication of final regulations.

Currently, income derived from sales
of inventory produced in the United
States and sold in a possession of the
United States or produced in a possession
of the United States and sold in the United
States (Possession Production Sales), is
allocated or apportioned between the
United States and a possession according
to one of three methods. Such income is
allocated under the independent factory
price method, apportioned under an apportionment method, or, with permission
of the District Director, allocated or apportioned on the basis of the taxpayer’s
books and records.
Under the current regulations, if an independent factory or production price
(IFP) exists for Possession Production
Sales, taxpayers must use the IFP method
to determine the income attributable to
production activities in both the sale establishing the IFP and in sales of similar
products.
If an IFP does not exist, the current
possessions regulations provide that the
taxable income from Possession Production Sales is first computed and then apportioned between the United States and
the possession. One-half of the taxable
income is apportioned on the basis of the
taxpayer’s property within the United
States and within the possession. In applying the property fraction, the taxpayer’s property includes property held or
used to produce income derived from
Possession Production Sales. The other
half of the taxpayer’s taxable income is
apportioned between U.S. and possession
sources on the basis of the business of the
taxpayer within the United States and
within the possession. Currently, busi-

Explanation of Provisions
I. Income Partly From Sources Within a
Possession
A. Current Regulations
Section 863 authorizes the Secretary to
promulgate regulations allocating or apportioning to sources within or without
the United States all items of gross income, expenses, losses, and deductions
other than those items specified in sections 861(a) and 862(a).
Guidance to determine the source of
possession income is divided into two
types of transactions: transactions described in section 863(b)(2) for property
produced in the United States and sold in
a possession (or vice versa), and transactions described in section 863(b)(3) for
property purchased in a possession and
sold in the United States (collectively,
Section 863 Possession Sales).
Section 1.863–3 of the income tax regulations contains rules for determining the
source of income derived from sales of
certain property. These regulations were
published in the Federal Register on No-

1997–48 I.R.B.

19

ness of the taxpayer is measured by the
sum of certain expenses, including
amounts paid for labor, and the purchase
of certain supplies, plus receipts from
Possession Production Sales. Finally, as a
third method, the existing regulations
allow a taxpayer to request permission
from the District Director to use the taxpayer’s books and records to allocate or
apportion income to sources within or
without the United States if those books
reflect more clearly than the other methods the taxable income derived from
sources within the United States.
2. Property purchased and sold
The second type of possession transaction governed by the existing regulations
is the sale of inventory purchased in a
possession and sold in the United States
(Possession Purchase Sales) as described
in section 863(b)(3). Under the current
regulations, the income from such sales is
divided between the United States and
possession sources under one of two
methods. The income can be apportioned, or, with permission of the District
Director, allocated or apportioned on the
basis of the taxpayer’s books and records.
Under the apportionment method, taxable income is first determined, and then
apportioned by a fraction, the numerator
being the business of the taxpayer in the
United States, the denominator being the
total business of the taxpayer in the
United States and in the possession. The
fraction is computed in the same manner
as the business fraction discussed previously, except that such expenses, purchases, and sales are limited to those attributable to Possession Purchase Sales.
B. Issues Under Current Regulations
The IRS and Treasury believe the rules
for allocating and apportioning income
between the United States and the possessions of the United States should be
amended to reflect certain changes made
to the regulations under §1.863–3 governing cross-border sales of inventory involving the United States and a foreign
country (other than those involving possessions). Thus, for example, under the
apportionment method provided in the
proposed regulations, the property and
business activity fractions apportioning
income between the United States and a
possession are modified to apportion

December 1, 1997

gross income attributable to an activity,
rather than to apportion net income.
The IRS and Treasury also believe certain ambiguities exist in the current regulations. The possessions rules were originally promulgated in 1926, and may not
reflect current business practices. The
current regulations use examples to illustrate methods for allocating or apportioning income between the United States and
a possession, and should be modified to
state rules.
Further, although the apportionment
method for allocating Possession Production Sales income under the existing possessions regulations treats half of the income as production income, the
production formula is not necessarily limited to production assets. The current inclusion of sales assets in the formula apportioning production income results in
excessive income being allocated to sales
activities. The production income formula should only take into account assets
directly involved in production of inventory. In addition, the IRS and Treasury
have reexamined the business activity
fraction, and have concluded it should be
revised to more clearly reflect the taxpayer’s business other than production.
The current fraction, for example, omits
certain investments or expenses, such as
marketing and advertising expenses, although income attributable in part to such
expenses or investments is then included
in the income apportioned by the fraction.
The current regulations also take into account production expenses in the business
activity fraction apportioning income
from Possession Production Sales. The
Service and Treasury believe that this is
inappropriate in the context of Possession
Production Sales because the business activity fraction is not intended to determine
the source of income attributable to production activity. In the proposed regulations, the fraction apportioning Possession Production Sales is renamed the
business sales activity fraction and excludes factors reflecting production activity.
The current regulations also do not address issues in attributing to the United
States or to the possession, the activities
reflected in the business activity fraction.
For example, the current regulations provide no guidance on whether a particular
expense should be represented in the frac-

December 1, 1997

tion as attributable to the United States or
to a possession.
Accordingly, the IRS and Treasury are
issuing proposed regulations under section 863 to make the possessions rules
more consistent with the other regulations
governing the source of income from
cross-border sales of inventory, and to address certain ambiguities and problems in
the existing regulations.
C. Proposed Regulations
Section 1.863-3(f) generally retains the
methods of the current regulations for dividing income between the United States
and a possession of the United States,
with several modifications.
1. Methods to allocate gross income to
activities of the taxpayer
a. Property produced and sold
i. The possession 50/50 method
Consistent with the final regulations
under §1.863–3, paragraph (f)(2)(i)(A) of
the proposed regulations makes the 50/50
method the general rule to allocate gross
income from Possession Production Sales
between production and business sales activity, so that the income from each type
of activity can then be apportioned between U. S. and foreign sources. The taxpayer, however, may elect to apply the
IFP method (described in paragraph
(f)(2)(i)(B)), or, with the consent of the
District Director, the books and records
method (described in paragraph
(f)(2)(i)(C)).
Under the possession 50/50 method,
the proposed regulations allocate half of
the taxpayer’s gross income from Possession Production Sales to production activity and half to business sales activity. The
income is then apportioned between U.S.
and possession sources based on a property fraction and a business sales activity
fraction. As described below, the proposed regulations make certain changes to
the existing property fraction and to the
existing business activity fraction.
The proposed regulations apply the
property fraction in §1.863–3(c) to apportion the half of a taxpayer’s income allocated to production activity. Thus, income is apportioned to the United States
or to a possession based on the location of
the taxpayer’s production assets. In a
change from the current regulations, and
consistent with the changes made to the
regulations under §1.863–3(c), produc-

20

tion assets are defined as tangible and intangible assets owned directly by the taxpayer that are directly used by the taxpayer to produce inventory sold in
Possession Production Sales, instead of
all its assets that produce income from
Possession Production Sales. Production
assets are included in the fraction at their
adjusted tax basis.
The other half of the taxpayer’s gross
income is apportioned according to a
business sales activity fraction. The portion of this income that is possession
source income is determined by multiplying the income by a fraction, the numerator being the business sales activity of the
taxpayer in the possession, and the denominator being the business sales activity of the taxpayer within the possession
and outside the possession. The remaining income is sourced in the United
States. Although some of the business
sales activity factors not incurred in a possession may be incurred in a foreign
country, Treasury and the Internal Revenue Service believe that the business
sales activity fraction is only intended to
source the business sales activity portion
of Possession Production Sales outside
the United States to the extent of business
sales activity located in a possession.
The proposed regulations make some
modifications to the factors in the fraction
representing the business sales activity of
the taxpayer. Business sales activity is
measured by the sum of certain expenses,
including amounts paid for labor, materials, advertising, and marketing (but excluding any expenses or other amounts
that are nondeductible under section
263A, interest, and research and development), plus receipts for the sale of goods.
This formula is intended to reflect better
the business sales activity producing the
income by including more of the factors
responsible for producing that income.
Cost of goods sold is also excluded from
the business sales activity fraction apportioning income from Possession Production Sales, because such costs generally
reflect production activity. Production
activity is already represented in the formula by the one-half of the taxpayer’s income apportioned according to the location of production assets.
Finally, the proposed regulations provide more explicit guidance for attributing business sales activity between the

1997–48 I.R.B.

United States and a possession. Expenses
are allocated and apportioned between the
United States and a possession based on
the rules in §§1.861–8 through
1.861–14T. Gross sales are allocated to
the United States or a possession based on
the place of sale.
ii. The IFP method
The proposed regulations make the IFP
method elective, and thus eliminate any
bias against taxpayers choosing to export
through independent distributors. The
regulations rely upon the revised regulations under §1.863–3 for rules in applying
the IFP method.
iii. Books and records method
The proposed regulations retain the
books and records method of the existing
regulations, permitting taxpayers to request permission from the District Director to use their books and records to determine the source of their income. The
proposed regulations refer to revised
§1.863–3(b)(3) in applying the method to
Possession Production Sales.
b. Property purchased and sold
i. The business activity method
Paragraph (f)(3)(i)(A) makes the business activity method the general rule to
apportion income from Possession Purchase Sales between the United States and
a possession. The taxpayer may, however, elect to apply, with consent of the
District Director, the books and records
method.
The proposed regulations retain the
structure of the existing regulations by apportioning the taxpayer’s income from
Possession Purchase Sales on the basis of
a business activity fraction. The portion
of this income that is possession source
income is determined by multiplying the
income by a fraction, the numerator being
the business of the taxpayer in the possession, and the denominator being the business of the taxpayer within the possession
and outside the possession. The remaining income is sourced in the United
States.
The business activity fraction is similar
to that discussed previously, used to apportion the taxpayer’s income in Possession Production Sales, except that the
fraction applies only to expenses, cost of
goods sold, and sales attributable to Possession Purchase Sales. In addition, the
business activity fraction apportioning
Possession Purchase Sales includes

1997–48 I.R.B.

amounts paid for cost of goods sold.
Such costs are attributed to the possession, however, only to the extent the property purchased is manufactured, produced, grown, or extracted in the
possession. Treasury and the Internal
Revenue Service anticipate that if a taxpayer acts in the reasonable belief that the
products were manufactured in the possession, the taxpayer could act on that
basis in preparing its tax return. As modified, the business activity fraction reflects
the view of Treasury and the Internal Revenue Service that section 863(b)(3)’s purchase rule was intended to apply only to
purchase and resale transactions, where
the goods purchased are created or derived from the possession.
ii. Books and records method
The proposed regulations retain the
books and records method of the existing
regulations, permitting taxpayers to request permission from the District Director to use their books and records to determine the source of their income. The
proposed regulations refer to revised
§1.863–3(b)(3) in applying the method to
Possession Purchase Sales.
2. Determination of source of gross
income
Unlike the current regulations which
provide specific rules for determining the
source of income attributable to production activity and business activity only for
purposes of the 50/50 method, the proposed regulations adopt rules applicable
to each of the methods. Under the proposed regulations, once gross income attributable to production activity, business
activity, or sales activity has been determined under one of the prescribed methods, the source of the gross income is determined separately for each type of
income. The source of gross income attributable to production activity (when
applying the possession 50/50 method) is
determined under paragraph (c)(1), based
on the location of production assets. The
source of gross income attributable to
sales activity (when applying the IFP
method or the books and records method)
is determined under paragraph (c)(2),
based generally on the location of the
sale. The source of gross income attributable to business sales activity (when applying the possession 50/50 method) is
determined under paragraph (f)(2)(ii)(B),

21

based on expenses, and gross sales attributable to Possession Production Sales.
The source of gross income attributable to
business activity (when applying the business activity method) is determined under
paragraph (f)(3)(ii), based on expenses,
cost of goods sold, and gross sales attributable to Possession Purchase Sales.
3. Determination of source of
taxable income
Once the source of gross income is determined under paragraph (f)(2) or (3),
taxpayers then determine the source of
taxable income. Under proposed paragraph (f)(4), taxpayers must allocate or
apportion under §§1.861–8 through
1.861–14T the amounts of expenses,
losses and other deductions to gross income determined under each of the prescribed methods. In the case of amounts
of expenses, losses and other deductions
allocated or apportioned to gross income
determined under the IFP method or the
books and records method, the taxpayer
must apply the rules of §§1.861–8
through 1.861–14T to allocate or apportion these amounts between gross income
from sources within the United States and
within a possession. For expenses, losses
and other deductions allocated or apportioned to gross income determined under
the possessions 50/50 method, taxpayers
must apportion expenses and other deductions pro rata based on the relative
amounts of U.S. and possession source
gross income. The research and experimental (R&E) expense allocation rules in
§1.861–17 apply to taxpayers using the
50/50 method, so that the R&E set aside
(described in §1.861–17) remains available to such taxpayers.
4. Treatment of gross income derived
from certain purchases from a
corporation that has an election
in effect under section 936
The proposed regulations clarify that
section 863 does not apply to determine
the source of a taxpayer’s gross income
derived from a purchase of inventory
from a corporation that has an election in
effect under section 936, if the taxpayer’s
income from sales of that inventory is
taken into account to determine benefits
under section 936(h)(5)(C) for the section
936 corporation.

December 1, 1997

5. Treatment of partners and partnerships
The proposed regulations rely on the
rules in §1.863–3(g) for determining the
appropriate treatment in transactions involving partnerships. Under those rules,
the aggregate approach applies to a partnership’s production and sales activity for
two purposes only. First, the aggregate approach applies in determining the character
of a partner’s distributive share of partnership income. Second, the aggregate approach applies in sourcing income from
sales of inventory property that is transferred in-kind from or to a partnership.

source without regard to whether a possession product is a component, endproduct form, or integrated product. No
inference should be drawn from the proposed effective date concerning the treatment of transactions involving sales of
property purchased from a section 936
corporation entered into before the regulations are applicable.
Proposed Effective Dates
These regulations are proposed to be
effective for taxable years beginning on
or after the date that is 30 days after the
date of publication of final regulations.

6. Election and reporting rules
Special Analyses
Under paragraph (f)(6)(i) of the proposed regulations, a taxpayer must use the
50/50 method to determine the source of
income from Possession Production Sales
unless the taxpayer elects to use the IFP
method, or elects the books and records
method. For Possession Purchase Sales, a
taxpayer must use the business activity
method, unless the taxpayer elects the
books and records method. The taxpayer
makes an election by using the method on
its timely filed original tax return. That
method must be used in later taxable
years unless the Commissioner or his delegate consents to a change. Permission to
change methods in later years will not be
withheld unless the change would result
in a substantial distortion of the source of
income.
A taxpayer must fully explain the
methodology used in applying either
paragraph (f)(2) or (3), and the amount of
income allocated or apportioned to U.S.
and foreign sources, in a statement attached to its tax return.
II. Income Derived From Certain
Purchases From a Corporation That Has
an Election in Effect Under Section 936
These proposed regulations clarify that
where a taxpayer purchases a product
from a corporation that has an election in
effect under section 936, the source of the
taxpayer’s gross income derived from
sales of that product (in whatever form
sold) in the United States is U.S. source,
if the taxpayer’s income from sales of
that product is taken into account to determine benefits under section
936(h)(5)(C)(i) for the section 936 corporation. The taxpayer’s income is U.S.

December 1, 1997

It has been determined that this notice
of proposed rulemaking 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, this notice of proposed rulemaking
will be submitted to the Chief Counsel for
Advocacy of the Small Business Administration for comment on its impact on
small business.
Comments and Public Hearing
Before these proposed regulations are
adopted as final regulations, consideration will be given to any comments that
are submitted timely (in the manner described under the ADDRESSES caption)
to the IRS. All comments will be available for public inspection and copying.
A public hearing has been scheduled
for January 29, 1998, at 10 a.m., in room
2615, Internal Revenue Building, 1111
Constitution Avenue, NW, Washington,
DC. Because of access restrictions, visitors will not be admitted beyond the Inter-

22

nal Revenue Building lobby more than 15
minutes before the hearing starts.
The rules of 26 CFR 601.601(a)(3)
apply to the hearing.
Persons that wish to present oral comments at the hearing must submit comments and an outline of topics to be discussed and the time to be devoted to each
topic (in the manner described under the
ADDRESSES caption of this preamble)
by January 8, 1998.
A period of 10 minutes will be allotted
to each person for making comments.
An agenda showing the scheduling of
the speakers will be prepared after the
deadline for receiving outlines has
passed. Copies of the agenda will be
available free of charge at the hearing.
Drafting Information
The principal author of these regulations is Anne Shelburne, Office of Associate Chief Counsel (International). However, other personnel from the IRS and
Treasury Department participated in their
development.
*

*

*

*

*

Proposed Amendments to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 is amended by revising the entry for
“Section 1.863-3”, removing the entry for
“Sections 1.936-4 through 1.936-7” and
adding entries in numerical order to read
as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.863-3 also issued under 26
U.S.C. 863(a) and (b), and 26 U.S.C.
936(h).***
Section 1.936-4 also issued under 26
U.S.C. 936(h).
Section 1.936-5 also issued under 26
U.S.C. 936(h).
Section 1.936-6 also issued under 26
U.S.C. 863(a) and (b), and 26 U.S.C.
936(h).
Section 1.936-7 also issued under 26
U.S.C. 936(h).***
Par. 2 Section 1.863-3 is amended as
follows:
1. Paragraph (f) is revised.
2. Paragraph (h) is amended by adding
a sentence at the end of the paragraph.

1997–48 I.R.B.

The revision and addition read as follows:
§1.863-3 Allocation and apportionment
of income from certain sales of inventory.
*

*

*

*

*

(f) Income partly from sources within a
possession of the United States—(1) In
general. This paragraph (f) relates to
gains, profits, and income, which are
treated as derived partly from sources
within the United States and partly from
sources within a possession of the United
States (Section 863 Possession Sales).
This paragraph (f) applies to determine
the source of income derived from the
sale of inventory produced (in whole or in
part) by the taxpayer within the United
States and sold within a possession, or
produced (in whole or in part) by a taxpayer in a possession and sold within the
United States (Possession Production
Sales). It also applies to determine the
source of income derived from the purchase of personal property within a possession of the United States and its sale
within the United States (Possession Purchase Sales). A taxpayer subject to this
paragraph (f) must divide gross income
from Section 863 Possession Sales using
one of the methods described in either
paragraph (f)(2)(i) of this section (in the
case of Possession Production Sales) or
paragraph (f)(3)(i) of this section (in the
case of Possession Purchase Sales). Once
a taxpayer has elected a method, the taxpayer must separately apply that method
to the applicable category of Section 863
Possession Sales in the United States and
to those in a possession. The source of
gross income from each type of activity
must then be determined under either
paragraph (f)(2)(ii) or (3)(ii) of this section, as appropriate. The source of taxable
income from Section 863 Possession
Sales is determined under paragraph
(f)(4) of this section. The taxpayer must
apply the rules for computing gross and
taxable income by aggregating all Section
863 Possession Sales to which a method
in this section applies after separately applying that method to Section 863 Possession Sales in the United States and to Section 863 Possession Sales in a possession.
This section does not apply to determine
the source of a taxpayer’s gross income
derived from a sale of inventory purchased from a corporation that has an

1997–48 I.R.B.

election in effect under section 936, if the
taxpayer’s income from sales of that inventory is taken into account to determine
benefits under section 936 for the section
936 corporation. For rules to be applied
to determine the source of such income,
see §1.936-6(a)(5) Q&A 7a and (b)(1)
Q&A 13.
(2) Allocation or apportionment for
Possession Production Sales—(i) Methods for determining the source of gross
income for Possession Production
Sales—(A) Possession 50/50 method.
Under the possession 50/50 method, gross
income from Possession Production Sales
is allocated between production activity
and business sales activity as described in
this paragraph (f)(2)(i)(A). Under the
possession 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 (f)(2)(ii)(A) of this section. The remaining one-half of such gross income
will be considered income attributable to
business sales activity and the source of
that income will be determined under the
rules of paragraph (f)(2)(ii)(B) of this section.
(B) IFP method. In lieu of the possession 50/50 method, a taxpayer may elect
the independent factory price (IFP)
method. Under the IFP method, gross income from Possession Production Sales is
allocated to production activity or sales
activity using the IFP method, as described in paragraph (b)(2) of this section,
if an IFP is fairly established under the
rules of paragraph (b)(2) of this section.
See paragraphs (f)(2)(ii)(A) and (C) of
this section for rules for determining the
source of gross income attributable to
production activity and sales activity.
(C) Books and Records method. A
taxpayer may elect to allocate gross income using the books and records
method described in paragraph (b)(3) of
this section, if it has received in advance
the permission of the District Director
having audit responsibility over its return. See paragraph (f)(2)(ii) of this section for rules for determining the source
of gross income.
(ii) Determination of source of gross
income from production, business sales,
and sales activity—(A) Gross income attributable to production activity. The

23

source of gross income from production
activity is determined under the rules of
paragraph (c)(1) of this section, except
that the term possession is substituted for
foreign country wherever it appears.
(B) Gross income attributable to business sales activity—(1) Source of gross
income. Gross income from the taxpayer’s business sales activity is sourced
in the possession in the same proportion
that the amount of the taxpayer’s business
sales activity for the taxable year within
the possession bears to the amount of the
taxpayer’s business sales activity for the
taxable year both within the possession
and outside the possession, with respect
to Possession Production Sales. The remaining income is sourced in the United
States.
(2) Business sales activity. For purposes of this paragraph (f)(2)(ii)(B), the
taxpayer’s business sales activity is equal
to the sum of—
(i) The amounts for the taxable period
paid for wages, salaries, and other compensation of employees, and other expenses attributable to Possession Production Sales (other than amounts that are
nondeductible under section 263A, interest, and research and development); and
(ii) Possession Production Sales for the
taxable period.
(3) Location of business sales activity.
For purposes of determining the location
of the taxpayer’s business activity within
a possession, the following rules apply:
(i) Sales. Receipts from gross sales
will be attributed to a possession under
the provisions of paragraph (c)(2) of this
section.
(ii) Expenses. Expenses will be attributed to a possession under the rules of
§§1.861–8 through 1.861–14T.
(C) Gross income attributable to sales
activity. T

[Text truncated at 120,000 characters. The full text is on the page linked above.]

---

Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/agency%3Airs%3A3752627821654745. Public record. Not legal advice.