Bulletin No. 1998–16

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Internal Revenue

bulletin

Bulletin No. 1998–16

April 20, 1998

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

T.D. 8765, page 11.

Final regulations under section 985 of the Code relate to adjustments required when a qualified business unit (QBU) that

used the profit and loss method of accounting (P&L) in a

post-1986 year begins to use the dollar approximate separate transaction method of accounting (DASTM) and adjustments required when a QBU that used DASTM begins using

P&L.

T.D. 8766, page 17.

REG–104062–97, page 20.

Final, temporary, and proposed regulations under section

1502 of the Code relate to limitations on the use of certain

tax credits and related attributes by corporations filing consolidated income tax returns. A public hearing on the proposed regulations will be held on May 7, 1998.

T.D. 8767, page 4.

REG–104537–97, page 21.

Final, temporary, and proposed regulations under section

954 of the Code relate to the treatment under subpart F of

certain payments involving branches of a controlled foreign

Finding Lists begin on page 52.

Department of the Treasury

Internal Revenue Service

corporation (CFC) that are treated as separate entities for

foreign tax purposes or partnerships in which CFCs are

partners. A public hearing on the proposed regulations will

be held on July 15, 1998.

EXEMPT ORGANIZATIONS

Announcement 98–29, page 48.

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

ADMINISTRATIVE

REG–208299–90, page 26.

Proposed regulations under sections 482 and 864 of the

Code relate to rules for the allocation among controlled taxpayers and sourcing of income, deductions, gains and

losses from a global dealing operation; rules applying these

allocation and sourcing rules to foreign currency transactions and to foreign corporations engaged in a U.S. trade or

business; and rules concerning the mark-to-market treatment resulting from hedging activities of a global dealing operation. A public hearing will be held on July 9, 1998.

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.

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 semiannual basis

and are published in the first Bulletin of the succeeding 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.

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

Section 954.—Foreign Base

Company Income

26 CFR 1.954–9T: Hybrid branches (temporary).

T.D. 8767

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 301

Guidance Under Subpart F

Relating to Partnerships and

Branches

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Temporary and final regulations.

SUMMARY: This document contains

regulations relating to the treatment under

subpart F of certain payments involving

branches of a controlled foreign corporation (CFC) that are treated as separate entities for foreign tax purposes or partnerships in which CFCs are partners. These

regulations are necessary to provide guidance on transactions relating to such entities. These regulations will affect United

States shareholders of controlled foreign

corporations. The text of these temporary

regulations also serves as the text of the

proposed regulations published in

REG–104537–97, page 21 of this Bulletin.

DATES: Effective date: These regulations are effective March 23, 1998.

Applicability date: For dates of applicability see §§1.904–5T(o), 1.954–1T(c)(1)(i)(E), 1.954–2T(a)(5)(iii) and

(a)(6)(ii), 1.954–9T(d) and 301.7701–

3T(f) of these regulations.

FOR FURTHER INFORMATION CONTACT: Valerie Mark, (202) 622-3840

(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

I. In general

In these temporary regulations and in

proposed regulations published in

REG–104537–97, the Treasury and IRS

set forth a framework for dealing with is-

April 20, 1998

sues posed by the use of certain entities

that are regarded as fiscally transparent

for purposes of U.S. tax law, with regard

to the application of subpart F of the Internal Revenue Code.

Subpart F was enacted by Congress to

limit the deferral of U.S. taxation of certain income earned outside the United

States by foreign corporations controlled

by U.S. persons. Limited deferral was retained after the enactment of subpart F to

protect the competitiveness of controlled

foreign corporations (CFCs) doing business overseas. See S. Rep. No. 1881,

87th Cong., 2d Sess. 78–80 (1962). This

limited deferral furthers the objective of

allowing a CFC engaged in an active

business, and located in a foreign country

for appropriate economic reasons, to

compete in a similar tax environment with

non-U.S. owned corporations located in

the same country.

Conversely, one of the purposes of subpart F is to prevent CFCs from converting

active income that is not easily moveable

and is earned in a jurisdiction in which a

business is located for non-tax reasons,

into passive, easily moveable income that

is shifted to a lower tax jurisdiction primarily for tax avoidance. Moreover,

when subpart F was first enacted it was

realized that related person transactions

can be easily manipulated to reduce both

United States and foreign taxes. Consequently, in enacting subpart F, Congress

provided that transactions of CFCs that

involve related persons generally give rise

to subpart F income with certain enumerated exceptions.

Hybrid branches, which, by definition,

are not regarded as fiscally transparent

under foreign law, are particularly well

suited to the type of tax avoidance described above. In light of the recent proliferation of hybrid branches, Treasury

and the IRS believe that it is appropriate

to consider the issues related to transactions involving hybrid branches, or other

hybrid entities, under subpart F.

The use of partnerships that are fiscally

transparent for U.S. tax purposes raises

additional issues in the context of subpart

F that are similar to those raised in

connection with hybrid branches. Such

partnerships may or may not be fiscally

transparent under foreign law. (Other fis-

cally-transparent entities, such as grantor

trusts, will be the subject of guidance issued in conjunction with the finalization

of regulations under section 672(f).)

The entity classification regulations of

§§301.7701–1 through 301.7701–3 (the

check-the-box regulations) make entity

classification generally elective, in part so

that taxpayers can choose a tax status that

is consistent with their business objectives. This administrative provision was

not intended to change substantive law.

Particularly in the international area, the

ability to more easily achieve fiscal transparency can lead to inappropriate results

under certain substantive international

provisions of the Code. Thus, the Treasury and the IRS believe that it is necessary to provide additional guidance regarding the use of hybrid entities in the

international context. See preamble to

TD 8697, 61 Fed. Reg. 66585 (December

18, 1996).

II. Hybrid Branches

As announced in Notice 98–11 (1998–

6 I.R.B. 13), the Treasury and the IRS understand that certain taxpayers are using

arrangements involving hybrid branches

to circumvent the purposes of subpart F

(sections 951 through 964 of the Code).

These arrangements generally involve the

use of deductible payments to reduce the

taxable income of a CFC under foreign

law, thereby reducing that CFC’s foreign

tax and, also under foreign law, the corresponding creation in another entity of

low-taxed, passive income of the type to

which subpart F was intended to apply.

Because of the structure of these arrangements, however, taxpayers take the position that this income is not taxed under

subpart F. Treasury and the IRS have

concluded that use of these hybrid branch

arrangements is contrary to the policies

and rules of subpart F.

U.S. international tax policy seeks to

balance the objective of neutrality of taxation between domestic and foreign business enterprises (seeking neither to encourage nor to discourage one over the

other), while keeping U.S. business competitive. Subpart F strongly reflects and

enforces that balance, while the arrangements described above involving hybrid

branches upset that balance.

1998–16 I.R.B.

Explanation of Provisions

Under these temporary regulations, hybrid branch payments, as defined in the

regulations, between a CFC and its hybrid

branch, or between hybrid branches of the

CFC may give rise to subpart F income.

When certain conditions are present, the

non-subpart F income of the CFC, in the

amount of the hybrid branch payment, is

recharacterized as subpart F income of the

CFC. Those conditions include that: the

hybrid branch payment reduces the foreign tax of the payor; the hybrid branch

payment would have been foreign personal holding company income if made

between separate CFCs; and there is a disparity between the effective rate of tax on

the payment in the hands of the payee and

the hypothetical rate of tax that would

have applied if the income had been taxed

in the hands of the payor. Treasury and

the IRS are considering applying similar

principles with respect to the foreign base

company services income rules of section

954(e). Comments are requested on this

issue. Any regulations promulgated on

this issue will be prospective.

Policies underlying subpart F would

also be avoided in certain non-hybrid

branch transactions that do not reduce the

tax of the payor. Treasury and the IRS invite comments on the extent to which

rules should be provided to address such

transactions. Any regulations promulgated on this issue will be prospective.

Comments are also requested regarding

the application of these rules to dividend

and other equity distributions.

The temporary regulations make clear

that the CFC and the hybrid branch, or the

hybrid branches, are treated as separate

corporations only to recharacterize nonsubpart F income as subpart F income in

the amount of the hybrid branch payment,

and to apply the tax disparity rule of

§1.954–9T(a)(5)(iv). For all other purposes (e.g., for purposes of the earnings

and profits limitation of section 952), a

CFC and its hybrid branch, or hybrid

branches, are not treated as separate corporations.

The temporary regulations provide that

the amount recharacterized as subpart F

income is the gross amount of the hybrid

branch payment limited by the amount of

the CFC’s earnings and profits attributable to non-subpart F income. This

1998–16 I.R.B.

amount is the excess of current earnings

and profits over subpart F income, determined after the application of the rules of

sections 954(b) and 952(c) and before the

application of these temporary regulations. To the extent that the full amount

required to be recharacterized under this

provision cannot be recharacterized because it exceeds earnings and profits attributable to non-subpart F income, there

is no requirement to carry such amounts

back or forward to another year.

For purposes of determining the

amount of taxes deemed paid under section 960, the amount of non-subpart F income recharacterized as subpart F income

is treated as attributable to income in separate foreign tax credit baskets in proportion to the ratio of non-subpart F income

in each basket to the total amount of nonsubpart F income of the CFC for the taxable year.

The temporary regulations provide

that, under certain circumstances, the

recharacterization rules will also apply to

a CFC’s proportionate share of any hybrid

branch payment made between a partnership in which the CFC is a partner and a

hybrid branch of the partnership, or between hybrid branches of such a partnership. When the partnership is treated as

fiscally transparent by the CFC’s taxing

jurisdiction, the recharacterization rules

are applied by treating the hybrid branch

payment as if it had been made directly

between the CFC and the hybrid branch,

or as though the hybrid branches of the

partnership had been hybrid branches of

the CFC, as applicable. If the partnership

is treated as a separate entity by the CFC’s

taxing jurisdiction, the recharacterization

rules are applied to the partnership as if it

were a CFC. Comments are requested on

whether the rule for such non-fiscally

transparent partnerships should be relaxed

in the case of small ownership interests.

The temporary regulations provide that

income will not be recharacterized unless

there is a disparity between the effective

rate at which the hybrid branch payment

is taxed to the payee and a hypothetical

tax rate that measures the tax savings to

the payor from the deductible payment.

This provision is similar to the rule in

§1.954–3(b), and adopts the same percentage tests as contained in that provision. The regulations also provide a special high tax exception applicable to the

hybrid branch payment that is similar to

the one contained in section 954(b)(4).

Comments are invited on whether the

rules of §1.954–9T could cause inappropriate multiple recharacterizations where

the hybrid branch payments are made

through a series of related hybrid entities.

The temporary regulations provide that

if these provisions affect an entity that has

elected under §301.7701–3(c) to be

treated as an entity disregarded as separate from its owner, such an entity may

elect to be classified as a corporation, provided it fulfills certain requirements,

notwithstanding the sixty-month limitation in that section.

III. Related Provisions

These temporary regulations provide

rules, contained in §1.954–1T(c)(1)(i)(B),

to prevent expenses, including related

person interest expense which would normally be allocable under section

954(b)(5) to subpart F income of a CFC,

from being allocated to a payment from

which the expense arises. The allocation

limit applies: (i) to the extent such payment is included in the subpart F income

of the CFC; (ii) if the expense arises from

any payment by the CFC to a hybrid partnership in which the CFC is a partner; and

(iii) if the payment reduces foreign tax

and there is a significant disparity in tax

rates between the payor and payee jurisdictions.

These temporary regulations also address the application of the related person

exceptions to the foreign personal holding

company income rules in the context of

partnership distributive shares and transactions involving hybrid branches. Under

section 954(c)(3), foreign personal holding company income does not include

certain interest, dividends, rents and royalties received from related corporations.

These exceptions apply, in the case of interest and dividends, when the related

corporate payor is organized in the country in which the CFC is organized and

uses a substantial part of its assets in a

trade or business in that country and, in

the case of rents and royalties, when the

rent or royalty payment is made for the

use or privilege of using property within

the CFC’s country of incorporation.

The rules regarding the application of

the related person exceptions with respect

to a CFC partner’s distributive share of

April 20, 1998

partnership income are part of the broader

set of rules addressing distributive share

issues in the context of subpart F contained in the proposed regulations published in REG–104537–97. Certain rules

relating to the related person exception

with respect to a CFC partner’s distributive share of partnership income, and certain rules relating to the related person exception with respect to hybrid branches,

however, are included in these temporary

regulations because they address a fact

pattern similar to the one to which the hybrid branch payment rules apply. No inference is intended as to the treatment

under existing law of such arrangements

in relation to the related party exceptions.

Under these rules, if the partnership receives an item of income that reduces the

income tax of the payor, the related person exceptions of section 954(c)(3) apply

to exclude the income from the foreign

personal holding company income of the

CFC partner only where: the exception

would have applied if the CFC earned the

income directly (testing relatedness and

country of incorporation at the CFC partner level); and either the partnership is organized and operates in the CFC’s country of incorporation, the partnership is

treated as fiscally transparent in the

CFC’s countries of incorporation and operation, or there is no significant disparity

between the effective rate of tax imposed

on the income and the rate of tax that

would be imposed on the income if

earned directly by the CFC partner.

The rules applying the related person

exceptions with respect to hybrid

branches address transactions illustrated

in the first example of Notice 98–11

(1998–6 I.R.B. 13). These rules apply to

payments by a CFC to a hybrid branch of

a related CFC. Under these rules, the related person exceptions will apply to exclude the payments from the foreign personal holding company income of the

recipient CFC only if the payment would

have qualified for the exception if the hybrid branch had been a separate CFC incorporated in the jurisdiction in which the

payment is subject to tax (other than a

withholding tax).

1.954–2T(a)(5)(iii) and (6)(iii), 1.954–

9T(d) and 301.7701–3T(f) of these regulations.

IV. Effective Date.

These regulations are effective March

23, 1998. For dates of applicability see

§§1.904–5T(o), 1.954–1T(c)(1)(i)(E),

(o) * * * Paragraph (k)(1) of this section does not apply on or after March 23,

1998. For rules applicable on or after

March 23, 1998, see §1.904–5T(k)(1).

April 20, 1998

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order

12866. Therefore, a regulatory assessment is not required. It has also been determined that section 553(b) of the Administrative Procedures Act (5 U.S.C.

chapter 5) does not apply to these regulations and, because the regulation does not

impose a collection of information on

small entities, the Regulatory Flexibility

Act (5 U.S.C. chapter 6) does not apply.

Pursuant to section 7805(f) of the Internal

Revenue Code, these temporary regulations will be submitted to the Chief Counsel for Advocacy of the Small Business

Administration for comment on their impact on small business.

Par. 3. §1.904–5T is added to read as

follows:

§1.904–5T Look-through rules as

applied to controlled foreign

corporations and other entities

(temporary).

Accordingly, 26 CFR parts 1 and 301

are amended as follows:

(a) through (j) [Reserved]. For further

guidance, see §1.904–5(a) through (j).

(k) Ordering rules—(1) In general. Income received or accrued by a related

person to which the look-through rules

apply is characterized before amounts included from, or paid or distributed by, that

person and received or accrued by a related person. For purposes of determining the character of income received or

accrued by a person from a related person

if the payor or another related person also

receives or accrues income from the recipient and the look-through rules apply

to the income in all cases, the rules of

paragraph (k)(2) of this section apply.

Notwithstanding any other provision of

this section, the principles of §1.954–

1T(c)(1)(i) will apply to any expense subject to that subparagraph.

(k)(2) through (n) [Reserved]. For further guidance, see §1.904–5(k)(2) through

(n).

(o) Effective date. Section 1.904–

5T(k)(1) applies on or after March 23,

1998. For rules prior to March 23, 1998,

see §1.904–5(k)(1).

Par. 4. Section 1.954–0(b) is amended

by revising the paragraph heading and the

entry for §1.954–0(b) in the list to read as

follows:

PART 1—INCOME TAXES

§1.954–0 Introduction.

Drafting Information

The principal author of these regulations is Valerie Mark, of the Office of the

Associate Chief Counsel (International).

Other personnel from the IRS and Treasury Department also participated in the

development of these regulations.

Adoption of Amendments to the

Regulations

Paragraph 1. The authority citation for

26 CFR part 1 continues to read in part as

follows:

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

Par. 2. In §1.904–5, paragraph (o) is

amended by adding a sentence at the end

to read as follows:

§1.904–5 Look-through rules as applied

to controlled foreign corporations and

other entities.

(b) Outline of §§1.954–0, 1.954–1 and

1.954–2.

§1.954–0 Introduction.

(b) Outline of §§1.954–0, 1.954–1, and

1.954–2.

* * * * *

Par. 5. Section 1.954–1 is amended by

adding a new paragraph (c)(1)(iv) to read

as follows:

§1.954–1 Foreign base company income.

1998–16 I.R.B.

(1) * * *

(iv) Effective date. Paragraph (c)(1)(i)

of this section does not apply to all

amounts paid or accrued on or after

March 23, 1998, except for amounts paid

or accrued pursuant to arrangements entered into before March 23, 1998, and not

substantially modified (including, for example, by expansion of the arrangement

(whether by exercise of an option or otherwise) such as by an increase in the

amount of or term of any borrowing, leasing or licensing constituting the arrangement, changes in direct or indirect control

of any entity that is a party to the arrangement, or any similar measure which materially increases the tax benefit of the

arrangement) on or after March 23, 1998.

For rules applicable on or after March 23,

1998, see §1.954–1T(c)(1)(i).

Par. 6. Section 1.954–1T is added to

read as follows:

§1.954–1T Foreign base company

income (temporary).

(a) through (c)(1)(i) [Reserved]. For

further guidance, see §1.954–1(a) through

(c)(1).

(c)(1)(i) Deductions against gross foreign base company income—(A) In general. [Reserved]. For further guidance,

see §1.954–1(c)(1)(i).

(B) Special rule for deductible payments to certain non-fiscally transparent

entities. Notwithstanding any other provision of this section, except as provided

in paragraph (c)(1)(i)(C) of this section,

an expense (including a distributive share

of any expense) that would otherwise be

allocable under section 954(b)(5) against

the subpart F income of a controlled foreign corporation shall not be allocated

against subpart F income of the controlled

foreign corporation resulting from the

payment giving rise to the expense if—

(1) Such expense arises from a payment between the controlled foreign corporation and a partnership in which the

controlled foreign corporation is a partner

and the partnership is not regarded as fiscally transparent, as defined in §1.954–

9T(a)(7), by any country in which the

controlled foreign corporation does business or has substantial assets; and

(2) The payment from which the expense arises would have met the foreign

tax reduction test of §1.954–9T(a)(3) and

1998–16 I.R.B.

the tax disparity test of §1.954–

9T(a)(5)(iv) if those provisions had been

applicable to the payment.

shall not apply to the extent that the controlled foreign corporation partner has no

income against which to allocate the expense, other than its distributive share of a

payment described in paragraph (c)(1)(i)(B) of this section. Similarly, to the extent an expense described in paragraph

(c)(1)(i)(B) of this section exceeds the

controlled foreign corporation partner’s

distributive share of the payment from

which the expense arises, such excess

amount of the expense may reduce subpart F income (other than such payment)

to which it is properly allocable or apportionable under section 954(b)(5).

(D) Example. The following example

illustrates the application of paragraph

(c)(1)(i)(B) and (C) of this section:

Example. CFC, a controlled foreign corporation

in Country A, is a 70 percent partner in partnership

P, located in Country B. Country A’s tax laws do not

classify P as a fiscally transparent entity. The rate of

tax in country B is 15 percent of the tax rate in country A. P loans $100 to CFC at a market rate of interest. In year 1, CFC pays P $10 of interest on the

loan. The interest payment would have caused the

recharacterization rules of §1.954–9T to apply if the

payment were made between the entities described

in §1.954–9T(a)(2). CFC’s distributive share of P’s

interest income is $7, which is foreign personal

holding company income to CFC under section

954(c). Under paragraph (c)(1)(i)(B) of this section,

$7 of the $10 interest expense may not be allocated

against any of CFC’s subpart F income. However,

to the extent the remaining $3 of interest expense is

properly allocable to subpart F income of CFC other

than its distributive share of P’s interest income, this

expense may offset such other subpart F income.

(E) Effective date. Paragraph (c)(1)(i)(B), (C) and (D) of this section shall

apply to all amounts paid or accrued on or

after March 23, 1998, except for amounts

paid or accrued pursuant to arrangements

entered into before March 23, 1998, and

not substantially modified (including, for

example, by expansion of the arrangement (whether by exercise of an option or

otherwise) such as by an increase in the

amount of or term of any borrowing, leasing or licensing constituting the arrangement, changes in direct or indirect control

of any entity that is a party to the arrangement, or any similar measure which materially increases the tax benefit of the

arrangement) on or after March 23, 1998.

For rules applicable to amounts paid or

accrued pursuant to arrangements entered

into before March 23, 1998, see §1.954–1.

(c)(1)(ii) through (f) [Reserved]. For

further guidance, see §1.954–1(c)(1)(ii)

through (f).

Par. 7. Section 1.954–2T is added to

read as follows:

§1.954–2T Foreign personal holding

company income (temporary).

(a)(1) through (4) [Reserved]. For further guidance, see §1.954–2(a) through (4).

(5) Special rules applicable to distributive share of partnership income—(i) Application of related person exceptions

where payment reduces foreign tax of

payor. If a partnership receives an item of

income that reduced the foreign income

tax of the payor (determined under the

principles of §1.954–9T(a)(3)), to determine the extent to which a controlled foreign corporation’s distributive share of

such item of income is foreign personal

holding company income, the exceptions

contained in section 954(c)(3) shall apply

only if—

(A)(1) Any such exception would have

applied to exclude the income from foreign personal holding company income if

the controlled foreign corporation had

earned the income directly (determined

by testing, with reference to such controlled foreign corporation, whether an

entity is a related person, within the

meaning of section 954(d)(3), or is organized under the laws of, or uses property

in, the foreign country in which the controlled foreign corporation is created or

organized); and

(2) The distributive share of such income is not in respect of a payment made

by the controlled foreign corporation to

the partnership; and

(B)(1) The partnership is created or organized, and uses a substantial part of its

assets in a trade or business in the country

under the laws of which the controlled

foreign corporation is created or organized (determined under the principles of

§1.954–2(b)(4));

(2) The partnership is regarded as fiscally transparent, as defined in §1.954–

9T(a)(7), by all countries under the laws

of which the controlled foreign corporation is created or organized or has substantial assets; or

(3) The income is taxed in the year

when earned at an effective rate of tax

April 20, 1998

(determined under the principles of

§1.954–1(d)(2)) that is not less than 90

percent of, and not more than five percentage points less than, the effective rate of

tax that would have applied to such income under the laws of the country in

which the controlled foreign corporation is

created or organized if such income were

earned directly by the controlled foreign

corporation partner from local sources.

(ii) Certain other exceptions applicable

to foreign personal holding company income. [Reserved].

(iii) Effective date. Paragraph (a)(5)(i)

of this section shall apply to all amounts

paid or accrued on or after March 23,

1998, except for amounts paid or accrued

pursuant to arrangements entered into before March 23, 1998, and not substantially modified (including, for example,

by expansion of the arrangement (whether

by exercise of an option or otherwise)

such as by an increase in the amount of or

term of any borrowing, leasing or licensing constituting the arrangement, changes

in direct or indirect control of any entity

that is a party to the arrangement, or any

similar measure which materially increases the tax benefit of the arrangement) on or after March 23, 1998.

(6) Special rules applicable to exceptions from foreign personal holding company income treatment in circumstances

involving hybrid branches—(i) In general. In the case of a payment between a

controlled foreign corporation (or its hybrid branch, as defined in §1.954–9T(a)(6)) and the hybrid branch of a related

controlled foreign corporation, the exceptions contained in section 954(c)(3) shall

apply only if the payment would have

qualified for the exception if the payor

were a separate controlled foreign corporation created or organized in the jurisdiction where foreign tax is reduced and the

payee were a separate controlled foreign

corporation created or organized under

the laws of the jurisdiction in which the

payment is subject to tax (other than a

withholding tax).

(ii) Exception where no tax reduction

or tax disparity. Paragraph (a)(6)(i) of

this section shall not apply unless the payment would have met the foreign tax reduction test of §1.954–9T(a)(3) and the

tax disparity test of §1.954–9T(a)(5)(iv) if

those provisions had been applicable to

the payment.

April 20, 1998

(iii) Effective date. The rules of this

section shall apply to all amounts paid or

accrued on or after January 16, 1998, except for amounts paid or accrued pursuant

to arrangements entered into before January 16, 1998, and not substantially modified (including, for example, by expansion of the arrangement (whether by

exercise of an option or otherwise) such

as by an increase in the amount of or term

of any borrowing, leasing or licensing

constituting the arrangement, changes in

direct or indirect control of any entity that

is a party to the arrangement, or any similar measure which materially increases

the tax benefit of the arrangement) on or

after January 16, 1998.

(b) through (h) [Reserved]. For further

guidance, see §1.954–2(b) through (h).

Par. 8. Section 1.954–9T is added to

read as follows:

§1.954–9T Hybrid branches

(temporary).

(a) Subpart F income arising from certain payments involving hybrid

branches—(1) Payment causing foreign

tax reduction gives rise to additional subpart F income. The non-subpart F income of the controlled foreign corporation will be recharacterized as subpart F

income, to the extent provided in paragraph (a)(5) of this section, if—

(i) A hybrid branch payment, as defined

in paragraph (a)(6) of this section, is

made between the entities described in

paragraph (a)(2) of this section;

(ii) The hybrid branch payment reduces

foreign tax, as determined under paragraph (a)(3) of this section; and

(iii) The hybrid branch payment is

treated as falling within a category of foreign personal holding company income

under the rules of paragraph (a)(4) of this

section.

(2) Hybrid branch payment between

certain entities—(i) In general. Paragraph (a)(1) of this section shall apply to

hybrid branch payments between—

(A) A controlled foreign corporation

and its hybrid branch;

(B) Hybrid branches of a controlled

foreign corporation;

foreign corporation is a partner (either directly or through one or more branches or

other partnerships) and a hybrid branch of

the partnership; or

(D) Hybrid branches of a partnership in

which a controlled foreign corporation is

a partner (either directly or through one or

more branches or other partnerships).

(ii) Hybrid branch payment involving

partnership—(A) Fiscally transparent

partnership. To the extent of the controlled foreign corporation’s proportionate share of a hybrid branch payment, the

rules of paragraphs (a)(3), (4) and (5) of

this section shall be applied by treating

the hybrid branch payment between the

partnership and the hybrid branch as if it

were made directly between the controlled foreign corporation and the hybrid

branch, or as if the hybrid branches of the

partnership were hybrid branches of the

controlled foreign corporation, if the hybrid branch payment is made between—

(1) A fiscally transparent partnership in

which a controlled foreign corporation is

a partner (either directly or through one or

more branches or other fiscally transparent partnerships) and the partnership’s hybrid branch; or

(2) Hybrid branches of a fiscally transparent partnership in which a controlled

foreign corporation is a partner (either directly or through one or more branches or

other fiscally transparent partnerships).

(B) Non-fiscally transparent partnership. To the extent of the controlled foreign corporation’s proportionate share of

a hybrid branch payment, the rules of

paragraphs (a)(3) and (4) and (a)(5)(iv) of

this section shall be applied to the non-fiscally transparent partnership as if it were

the controlled foreign corporation, if the

hybrid branch payment is made between—

(1) A non-fiscally transparent partnership in which a controlled foreign corporation is a partner (either directly or

through one or more branches or other

partnerships) and the partnership’s hybrid

branch; or

(2) Hybrid branches of a non-fiscally

transparent partnership in which a controlled foreign corporation is a partner (either directly or through one or more

branches or other partnerships).

illustrate the application of this paragraph

(a)(2)(ii).

Example 1. CFC, a controlled foreign corporation in Country A, is a 90 percent partner in partnership P, which is treated as fiscally transparent under

the laws of Country A. P has a hybrid branch, BR,

1998–16 I.R.B.

in Country B. P makes an interest payment of $100

to BR. Under Country A law, CFC’s 90 percent

share of the payment reduces CFC’s Country A income tax. Under paragraph (a)(2)(ii)(A) of this section, the recharacterization rules of this section are

applied by treating the payment as if made by CFC

to BR. Ninety dollars of CFC’s non-subpart F income, to the extent available, and subject to the

earnings and profits and tax rate limitations of

§1.954–9T(a)(5), is recharacterized as subpart F income.

Example 2. CFC, a controlled foreign corporation in Country A, is a 90 percent partner in partnership P, which is treated as fiscally transparent under

the laws of Country A. P has two branches in Country B, BR1 and BR2. BR1 is treated as fiscally

transparent under the laws of Country A. BR2 is a

hybrid branch. BR1 makes an interest payment of

$100 to BR2. Under paragraph (a)(2)(ii)(A) of this

section, the payment by BR1, the fiscally transparent branch, is treated as a payment by P, and the

deemed payment by P, a fiscally transparent partnership, is treated as made by CFC. Under Country A

law, CFC’s 90 percent share of BR1’s payment reduces CFC’s Country A income tax. Ninety dollars

of CFC’s non-subpart F income, to the extent available, and subject to the earnings and profits and tax

rate limitations of §1.954–9T(a)(5), is recharacterized as subpart F income.

(3) Application when payment reduces

foreign tax. For purposes of paragraph

(a)(1) of this section, a hybrid branch payment reduces foreign tax when the foreign

tax imposed on the income of the payor or

any owner of the payor is less than the foreign tax that would have been imposed on

such income had the hybrid branch payment not been made, or the hybrid branch

payment creates or increases a loss or

deficit or other tax attribute which may be

carried back or forward to reduce the foreign income tax of the payor or any owner

in another year (determined by taking into

account any refund of such tax made to

the payor, payee or any other person).

(4) Hybrid branch payment that is included within a category of foreign personal holding company income—(i) In

general. For purposes of paragraph (a)(1)

of this section, whether the hybrid branch

payment is treated as income included

within a category of foreign personal

holding company income is determined

by treating a hybrid branch that is either

the payor or recipient of the hybrid branch

payment as a separate wholly-owned subsidiary corporation of the controlled foreign corporation that is incorporated in

the jurisdiction under the laws of which

such hybrid branch is created, organized

for foreign law purposes, or has substantial assets. Thus, the hybrid branch pay-

1998–16 I.R.B.

ment will be treated as included within a

category of foreign personal holding company income if, taking into account any

specific exceptions for that category, the

payment would be included within a category of foreign personal holding company

income if the branch or branches were

treated as separately incorporated for U.S.

tax purposes.

(ii) Extent to which controlled foreign

corporation and hybrid branches treated

as separate entities. For purposes other

than the determination under paragraph

(a)(4)(i) of this section, a controlled foreign corporation and its hybrid branch, a

partnership and its hybrid branch, or hybrid branches shall not be treated as separate entities. Thus, for example, if a controlled foreign corporation, including all

of its hybrid branches, has an overall

deficit in earnings and profits to which

section 952(c) applies, the limitation of

such section on the amount includible in

the subpart F income of such corporation

will apply. Similarly, for purposes of applying the de minimis and full inclusion

rules of section 954(b)(3), a controlled

foreign corporation and its hybrid branch,

or hybrid branches shall not be treated as

separate corporations. Further, a hybrid

branch payment that would reduce foreign personal holding company income

under section 954(b)(5) if made between

two separate entities will not create an expense if made between a controlled foreign corporation and its hybrid branch, a

partnership and its hybrid branch, or hybrid branches.

(5) Recharacterization of income attributable to current earnings and profits

as subpart F income—(i) General rule.

Non-subpart F income of a controlled foreign corporation in an amount equal to the

excess of earnings and profits of the controlled foreign corporation for the taxable

year over subpart F income, as defined in

section 952(a), will be recharacterized as

subpart F income under paragraph (a)(1)

of this section only to the extent provided

under paragraphs (a)(5)(ii) through (vi) of

this section.

(ii) Subpart F income. For purposes of

determining the excess of current earnings and profits over subpart F income

under paragraph (a)(1) of this section, the

amount of subpart F income is determined

before the application of the rules of this

section but after the application of the

rules of sections 952(c) and 954(b). Further, such amount is determined by treating the controlled foreign corporation and

all of its hybrid branches as a single corporation.

(iii) Recharacterization limited to gross

amount of hybrid branch payment—(A)

In general. The amount recharacterized

as subpart F income under paragraph

(a)(1) of this section is limited to the

amount of the hybrid branch payment.

(B) Exception for duplicative payments. [Reserved].

(iv) Tax disparity rule—(A) In general.

Paragraph (a)(1) of this section will apply

only if the hybrid branch payment falls

within the tax disparity rule. The hybrid

branch payment falls within the tax disparity rule if it is taxed in the year when

earned at an effective rate of tax that is

less than 90 percent of, and at least 5 percentage points less than, the hypothetical

effective rate of tax imposed on the hybrid branch payment, as determined under

paragraph (a)(5)(iv)(B) of this section.

(B) Hypothetical effective rate of tax—

(1) In general. The hypothetical effective

rate of tax imposed on the hybrid branch

payment is—

(i) For the taxable year of the payor in

which the hybrid branch payment is

made, the amount of income taxes that

would have been paid or accrued by the

payor if the hybrid branch payment had

not been made, less the amount of income

taxes paid or accrued by the payor; divided by

(ii) The amount of the hybrid branch

payment.

(2) Hypothetical effective rate of tax

when hybrid branch payment causes or

increases loss or deficit. If the hybrid

branch payment causes or increases a loss

or deficit of the payor for foreign tax purposes, and such loss or deficit can be carried forward or back, the hypothetical effective rate of tax imposed on the hybrid

branch payment is the effective rate of tax

that would be imposed on the taxable income of the payor for the year in which

the foreign law payment is made if the

payor’s taxable income were equal to the

amount of the hybrid branch payment.

paragraph (a)(5)(iv) is illustrated by the

following examples.

Example 1. In 1998, CFC organized in Country

A had net income of $60 from manufacturing for

April 20, 1998

Country A tax purposes. It also had a branch (BR) in

Country B. BR is a hybrid entity under paragraph

(a)(1) of this section. CFC made a payment of $40

to BR, which was a hybrid branch payment under

paragraph (a)(6) of this section, and was treated by

CFC as a deductible payment for Country A tax purposes. CFC paid $30 of Country A taxes in 1998. It

would have paid $50 of Country A taxes without the

deductible payment. Country A did not impose any

withholding tax on the $40 payment to BR. Country

B also did not impose a tax on the $40 received by

BR. Therefore, the effective rate of tax on that payment is 0%. Furthermore, the hypothetical effective

rate of tax on the $40 hybrid branch payment is 50%

($50-$30/$40). The effective rate of tax (0%) is less

than 90% of, and more than 5 percentage points less

than, this hypothetical rate of tax of 50%. As a result, the $40 hybrid branch payment falls within the

tax disparity rule of this paragraph (a)(5)(iv).

Example 2. Assume the same facts as in Example

1, except that CFC has a loss of $100 for the year for

Country A tax purposes. Under Country A law, CFC

can carry the loss forward for use in subsequent

years. CFC paid no Country A taxes in 1998. The

rate of tax in Country A is graduated from 20% to

50%. If the $40 hybrid branch payment were the

only item of taxable income of CFC, Country A

would have imposed tax at an effective rate of 30%.

The effective rate of tax (0%) is less than 90 percent

of, and more than 5 percentage points less than, the

hypothetical effective rate of tax (30%) imposed on

the hybrid branch payment. As a result, the $40 hybrid branch payment falls within the tax disparity

rule of this paragraph (a)(5)(iv).

Example 3. Assume the same facts as in Example

1, except that Country B imposes tax on the $40 hybrid payment to BR at an effective rate of 50%. The

effective rate of 50% is equal to the hypothetical effective rate of tax. As a result, the hybrid branch

payment does not fall within the tax disparity rule of

this paragraph (a)(5)(iv) and, thus, the recharacterization rules of paragraph (a)(1) of this section do not

apply. See also the special high tax exception of

paragraph (a)(5)(v) of this section.

(v) Special high tax exception—(A) In

general. Paragraph (a)(1) of this section

shall not apply if the non-subpart F income

recharacterized as subpart F income under

this section was subject to foreign income

taxes imposed by a foreign country or

countries at an effective rate that is greater

than 90 percent of the maximum rate of tax

specified in section 11 for the taxable year

of the controlled foreign corporation.

(B) Effective rate of tax. The effective

rate of tax imposed on the net amount of

the hybrid branch payment is determined

under the principles of §1.954–1(d)(2)

and (3). See paragraph (c) of this section

for the application of section 960 to

amounts recharacterized as subpart F income under this section.

(vi) No carryback or carryforward of

amounts in excess of current year earn-

April 20, 1998

ings and profits limitation. To the extent

that some or all of the amount required to

be recharacterized under this section is

not recharacterized as subpart F income

because the hybrid branch payment exceeds the amount that can be recharacterized, as determined under paragraph

(a)(5)(i) of this section, this excess shall

not be carried back or forward to another

year.

(6) Definitions. For purposes of this

section—

Entity means any person that is treated

by the United States or any jurisdiction as

other than an individual.

Hybrid branch means an entity that—

(i) Has a single owner (including ownership through branches) that is either a

controlled foreign corporation or a partnership in which a controlled foreign corporation is a partner (either directly or indirectly through one or more branches or

partnerships);

(ii) Is treated as fiscally transparent by

the United States; and

(iii) Is treated as non-fiscally transparent by the country in which the payor entity, any owner of a fiscally-transparent

payor entity, the controlled foreign corporation, or any intermediary partnership is

created, organized or has substantial assets.

Hybrid branch payment means the

gross amount of any payment (including

any accrual) which, under the tax laws of

any foreign jurisdiction to which the

payor is subject, is regarded as a payment

between two separate entities but which,

under U.S. income tax principles, is not

income to the recipient because it is between two parts of a single entity.

(7) Fiscally transparent and non-fiscally transparent. For purposes of this

section an entity shall be treated as fiscally transparent with respect to an interest holder of the entity, if such interest

holder is required, under the laws of any

jurisdiction to which it is subject, to take

into account separately, on a current basis,

such interest holder’s share of all items

which, if separately taken into account by

such interest holder, would result in an income tax liability for the interest holder in

such jurisdiction different from that

which would result if the interest holder

did not take the share of such items into

account separately. A non-fiscally transparent entity is an entity that is not fis-

cally transparent under this paragraph

(a)(7).

(b) Election to change classification—

(1) In general. If a hybrid branch subject

to the provisions of paragraph (a) of this

section is an entity that has made an election under §301.7701–3(c)(1) of this chapter to be disregarded as an entity separate

from its owner, such entity may elect to

change its classification to that of an association taxable as a corporation, under the

procedures described in §301.7701–3(c) of

this chapter, without regard to the limitation of §301.7701–3T(c)(1)(iv) of this

chapter, but only if such election is made

on or before the last day of the first taxable

year beginning on or after January 1, 1998.

An election made pursuant to this paragraph (b)(1) is effective as of the first day

of such taxable year. The 75 day limitation

on retroactivity in §301.7701–3(c)(1)(iii)

of this chapter does not apply.

(2) Limitation. An entity can elect to

change its classification under the provisions of this paragraph only one time.

deemed paid under section 960, the

amount of non-subpart F income recharacterized as subpart F income under this

section shall be treated as attributable to

income in separate categories, as defined

in §1.904–5(a)(1), in proportion to the

ratio of non-subpart F income in each

such category to the total amount of nonsubpart F income of the controlled foreign

corporation for the taxable year.

(d) Effective dates—(1) Hybrid

branches of controlled foreign corporations. With respect to hybrid branch payments described in paragraph (a)(2)(i)(A)

and (B) of this section, the rules of this

section shall apply to all amounts paid or

accrued on or after January 16, 1998, except for amounts paid or accrued pursuant

to arrangements entered into before January 16, 1998, and not substantially modified (including, for example, by expansion of the arrangement (whether by

exercise of an option or otherwise) such

as by an increase in the amount of or term

of any borrowing, leasing or licensing

constituting the arrangement, changes in

direct or indirect control of any entity that

is a party to the arrangement, or any similar measure which materially increases

the tax benefit of the arrangement) on or

after January 16, 1998.

1998–16 I.R.B.

(2) Hybrid branches of partnerships in

which controlled foreign corporations are

partners. With respect to hybrid branch

payments described in paragraph (a)(2)(i)(C) and (D) of this section, the rules of

this section shall apply to all amounts

paid or accrued on or after March 23,

1998, except for amounts paid or accrued

pursuant to arrangements entered into before March 23, 1998, and not substantially modified (including, for example,

by expansion of the arrangement (whether

by exercise of an option or otherwise)

such as by an increase in the amount of or

term of any borrowing, leasing or licensing constituting the arrangement, changes

in direct or indirect control of any entity

that is a party to the arrangement, or any

similar measure which materially increases the tax benefit of the arrangement) on or after March 23, 1998.

PART 301—PROCEDURE AND

ADMINISTRATION

Par. 9. The authority citation for 26

CFR part 301 continue to read in part as

follows:

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

Par. 10. In §301.7701–3, paragraph

(f)(1) is amended by adding a sentence at

the end to read as follows:

§301.7701–3. Classification of certain

business entities.

(f)(1) * * * Paragraphs (a), (c)(1)(iv)

and (f) of this section do not apply on or

after March 23, 1998. For rules applicable on or after March 23, 1998, see

§301.7701–3T(a), (c)(1)(iv) and (f).

Par. 11. Section 301.7701–3T is added

to read as follows:

§301.7701–3T Classification of certain

business entities (temporary).

(a) In general. A business entity that is

not classified as corporation under

§301.7701–2(b)(1), (3), (4), (5), (6), (7),

or (8) (an eligible entity) can elect its classification for federal tax purposes as provided in this section. An eligible entity

with at least two members can elect to be

classified as either an association (and

thus a corporation under §301.7701–

2(b)(2)) or a partnership, and an eligible

entity with a single owner can elect to be

classified as an association or to be disre-

1998–16 I.R.B.

garded as an entity separate from its

owner. Paragraph (b) of this section provides a default classification for an eligible entity that does not make an election.

Thus, elections are necessary only when

an eligible entity chooses to be classified

initially as other than the default classification or when an eligible entity chooses

to change its classification. An entity

whose classification is determined under

the default classification retains that classification (regardless of any changes in

the members’ liability that occurs at any

time during the time that the entity’s classification is relevant as defined in paragraph (d) of this section) until the entity

makes an election to change that classification under paragraph (c)(1) of this section. Paragraph (c) of this section provides rules for making express elections.

Paragraph (d) provides special rules for

foreign eligible entities. Paragraph (e) of

this section provides special rules for

classifying entities resulting from partnership terminations and divisions under section 708(b). Paragraph (f) of this section

sets forth the effective date of this section

and a special rule relating to prior periods.

An entity that has elected to be disregarded as an entity separate from its

owner may nevertheless be treated as a

corporation for the limited purposes of

§1.954–9T(a)(4)(i) of this chapter.

(b) through (c)(1)(iii) [Reserved]. For

further guidance, see §301.7701–3(b)

through (c)(1)(iii).

(c)(1)(iv) Limitation. If an eligible entity makes an election under paragraph

(c)(1)(i) of this section to change its classification (other than an election made by

an existing entity to change its classification as of the effective date of this section), the entity cannot change its classification by election again during the sixty

months succeeding the effective date of

the election. However, the Commissioner

may permit the entity to change its classification by election within the sixty

months if more than fifty percent of the

ownership interests in the entity as of the

effective date of the subsequent election

are owned by person that did not own any

interests in the entity on the filing date or

on the effective date of the entity’s prior

election. See §1.954–9T(b) of this chapter, for circumstances under which certain

eligible entities may make an election to

change their classification within the

sixty-month period.

(c)(1)(v) through (e) [Reserved]. For

further guidance, see §301.7701–3(c)(1)(v) through (e).

(f) Effective date. Section 301.7701–

3T(a) and (c)(1)(iv) applies on or after

March 23, 1998. For rules prior to March

23, 1998, see §301.7701–3(a) and

(c)(1)(iv).

Michael P. Dolan,

Deputy Commissioner of

Internal Revenue.

Donald C. Lubick,

Assistant Secretary of

the Treasury.

(Filed by the Office of the Federal Register on

March 23, 1998, 12:58 p.m., and published in the

issue of the Federal Register for March 26, 1998, 63

F.R. 14613)

Section 985.—Functional

Currency

26 CFR 1.985–1: Functional currency.

T.D. 8765

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

Change From Dollar

Approximate Separate

Transactions Method of

Accounting (DASTM) to the

Profit and Loss Method of

Accounting/Change From the

Profit and Loss Method to

DASTM

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Final Regulations.

SUMMARY: This document contains

final Income Tax Regulations relating to

adjustments required when a qualified

business unit (QBU) that used the profit

and loss method of accounting (P&L) in a

post-1986 year begins to use the dollar

approximate separate transaction method

of accounting (DASTM) and adjustments

required when a QBU that used DASTM

begins using P&L. The regulations provide rules for taxpayers to construct an

April 20, 1998

opening dollar balance sheet for the QBU

and require income adjustments in certain

cases.

DATES: These regulations are effective

April 6, 1998.

FOR FURTHER INFORMATION CONTACT: Howard Wiener at (202) 6223870 (not a toll-free number) of the office

of Chief Counsel (International) within

the Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue,

NW, Washington, DC 20224.

SUPPLEMENTARY INFORMATION:

Background

On January 5, 1993 and July 25, 1994,

the IRS published proposed amendments

to §1.985–7 in the Federal Register at 58

F.R. 300 (INTL–0045–92) and §1.985–1

in the Federal Register at 59 F.R. 37733

(INTL–0066–92), respectively. No public hearing was held and few comments

were received. After consideration of

these comments, the regulations are

adopted as a Treasury Decision with modifications as described below.

Explanation of Provisions

I. Proposed Rules for Changing From

P&L to DASTM (§1.985–7)

1. The Proposed Regulations

The proposed regulations under

§1.985–7 set forth transition rules for

QBUs changing from the profit and loss

method of accounting (P&L) to DASTM

in tax years after 1987. Section 1.985–6

provides the translation rules for QBUs

using DASTM in 1987. Generally, when

a QBU changes its functional currency,

two basic issues arise: (1) How should the

QBU translate its balance sheet accounts

into the new functional currency in a way

that preserves any unrecognized currency

gain or loss which accrued in the old

functional currency; and (2) whether income adjustments need to be made to recognize any currency gain or loss which

accrued in the old functional currency that

cannot be preserved.

Section 1.985–5 provides rules that

generally apply when a QBU changes its

functional currency. Under §1.985–5 balance sheet accounts are translated using

the spot rate on the last day prior to the

April 20, 1998

taxable year of change. In addition,

§1.985–5 generally requires recognition

of unrealized exchange gain or loss on instruments and other accounts that were

maintained in the functional currency to

which the QBU is changing.

The proposed regulations issued under

§1.985–7 were issued in response to taxpayer comments that §1.985–5 resulted in

significant distortions when a QBU either

elected or was required to use DASTM.

Applying the spot rate on the last day

prior to the year in which the QBU begins

to use DASTM (the “taxable year of

change”) to translate fixed assets typically

results in a significant loss of basis in dollar terms and does not take into account

certain income and expense distortions

that occur in the period immediately preceding the taxable year of change.

In response to taxpayers’ comments,

the proposed regulations provide for use

of the translation rules provided under

§1.985–3. These rules generally translate

fixed assets at the historical exchange rate

and other assets and liabilities at the current exchange rate. To correct for distortions that would result from applying historic exchange rates for fixed assets while

applying the current year’s spot rate for

other balance sheet accounts, the proposed regulations provide for income adjustments in the case of a controlled foreign corporation (CFC) and a branch that

reflect amounts that would have been included in income under DASTM.

In the case of a CFC, the proposed regulations provide for a shareholder level income adjustment to the extent subpart F

income realized during the period after

1986 until the taxable year of change differs from subpart F income that would

have been realized if the CFC had used

DASTM throughout this period. In the

case of a branch, the regulations provide

that any difference between the branch’s

local currency equity translated into dollars at the spot exchange rate on the last

day prior to the taxable year of change and

the taxpayer’s dollar basis pool on that day

is included in income over three taxable

years beginning with the taxable year of

change. For purposes of translating the

balance sheet of noncontrolled section 902

corporations, the proposed regulations

apply historic exchange rates for fixed assets. In such case, no shareholder level income adjustments are required.

Recognizing the administrative burden

of making income adjustments for all post1986 tax years in the case of a CFC, the

preamble to the proposed regulations requested comments regarding three alternative transition rules as follows: (1) requiring shareholder level adjustments for the

three-year base period used to determine

the hyperinflationary status of the local

currency, (in which case the general rule of

§1.985–5 would be applied in preparing

the balance sheet for the first year of the

base period); (2) treating a portion of retained earnings as subpart F income based

on an average historical rate of subpart F

income to total earnings and profits, and

(3) using the spot rate on the last day prior

to the taxable year of change to translate

balance sheet items with special rules to

allow historical exchange rates to translate

fixed assets to the extent of unrealized exchange loss on paid-in capital.

2. Reasons for change

The IRS is concerned that the approach

of the proposed regulations could create a

significant administrative burden for

shareholders of CFCs. The administrative

burden results from the requirement that

shareholders recompute subpart F income

for all of the CFC’s post 1986 taxable

years. If the functional currency of a CFC

becomes hyperinflationary in a year that

is significantly distant from the CFC’s

first post-1986 taxable year, records supporting the required recomputation may

be unavailable.

Further, the required recomputation

under the proposed regulations is generally inconsistent with the policy of sections 986 and 987 that the income of

branches with a functional currency different than that of the taxpayer and the

earnings and profits of foreign corporations be computed under a profit and loss

method, except in the case of hyperinflation. See S. Rep. No. 99–313, 99th

Cong., 2d Sess., 454 (1986). The recomputation under the proposed regulation

would put the CFC on DASTM for nonhyperinflationary years. Accordingly, the

rules in the proposed regulations have

been modified as described below.

II. Final Regulations for Changing

From P&L to DASTM (§1.985–7)

1. General Rule

The approach employed in the final

1998–16 I.R.B.

regulations has the general effect of treating a QBU as if it had applied §1.985–5

on the last day of the last taxable year

prior to the base period for determining

whether a currency is hyperinflationary

(transition date) and had applied DASTM

during the taxable years beginning after

the transition date until the taxable year of

change (look-back period). This approach addresses the problems of applying §1.985–5 in the taxable year of

change for purposes of translating fixed

assets by applying the historical exchange

rate to the extent fixed assets were acquired during the look-back period. Assets acquired prior to the look-back period

are translated by applying the spot rate on

the transition date. This approach also

corrects distortions in income and expense (generally interest income and expense) that occur during the look-back period.

The final regulations respond to taxpayers’ comments and provide an appropriate rule for translating the adjusted

basis of fixed assets into dollars by applying an exchange rate in effect prior to the

hyperinflationary period. Moreover, this

method more accurately reflects Congressional intent for QBUs to apply the profit

and loss method except in the case of hyperinflation. In addition, this approach

decreases the administrative burden of

changing to DASTM.

2. Foreign Corporations

In the case of a foreign corporation

which is either required or elects to use

DASTM, four basic corporate level adjustments are required as follows. (1) The

balance sheet is translated by treating the

corporation as if it had changed its functional currency to the dollar for the first

post-transition date taxable year and had

applied the rules of §1.985–5(c) on the

transition date. Assets acquired and liabilities incurred in the functional currency

during the look-back period are translated

by applying the rules of §1.985–3. (2)

The unrealized gain or loss on dollar denominated section 988 transactions as determined on the transition date are treated

as if recognized on that date (and actual

gain or loss recognized on dollar denominated section 988 transactions during the

look-back period is reversed). (3) The

dollar value of the pre-1987 E&P of the

corporation as stated on the transition date

in the functional currency is translated

1998–16 I.R.B.

into U.S. dollars at the spot rate in effect

on the transition date. (4) The dollar value

of the post-1986 E&P is computed by

translating the post-1986 E&P as stated

on the transition date in the functional

currency at the spot rate on such date and

adding to it the E&P for the years during

the look-back period as computed under

DASTM.

In the case of a CFC, there are three

shareholder level adjustments as follows:

(1) The U.S. shareholders must take into

income exchange gain or loss on the

deemed recognition of the section 988

transactions as determined at the corporate level to the extent such gain or loss is

subpart F income. (2) The U.S. shareholders must recognize foreign currency gain

or loss as computed under section 986(c)

as if all previously taxed earnings and

profits were distributed on the transition

date (however, any actual 986(c) gain or

loss recognized during the look-back period is reversed). (3) The subpart F income of the CFC is recomputed during

the look-back period under DASTM and

compared to the subpart F income as

computed under the P&L method. The

difference (positive or negative) is taken

into account in the taxable year of change

and spread over four years. Similar rules

apply to United States persons who have

made an election under section 1295 to

treat a passive foreign investment company as a qualified electing fund. In the

case of other foreign corporations, no

shareholder level income adjustments are

necessary.

4. Branches

In accord with the general approach articulated above, the regulations treat a

branch changing to DASTM as applying

the principles of §1.985–5 on the transition date. Thus, the balance sheet is translated by treating the branch as if it had

changed its functional currency to the dollar for the first post-transition date taxable

year and had applied the rules of §1.985–

5(c) on the transition date. Unrealized

gain or loss on dollar denominated section

988 transactions as stated on the transition

date are treated as if recognized on that

date (and any actual gain or loss realized

with respect to section 988 transactions

during the look-back period is reversed).

Further, the regulations require that the

taxpayer recognize gain or loss attributable to the branch’s equity pool (as stated

on the transition date) under the principles

of section 987, computed as if the branch

terminated on the transition date. Such

gain or loss is reduced by any section 987

gain and increased by any section 987

loss that was recognized by the taxpayer

with respect to remittances during the

look-back period. Finally, branch income

shall be determined under §1.985–3 for

each look-back year and compared to the

amount that was taken into account for

each year. The sum of the difference

(positive or negative) is taken into account in the taxable year of change and

spread over four years.

III. Rules for Changing from DASTM to

P&L (§1.985–1)

Under the proposed regulation, a QBU

that has been required or had elected to

use DASTM must change functional currency to the currency of its economic environment in a year in which the currency

is no longer hyperinflationary pursuant to

the three-year test under §1.985–1(b).

These rules provide that when a taxpayer

changes from DASTM to the P&L

method of accounting, §1.985–5 shall

apply for purposes of translating a QBU’s

balance sheet and for making certain income adjustments. Because these rules

generally do not create distortions and are

administrable, the final regulations adopt

these regulations as proposed.

IV. Other Changes

Various conforming changes have been

made to §§1.985–1 and 1.985–5 to account for the addition of §1.985–7. In addition, the definition of hyperinflation has

been liberalized to provide that for purposes of determining whether a currency

is hyperinflationary for income tax purposes, United States generally accepted

accounting principles will be accepted

provided that the determination is based

on criteria that is substantially similar to

the general rules provided in the regulations, the method of determination is applied consistently from year to year, and

the same method is applied to all related

persons.

Special Analysis

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

April 20, 1998

Therefore, a regulatory assessment is not

required. It also has been determined that

section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not

apply to these regulations, and because

the notice of proposed rulemaking preceding the regulations was issued prior to

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

apply. Accordingly, a regulatory flexibility analysis is not required. Pursuant to

section 7805(f) of the Code, the notice of

proposed rulemaking preceding these regulations was submitted to the Small Business Administration for comment on its

impact on small business.

Drafting Information

The principal author of these regulations is Howard A. Wiener of the Office

of the Associate Chief Counsel (International). Other personnel from the IRS and

Treasury Department also participated in

their development.

Adoption of Amendments to the

Regulations

Accordingly, 26 CFR part 1 is amended

as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for

part 1 continues to read in part as follows:

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

Par. 2. Section 1.985–1 is amended by:

1. Revising paragraph (b)(2)(ii)(C).

2. Adding a sentence to the end of

paragraph (b)(2)(ii)(D).

3. Adding paragraph (b)(2)(ii)(E).

The additions and revision reads as follows:

§1.985–1. Functional currency.

(b) * * *

(2) * * *

(ii) * * *

QBU is required to change its functional

currency to the dollar under paragraph

(b)(2)(ii)(A) of this section, or chooses or

is required to change its functional currency to the dollar for any open taxable

year (and all subsequent taxable years)

under §1.985–3(a)(2)(ii), the change is

April 20, 1998

considered to be made with the consent of

the Commissioner for purposes of

§1.985–4. A QBU changing functional

currency must make adjustments described in §1.985–7 if the year of change

(as defined in §1.481–1(a)(1)) begins

after 1987, or the adjustments described

in §1.985–6 if the year of change begins

in 1987. No adjustments under section

481 are required solely because of a

change in functional currency described

in this paragraph (b)(2)(ii)(C).

(D) * * * In making the determination

whether a currency is hyperinflationary,

the determination for purposes of United

States generally accepted accounting

principles may be used for income tax

purposes provided the determination is

based on criteria that is substantially similar to the rules previously set forth in this

paragraph (b)(2)(ii)(D), the method of determination is applied consistently from

year to year, and the same method is applied to all related persons as defined in

§1.985–3(e)(2)(vi).

(E) Change in functional currency

when currency ceases to be hyperinflationary–(1) In general. A QBU that has

been required to use the dollar as its functional currency under paragraph (b)(2) of

this section, or has elected to use the dollar as its functional currency under paragraph (b)(2)(ii)(B)(2) of this section or

§1.985–2, must change its functional currency as of the first day of the first taxable

year that follows three consecutive taxable years in which the currency of its

economic environment, determined under

paragraph (c)(2) of this section, is not a

hyperinflationary currency. The functional currency of the QBU for such year

shall be determined in accordance with

paragraph (c) of this section. For purposes of §1.985–4, the change is considered to be made with the consent of the

Commissioner. See §1.985–5 for adjustments that are required upon a change in

functional currency.

(2) Effective Date. This paragraph

(b)(2)(ii)(E) of this section applies to taxable years beginning after April 6, 1998.

Par. 3. Section 1.985–5(a) is amended

by adding the following sentence to the

end of the paragraph:

§1.985–5 Adjustments required upon

change in functional currency.

(a) * * *

However, a QBU that changes to the

dollar pursuant to §1.985–1(b)(2) after

1987 shall apply §1.985–7.

Par. 4. Section 1.985–7 is added as

follows:

1.985–7 Adjustments required in

connection with a change to DASTM.

(a) In general. If a QBU begins to use

the dollar approximate separate transactions method of accounting set forth in

§1.985–3 (DASTM) in a taxable year beginning after April 6, 1998, adjustments

shall be made as provided by this section.

For the rules with respect to foreign corporations, see paragraph (b) of this section. For the rules with respect to adjustments to the income of United States

shareholders of controlled foreign corporations, see paragraph (c) of this section.

For the rules with respect to adjustments

relating to QBU branches, see paragraph

(d) of this section. For the effective date

of this section, see paragraph (e). For

purposes of applying this section, the

look-back period shall be the period beginning with the first taxable year after

the transition date and ending on the last

day prior to the taxable year of change.

The term transition date means the later of

the last day of the last taxable year ending

before the base period as defined in

§1.985–1(b)(2)(ii)(D) or the last day of

the taxable year in which the QBU last

applied DASTM. The taxable year of

change shall mean the taxable year of

change as defined in §1.481–1(a)(1). The

application of this paragraph may be illustrated by the following examples:

Example 1. A calendar year QBU that has not

previously used DASTM operates in a country in

which the functional currency of the country is hyperinflationary as defined under §1.985–1(b)(2)(ii)(D) for the QBU’s 1999 tax year. The lookback period is the period from January 1, 1996

through December 31, 1998, the transition date is

December 31, 1995, and the taxable year of change

is the taxable year beginning January 1, 1999.

Example 2. A QBU that has not previously used

DASTM with a taxable year ending June 30, operates in a country in which the functional currency of

the country is hyperinflationary for the QBU’s tax

year beginning July 1, 1999 as defined under

§1.985–1(b)(2)(ii)(D)(where the base period is the

thirty-six calendar months immediately preceding

the first day of the current calendar year 1999). The

look-back period is the period from July 1, 1995

through June 30, 1999, the transition date is June 30,

1995, and the taxable year of change is the taxable

year beginning July 1, 1999.

1998–16 I.R.B.

(b) Adjustments to foreign corporations—(1) In general. In the case of a

foreign corporation, the corporation shall

make the adjustments set forth in paragraphs (b)(2) through (4) of this section.

The adjustments shall be made on the first

day of the taxable year of change.

(2) Treatment of certain section 988

transactions—(i) Exchange gain or loss

from section 988 transactions unrealized

as of the transition date. A foreign corporation shall adjust earnings and profits by

the amount of any unrealized exchange

gain or loss that was attributable to a section 988 transaction (as defined in sections 988(c)(1)(A), (B), and (C)) that was

denominated in terms of (or determined

by reference to) the dollar and was held

by the corporation on the transition date.

Such gain or loss shall be computed as if

recognized on the transition date and shall

be reduced by any gain and increased by

any loss recognized by the corporation

with respect to such transaction during the

look-back period. The amount of such

gain or loss shall be determined without

regard to the limitations of section 988(b)

(i.e., whether any gain or loss would be

realized on the transaction as a whole).

The character and source of such gain or

loss shall be determined under section

988. Proper adjustments shall be made to

account for gain or loss taken into account

by reason of this paragraph (b)(2). See

§1.985–5(f) Example 1, footnote 1.

(ii) Treatment of a section 988 transaction entered into and terminated during

the look-back period. A foreign corporation shall reduce earnings and profits by

the amount of any gain, and increase

earnings and profits by the amount of any

loss, that was recognized with respect to

any dollar denominated section 988 transactions entered into and terminated during

the look-back period.

(3) Opening balance sheet. The opening balance sheet of a foreign corporation

for the taxable year of change shall be determined as if the corporation had

changed its functional currency to the dollar by applying § 1.985–5(c) on the transition date and had translated its assets and

liabilities under §1.985–3 during the

look-back period.

(4) Earnings and profits adjustments—(i) Pre-1987 accumulated profits.

The foreign income taxes and accumulated profits or deficits in accumulated

1998–16 I.R.B.

profits of a foreign corporation that are attributable to taxable years beginning before January 1, 1987, as stated on the transition date, and that were maintained for

purposes of section 902 in the old functional currency, shall be translated into

dollars at the spot rate in effect on the

transition date. The applicable accumulated profits shall be reduced on a last-in,

first-out basis by the aggregate dollar

amount (translated from functional currency in accordance with the rules of section 989(b)) attributable to earnings and

profits that were distributed (or treated as

distributed) during the look-back period

to the extent such amounts distributed exceed the earnings and profits calculated

under (b)(4)(ii) or (b)(4)(iii), as applicable. See §1.902–1(b)(2)(ii). Once translated into dollars, these pre-1987 taxes

and accumulated profits or deficits in accumulated profits shall (absent a change

in functional currency) remain in dollars

for all federal income tax purposes.

(ii) Post-1986 undistributed earnings

of a CFC. In the case of a controlled foreign corporation (within the meaning of

section 957 or section 953(c)(1)(B))(CFC) or a foreign corporation subject to

the rules of §1.904–6(a)(2), the corporation’s post-1986 undistributed earnings in

each separate category as defined in

§1.904–5(a)(1) as of the first day of the

taxable year of change (and prior to adjustment under paragraph (c)(1) of this

section) shall equal the sum of—

(A) The corporation’s post-1986

undistributed earnings and profits (or

deficit in earnings and profits) in each

separate category as defined in §1.904–

5(a)(1) as stated on the transition date

translated into dollars at the spot rate in

effect on the transition date; and

(B) The sum of the earnings and profits (or deficit in earnings and profits) in

each separate category determined under

§1.985–3 for each post-transition date

taxable year prior to the taxable year of

change.

Such amount shall be reduced by the aggregate dollar amount (translated from

functional currency in accordance with

the rules of section 989(b)) attributable to

earnings and profits that were distributed

(or treated as distributed) during the lookback period out of post-1986 earnings and

profits in such separate category. For purposes of applying this paragraph

(b)(4)(ii)(B), the opening balance sheet

for calculating earnings and profits under

§1.985–3 for the first post-transition year

shall be translated into dollars pursuant to

§1.985–5(c).

(iii) Post-1986 undistributed earnings

of other foreign corporations. In the case

of a foreign corporation that is not a CFC

or subject to the rules of §1.904–6(a)(2),

the corporation’s post-1986 undistributed

earnings shall equal the sum of—

(A) The corporation’s post-1986

undistributed earnings (or deficit) on the

transition date translated into dollars at

the spot rate in effect on the transition

date; and

(B) The sum of the earnings and profits (or deficit in earnings and profits) determined under §1.985–3 for each posttransition date taxable year (or such later

year determined under section 902(c)(3)(A)) prior to the taxable year of

change.

Such amount shall be reduced by the aggregate dollar amount (translated from

functional currency in accordance with

the rules of section 989(b)) that was distributed (or treated as distributed) during

the look-back period out of post-1986

earnings and profits. For purposes of applying this paragraph (b)(4)(iii)(B), the

opening balance sheet for calculating

earnings and profits under §1.985-3 for

the first post-transition year shall be translated into dollars pursuant to §1.985–5(c).

the meaning of section 951(b) or section

953(c)(1)(B)) of a CFC that changes to

DASTM shall make the adjustments set

forth in paragraphs (c)(2) through (5) of

this section on the first day of the taxable

year of change. Adjustments under this

section shall be taken into account by the

shareholder (or such shareholder’s successor in interest) ratably over four taxable years beginning with the taxable year

of change. Similar rules shall apply in determining adjustments to income of

United States persons who have made an

election under section 1295 to treat a passive foreign investment company as a

qualified electing fund.

(2) Treatment under subpart F of income recognized on section 988 transactions. The character of amounts taken

into account under paragraph (b)(2) of

April 20, 1998

this section for purposes of sections 951

through 964, shall be determined on the

transition date and to the extent characterized as subpart F income shall be taken

into account in accordance with the rules

of paragraph (c)(1) of this section. Such

amounts shall retain their character for all

federal income tax purposes (including

sections 902, 959, 960, 961, 1248, and

6038).

(3) Recognition of foreign currency

gain or loss on previously taxed earnings

and profits on the transition date. Gain or

loss is recognized under section 986(c) as

if all previously taxed earnings and profits

as determined on the transition date, if

any, were distributed on such date. Such

gain or loss shall be reduced by any foreign currency gain and increased by any

foreign currency loss that was recognized

under section 986(c) with respect to distributions of previously taxed earnings

and profits during the look-back period.

Such amount shall be characterized in accordance with section 986(c) and taken

into account in accordance with the rules

of paragraph (c)(1) of this section.

(4) Subpart F income adjustment.

Subpart F income in a separate category

shall be determined under §1.985–3 for

each look-back year. For this purpose, the

opening DASTM balance sheet shall be

determined under §1.985–5. The sum of

the difference (positive or negative) between the amount computed pursuant to

§1.985–3 and amount that was included

in income for each year shall be taken into

account in the taxable year of change pursuant to paragraph (c)(1) of this section.

Such amounts shall retain their character

for all federal income tax purposes (including sections 902, 959, 960, 961,

1248, and 6038). For rules applicable if

an adjustment under this section results in

a loss for the taxable year in a separate

category, see section 904(f) and the regulations thereunder. The amount of previously taxed earnings and profits as determined under section 959(c)(2) shall be

adjusted (positively or negatively) by the

amount taken into account under this

paragraph (c)(4) as of the first day of the

taxable year of change.

(5) Foreign tax credit. A United States

shareholder of a CFC shall compute an

amount of foreign taxes deemed paid

under section 960 with respect to any positive adjustments determined under para-

April 20, 1998

graph (c) of this section. The amount of

foreign tax deemed paid shall be computed with reference to the full amount of

the adjustment and to the post-1986

undistributed earnings determined under

paragraph (b)(4)(i) and (ii) of this section

and the post-1986 foreign income taxes of

the CFC on the first day of the taxable

year of change (i.e., without taking into

account earnings and taxes for the taxable

year of change.) For purposes of section

960, the associated taxes in each separate

category shall be allocated pro rata

among, and deemed paid in, the shareholder’s taxable years in which the income is taken into account. (No adjustment to foreign taxes deemed paid in

prior years is required solely by reason of

a negative adjustment to income under

paragraph (c)(1) of this section.)

(d) QBU branches—(1) In general. In

the case of a QBU branch, the taxpayer

shall make the adjustments set forth in

paragraphs (d)(2) through (d)(4) of this

section. Adjustments under this section

shall be taken into account by the taxpayer ratably over four taxable years beginning with the taxable year of change.

(2) Treatment of certain section 988

transactions—(i) Exchange gain or loss

from section 988 transactions unrealized

as of the transition date. A QBU branch

shall adjust income by the amount of any

unrealized exchange gain or loss that was

attributable to a section 988 transaction

(as defined in sections 988(c)(1)(A), (B),

and (C)) that was denominated in terms of

(or determined by reference to) the dollar

and was held by the QBU branch on the

transition date. Such gain or loss shall be

computed as if recognized on the transition date and shall be reduced by any gain

and increased by any loss recognized by

the QBU branch with respect to such

transaction during the look-back period.

The amount of such gain or loss shall be

determined without regard to the limitations of section 988(b) (i.e., whether any

gain or loss would be realized on the

transaction as a whole). The character

and source of such gain or loss shall be

determined under section 988. Proper adjustments shall be made to account for

gain or loss taken into account by reason

of this paragraph (d)(2). See §1.985–5(f)

Example 1, footnote 1.

(ii) Treatment of a section 988 transaction entered into and terminated during

the look-back period. A QBU branch

shall reduce income by the amount of any

gain, and increase income by the amount

of any loss, that was recognized with respect to any dollar denominated section

988 transactions entered into and terminated during the look-back period.

(3) Deemed termination income adjustment. The taxpayer shall realize gain

or loss attributable to the QBU branch’s

equity pool (as stated on the transition

date) under the principles of section 987,

computed as if the branch terminated on

the transition date. Such amount shall be

reduced by section 987 gain and increased

by section 987 loss that was recognized

by such taxpayer with respect to remittances during the look-back period.

(4) Branch income adjustment.

Branch income in a separate category

shall be determined under §1.985–3 for

each look-back year. For this purpose, the

opening DASTM balance sheet shall be

determined under §1.985–5. The sum of

the difference (positive or negative) between the amount computed pursuant to

§1.985–3 and amount taken into account

for each year shall be taken into account

in the taxable year of change pursuant to

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

amounts shall retain their character for all

federal income tax purposes.

(5) Opening balance sheet. The opening balance sheet of a QBU branch for the

taxable year of change shall be determined

as if the branch had changed its functional

currency to the dollar by applying

§ 1.985–5(c) on the transition date and had

translated its assets and liabilities under

§1.985–3 during the look-back period.

(e) Effective date. This section is effective for taxable years beginning after April

6, 1998. However, a taxpayer may choose

to apply this section to all open taxable

years beginning after December 31, 1986,

provided each person, and each QBU

branch of a person, that is related (within

the meaning of §1.985–2(d)(3)) to the taxpayer also applies this section rules.

Michael P. Dolan,

Deputy Commissioner of

Internal Revenue.

Approved February 11, 1998.

Donald C. Lubick,

Assistant Secretary of

the Treasury.

1998–16 I.R.B.

(Filed by the Office of the Federal Register on

March 4, 1998, 8:45 a.m., and published in the issue

of the Federal Register for March 5, 1998, 63 F.R.

10772)

Section 1.1502–3: Regulations

26 CFR 1.1502–3: Consolidated investment credit.

T.D. 8766

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

Consolidated Returns—

Limitations on the Use of

Certain Credits; Overall

Foreign Loss Accounts

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Final and temporary regulations.

SUMMARY: This document contains

temporary amendments to the consolidated return regulations. The temporary

amendments modify the date temporary

regulations apply as published in the Federal Register on January 12, 1998, relating to the use of tax credits of a consolidated group and its members. The

amendments provide guidance to consolidated groups that have a taxable year beginning on or after January 1, 1997, for

which the income tax return is due on or

before March 13, 1998. The text of the

temporary regulations also serves as the

text of REG–104062–97, page 20 of this

Bulletin.

DATES: Effective dates: These amendments are effective March 13, 1998.

Applicability dates: For dates of application, see the Effective Dates portion of

the preamble under SUPPLEMENTARY

INFORMATION.

FOR FURTHER INFORMATION CONTACT: Roy A. Hirschhorn, (202) 6227770.

SUPPLEMENTARY INFORMATION:

Background and Explanation of

Provisions

On January 12, 1998, the IRS and Treasury published in the Federal Register

1998–16 I.R.B.

final, temporary and proposed regulations

(the January 12, 1998, regulations) relating to limitations on the use of certain tax

credits and related attributes by corporations filing consolidated income tax returns. In general, the January 12, 1998,

regulations relate to the separate return

limitation year provisions (and certain

consolidated return changes in ownership) for general business credits, alternative minimum tax credits, foreign tax

credits and overall foreign loss accounts.

The January 12, 1998, regulations were

generally applicable to consolidated return years beginning on or after January

1, 1997. IRS and Treasury have determined that the appropriate effective date

of those regulations should be for consolidated return years for which the due date

(without extensions) of the income tax return is after March 13, 1998. In lieu of

applying this effective date, a consolidated group may choose to apply the effective date provisions as published in the

January 12, 1998, regulations. Taxpayers

making this choice must apply all of those

effective date provisions for all relevant

years. Thus, such taxpayers may not

choose to apply one provision of the January 12, 1998, regulations and not another.

Effective Dates

The temporary amendments are applicable to consolidated return years for

which the due date of the income tax return (without extensions) is after March

13, 1998. As explained in the Background portion of this preamble, taxpayers may instead choose to apply the effective date provisions of the January 12,

1998, regulations (i.e., generally taxable

years beginning on or after January 1,

1997).

Special Analyses

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

Therefore, a regulatory assessment is not

required. It is hereby certified that these

regulations do not have a significant economic impact on a substantial number of

small entities. This certification is based

on the fact that these regulations principally affect corporations filing consolidated federal income tax returns that have

carryover or carryback of credits from

separate return limitation years. Available

data indicates that many consolidated return filers are large companies (not small

businesses). In addition, the data indicates that an insubstantial number of consolidated return filers that are smaller

companies have credit carryovers or carrybacks, and thus even fewer of these filers

have credit carryovers or carrybacks that

are subject to the separate return limitation

year rules. Therefore, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. It has also been determined that

under section 553(d) of the Administrative

Procedure Act (5 U.S.C. chapter 5) these

regulations should be effective immediately because they involve the applicability of regulations that modify the limitations on the use of certain tax attributes for

taxable years beginning on or after January 1, 1997. Pursuant to section 7805(f)

of the Internal Revenue Code, the notice

of proposed rulemaking accompanying

these regulations is being sent to the Small

Business Administration for comment on

their impact on small businesses.

Drafting Information

The principal author of these regulations is Roy A. Hirschhorn of the Office

of Assistant Chief Counsel (Corporate).

Other personnel from the IRS and Treasury participated in their development.

Adoption of Amendments to the

Regulations

Accordingly, 26 CFR part 1 is amended

as follows:

PART 1—INCOME TAXES

Paragraph. The authority citation for

part 1 continues to read in part as follows:

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

Par. 2. Section 1.1502–3 is amended by

revising paragraphs (c)(3), (d)(2) and

(e)(3) to read as follows:

§1.1502–3 Consolidated investment

credit.

(3) Special effective date. This paragraph (c) applies to consolidated return

April 20, 1998

years for which the due date of the income tax return (without extensions) is on

or before March 13, 1998. See §1.1502–

3T(c) for the rule that limits the group’s

use of a section 38 credit carryover or carryback from a SRLY for a consolidated return year for which the due date of the income tax return (without extensions) is

after March 13, 1998. For taxable years

not subject to §1.1502–3T(c), prior law

applies. See §1.1502–3(c) in effect prior

to January 12, 1998 (§1.1502–3(c) as contained in the 26 CFR part 1 edition revised

April 1, 1997) for prior law. See also

§1.1502–3T(c)(4) for an optional effective

date rule (generally making the rules of

this paragraph (c) inapplicable to a consolidated return year beginning after December 31, 1996, if the due date of the income

tax return (without extensions) for such

year is on or before March 13, 1998).

(d) Examples. * * *

(2) Example (2) and Example (3) of

this paragraph (d) do not apply to consolidated return years for which the due date

of the income tax return (without extensions) is after March 13, 1998. For consolidated return years for which the due

date of the income tax return (without extensions) is after March 13, 1998, see

§1.1502–3T(d).

(e) * * *

(3) Special effective date. This paragraph (e) applies only to a consolidated

return change of ownership that occurred

during a consolidated return year for

which the due date of the income tax return (without extensions) is on or before

March 13, 1998. See §1.1502–3T(c)(4)

for an optional effective date rule (generally making the rules of this paragraph

(e) inapplicable if the consolidated return

change of ownership occurred on or after

January 1, 1997, and during a consolidated return year for which the due date

of the income tax return (without extensions) is on or before March 13, 1998).

Par. 3. Section 1.1502–3T is amended

by revising paragraphs (c)(3) and (d)(2)

and adding a new paragraph (c)(4) to read

as follows:

§1.1502–3T Consolidated investment

credit (temporary).

April 20, 1998

(3) Effective date. This paragraph (c)

applies to consolidated return years for

which the due date of the income tax return (without extensions) is after March

13, 1998. However, a group does not take

into account a consolidated taxable year

for which the due date of the income tax

return (without extensions) is on or before

March 13, 1998, in determining a member’s (or subgroup’s) contributions to the

consolidated section 38(c) limitation

under this paragraph (c). See also

§1.1502–3(c).

(4) Optional effective date of January

1, 1997. In lieu of paragraphs (c)(3) and

(d)(2) of this section and §§1.1502–

3(c)(3), (d)(2) and (e)(3) (relating to the

general business credit), 1.1502–4(f)(3)

and (g)(3), 1.1502–4T(f) and (g)(3) (relating to the foreign tax credit), 1.1502–9(a)

(the next to last sentence), 1.1502–9T(b)(1)(v) (relating to overall foreign losses),

and 1.1502–55T(h)(4)(iii)(C) (relating to

the alternative minimum tax credit), a

consolidated group may apply such paragraphs as they appear in 1998–10 I.R.B.

23 (see §601.601(d)(2) of this chapter). A

consolidated group making this choice

must apply all such paragraphs for all relevant years.

(d) * * *

(2) This paragraph (d) applies to consolidated return years for which the due

date of the income tax return (without extensions) is after March 13, 1998. See

also §1.1502–3(d) for years for which the

due date of the income tax return (without

extensions) is on or before March 13,

1998.

* * * * *

Par. 4. Section 1.1502–4 is amended by

revising paragraphs (f)(3) and (g)(3) to

read as follows:

§1.1502–4 Consolidated foreign tax

credit.

(f) * * *

(3) Special effective date ending SRLY

limitation. See §1.1502–4T(f) for the rule

that ends the SRLY limitation with respect to foreign tax credits for consolidated return years for which the due date

of the income tax return (without extensions) is after March 13, 1998. See also

§1.1502–3T(c)(4) for an optional effec-

tive date rule (generally making the rules

of this paragraph (f) inapplicable to a consolidated return year beginning after December 31, 1996, if the due date of the income tax return (without extensions) for

such year is on or before March 13, 1998.

(g) * * *

(3) Special effective date for CRCO

limitation. See §1.1502–4T(g)(3) for the

rule that ends the CRCO limitation with

respect to a consolidated return change of

ownership that occurs on or after the first

day of a taxable year for which the due

date of the income tax return (without extensions) is after March 13, 1998. See

also §1.1502–3T(c)(4) for an optional effective date rule (generally making the

rules of this paragraph (g) inapplicable if

the consolidated return change of ownership occurred on or after January 1, 1997,

and during a consolidated return year for

which the due date of the income tax return (without extensions) is on or before

March 13, 1998).

Par. 5. Section 1.1502–4T is amended

by revising paragraphs (f) and (g)(3) to

read as follows:

§1.1502–4T Consolidated foreign tax

credit (temporary).

(f) Limitation on unused foreign tax

carryover or carryback from separate return limitation years. Section 1.1502–

4(f) does not apply for consolidated return

years for which the due date of the income tax return (without extensions) is

after March 13, 1998. For consolidated

return years for which the due date of the

income tax return (without extensions) is

after March 13, 1998, a group shall include an unused foreign tax of a member

arising in a SRLY without regard to the

contribution of the member to consolidated tax liability for the consolidated return year. See also §1.1502–3T(c)(4) for

an optional effective date rule (generally

making the rules of this paragraph (f) applicable to a consolidated return year beginning after December 31, 1996, if the

due date of the income tax return (without

extensions) for such year is on or before

March 13, 1998).

1998–16 I.R.B.

(g)(3) Special effective date for CRCO

limitation. Section 1.1502–4(g) applies

only to a consolidated return change of

ownership that occurred during a consolidated return year for which the due date

of the income tax return (without extensions) is on or before March 13, 1998.

See also §1.1502–3T(c)(4) for an optional

effective date rule (generally making the

rules of this paragraph (g)(3) applicable if

the consolidated return change of ownership occurred on or after January 1, 1997,

and during a consolidated return year for

which the due date of the income tax return (without extensions) is on or before

March 13, 1998).

Par. 6. In §1.1502–9, paragraph (a) is

amended by removing the last sentence

and adding two sentences in its place to

read as follows:

§1.1502–9 Application of overall foreign

loss recapture rules to corporations filing

consolidated returns.

(a) * * * See §1.1502–9T(b)(1)(v) for

the rule that ends the separate return limitation year limitation for consolidated return years for which the due date of the

income tax return (without extensions) is

after March 13, 1998. See also §1.1502–

3T(c)(4) for an optional effective date

rule (generally making the rules of paragraphs (b)(1)(iii) and (iv) of this section

inapplicable for a consolidated return year

beginning after December 31, 1996, if the

due date of the income tax return (without

extensions) for such year is on or before

March 13, 1998).

Par. 7. Section 1.1502–9T is amended

by revising paragraph (b)(1)(v) to read as

follows:

§1.1502–9T Application of overall

foreign loss recapture rules to

corporations filing consolidated returns

(temporary).

1998–16 I.R.B.

(b)(1)(v) Special effective date for

SRLY limitation. Sections 1.1502–

9(b)(1)(iii) and (iv) apply only to consolidated return years for which the due date

of the income tax return (without extensions) is on or before March 13, 1998.

For consolidated return years for which

the due date of the income tax return

(without extensions) is after March 13,

1998, the rules of §1.1502–9(b)(1)(ii)

shall apply to overall foreign losses from

separate return years that are separate return limitation years. For purposes of applying §1.1502–9(b)(1)(ii) in such years,

the group treats a member with a balance

in an overall foreign loss account from a

separate return limitation year on the first

day of the first consolidated return year

for which the due date of the income tax

return (without extensions) is after March

13, 1998, as a corporation joining the

group on such first day. An overall foreign loss that is part of a net operating

loss or net capital loss carryover from a

separate return limitation year of a member that is absorbed in a consolidated return year for which the due date of the income tax return (without extensions) is

after March 13, 1998, shall be added to

the appropriate consolidated overall foreign loss account in the year that it is absorbed. For consolidated return years for

which the due date of the income tax return (without extensions) is after March

13, 1998, similar principles apply to overall foreign losses when there has been a

consolidated return change of ownership

(regardless of when the change of ownership occurred). See also §1.1502–3T(c)(4) for an optional effective date rule

(generally making this paragraph

(b)(1)(v) applicable to a consolidated return year beginning after December 31,

1996, if the due date of the income tax return (without extensions) for such year is

on or before March 13, 1998).

Par. 8. Section 1.1502–55T is amended

by revising paragraph (h)(4)(iii)(C) to

read as follows:

§1.1502–55T Computation of alternative

minimum tax of consolidated groups

(temporary).

(h)(4) * * *

(iii) * * *

(h)(4)(iii) applies to consolidated return

years for which the due date of the income tax return (without extensions) is

after March 13, 1998. However, a group

does not take into account a consolidated

taxable year for which the due date of the

income tax return (without extensions) is

on or before March 13, 1998, in determining a member’s (or subgroup’s) contributions to the consolidated section 53(c)

limitation under paragraph (h)(4)(iii) of

this section. See §1.1502–3T(c)(4) for an

optional effective date rule (generally

making this paragraph (h)(4)(iii) applicable to a consolidated return year beginning after December 31, 1996, if the due

date of the income tax return (without extensions) for such year is on or before

March 13, 1998).

Michael P. Dolan,

Deputy Commissioner of

Internal Revenue.

Approved March 9, 1998.

Donald C. Lubick,

Assistant Secretary of

the Treasury.

(Filed by the Office of the Federal Register on

March 13, 1998, at 8:45 a.m., and published in the

Federal Register for March 16, 1998, 63 F.R. 12641)

April 20, 1998

Part IV. Items of General Interest

Notice of Proposed Rulemaking

and Notice of Public Hearing

the hearing, Mike Slaughter (202) 6227190 (not toll-free numbers).

Consolidated Returns—

Limitations on the Use of

Certain Credits and Related

Tax Attributes

SUPPLEMENTARY INFORMATION:

REG–104062–97

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Notice of proposed rulemaking by cross-reference to temporary regulations and notice of public hearing.

SUMMARY: In T.D. 8766 on page 17 of

this Bulletin, the IRS is issuing temporary

regulations that relate to the use of certain tax credits and losses of a consolidated group and its members. The text of

those temporary regulations also serves as

the text of these proposed regulations.

This document also provides notice of a

public hearing on these proposed regulations.

DATES: Written comments and outlines

of topics to be discussed at the public

hearing scheduled for May 7, 1998, at 10

a.m., must be received by April 13, 1998.

ADDRESSES: Send submissions to:

CC:DOM:CORP:R [REG–104062–97],

room 5226, Internal Revenue Service,

POB 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be

hand delivered between the hours of 8 a.m.

and 5 p.m. to: CC:DOM:CORP:R

[REG–104005–98], 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 on the 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 has been scheduled for

May 7, 1998, at 10 a.m., in room 2615, Internal Revenue Building, 1111 Constitution Avenue NW, Washington DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, in general, Roy A. Hirschhorn (202)

622-7770; concerning submissions and

April 20, 1998

Background

T.D. 8766 amends the Income Tax Regulations (26 CFR part 1) relating to section

1502. The temporary regulations provide

rules that relate to the use of certain tax

credits and related tax attributes of a consolidated group and its members. The

text of those temporary regulations also

serves as the text of these proposed regulations. The preamble to the temporary

regulations explains the temporary regulations.

Special Analyses

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 do not have a significant economic impact on a substantial

number of small entities. This certification is based on the fact that these regulations principally affect corporations filing

consolidated federal income tax returns

that have carryover or carryback of credits from separate return limitation years.

Available data indicates that many consolidated return filers are large companies

(not small businesses). In addition, the

data indicates that an insubstantial number of consolidated return filers that are

smaller companies have credit carryovers

or carrybacks, and thus even fewer of

these filers have credit carryovers or carrybacks that are subject to the separate return limitation year rules. Therefore, a

Regulatory Flexibility Analysis under the

Regulatory Flexibility Act (5 U.S.C.

chapter 6) 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 made available

for public inspection and copying.

A public hearing has been scheduled

for May 7, 1998, at 10 a.m., in room

2615. 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 who wish to present oral comments at the hearing must submit written

comments and an outline of the topics

(signed original and eight (8) copies) to

be discussed by April 13, 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 Roy A. Hirschhorn of the Office

of Assistant Chief Counsel (Corporate).

Other personnel from the IRS and Treasury 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

26 CFR part 1 is amended by adding entries in numerical order to read in part as

follows:

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

Section 1.1502–3 also issued under 26

U.S.C. 1502.

Section 1.1502–4 also issued under 26

U.S.C. 1502.

Section 1.1502–9 also issued under 26

U.S.C. 1502. * * *

Section 1.1502–55 also issued under 26

U.S.C. 1502. * * *

Par. 2. Section 1.1502–3, as proposed

to be amended at 63 F.R. 1804, January

1998–16 I.R.B.

12, 1998, is amended by revising paragraphs (c)(3) and (d)(2) and adding paragraph (c)(4) to read as follows:

§1.1502–3 Consolidated investment

credit.

(3) and (4) [The text of proposed paragraphs (c)(3) and (4) of this section is the

same as the text of §1.1502–3T(c)(3) and

(4) published in T.D. 8766.]

(d) * * *

(2) [The text of proposed paragraph

(d)(2) of this section is the same as the

text of §1.1502–3T(d)(2) published in

T.D. 8766.]

Par. 3. Section 1.1502–4, as proposed to

be amended at 63 F.R. 1804, January 12,

1998, is amended by revising paragraphs

(f)(3) and (g)(3) to read as follows:

§1.1502–4 Consolidated foreign tax

credit.

(f) * * *

(3) [The text of proposed paragraph

(f)(3) of this section is the same as the text

of §1.1502–4T(f)(3) published in T.D.

8766.]

(g) * * *

(3) [The text of proposed paragraph

(g)(3) of this section is the same as the

text of §1.1502–4T and (g)(3) published

in T.D. 8766.]

Par. 4. Section 1.1502–9, as proposed

to be amended at 63 F.R. 1804, January

12, 1998, is amended by revising paragraph (b)(1)(v) to read as follows:

§1.1502–9 Application of overall foreign

losses recapture rules to corporations

filing consolidated returns.

(b) * * *

(1) * * *

(v) [The text of proposed paragraph

(b)(1)(v) of this section is the same as the

text of §1.1502–9T(b)(1)(v) published in

T.D. 8766.]

1998–16 I.R.B.

Par. 5. Section 1.1502–55, as proposed

to be added at 57 F.R. 62257, December

30, 1992, and amended at 63 F.R. 1804,

January 12, 1998, is further amended by

revising paragraph (h)(4)(iii)(C) to read

as follows as follows:

§1.1502–55 Computation of alternative

minimum tax of consolidated groups.

(h) * * *

(4) * * *

(iii) * * *

(h)(4)(iii)(C) of this section is the same as

the text of §1.1502–55T(h)(4)(iii)(C)

published in T.D. 8766.]

Michael P. Dolan,

Deputy Commissioner of

Internal Revenue.

(Filed by the Office of the Federal Register on

March 13, 1998, at 8:45 a.m., and published in the

Federal Register for March 16, 1998, 63 F.R. 12717)

Notice of Proposed Rulemaking

and Notice of Public Hearing

Guidance Under Subpart F

Relating to Partnerships and

Branches

REG–104537–97

public hearing on these proposed regulations.

DATES: Written comments must be received by June 24, 1998. Outlines of oral

comments to be discussed at the public

hearing scheduled for July 15, 1998, must

be received by June 24, 1998.

ADDRESSES: Send submissions to:

CC:DOM:CORP:R (REG–104537–97),

room 5226, Internal Revenue Service,

POB 7604, Ben Franklin Station, Washington DC 20044. Submissions may be

hand delivered between the hours of 8

a.m. and 5 p.m. to: CC:DOM:CORP:T:R

(REG–104537–97), 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 on 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 20224.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Valerie Mark, (202) 622-3840; concerning

submissions and the hearing, Mike

Slaughter (202) 622-7190 (not toll-free

numbers).

SUPPLEMENTARY INFORMATION:

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Notice of proposed rulemaking, notice of proposed rulemaking by

cross-reference to temporary regulations

and notice of public hearing.

SUMMARY: The IRS and Treasury Department are issuing temporary regulations, published in T.D. 8767, page 4 of

this Bulletin, relating to the treatment

under subpart F of certain branches of a

controlled foreign corporation (CFC) that

are treated as separate entities for foreign

tax purposes . The text of the temporary

regulations also serves as the text of these

proposed regulations. In addition, this

document contains proposed regulations

relating to the treatment of a CFC’s distributive share of partnership income.

This document also provides notice of a

Background

I. In General

In these proposed regulations, and in

temporary regulations published in T.D.

8767, the Treasury and IRS set forth a

framework for dealing with the issues

posed by the use of certain entities which

are regarded as fiscally transparent for the

purposes of U.S. tax law, with regard to

the application of subpart F of the Internal

Revenue Code.

Subpart F was enacted by Congress to

limit the deferral of U.S. taxation of certain income earned outside the United

States by foreign corporations controlled

by U.S. persons. Limited deferral was retained after the enactment of subpart F to

protect the competitiveness of controlled

foreign corporations (CFCs) doing business overseas. See S. Rep. No. 1881,

April 20, 1998

87th Cong., 2d Sess. 78–80 (1962). This

limited deferral furthers the objective of

allowing a CFC engaged in an active

business, and located in a foreign country

for appropriate economic reasons, to

compete in a similar tax environment with

non-U.S. owned corporations located in

the same country.

Conversely, one of the purposes of subpart F is to prevent CFCs from converting

active income that is not easily moveable

and is earned in a jurisdiction in which a

business is located for non-tax reasons

into passive, easily moveable income

shifted to a lower tax jurisdiction primarily for tax avoidance. Moreover, when

subpart F was first enacted it was realized

that related person transactions can be

easily manipulated to reduce both United

States and foreign taxes. Consequently,

in enacting subpart F, Congress provided

that transactions of CFCs that involve related persons generally give rise to subpart F income with certain enumerated

exceptions.

Hybrid branches, by definition, are not

regarded as fiscally transparent under foreign law. Thus, they are particularly well

suited for the type of tax avoidance described above. In light of the recent proliferation of hybrid branches, Treasury

and the IRS believe that it is appropriate

to consider the issues related to transactions involving hybrid branches, or other

hybrid entities, under subpart F.

The use of other organizations that are

fiscally transparent for U.S. tax purposes,

including partnerships, raise additional issues. These entities may or may not be

fiscally transparent under foreign law. In

the context of subpart F, issues similar to

those raised in connection with hybrid

branches are raised in connection with

partnerships. (Other fiscally-transparent

entities, such as grantor trusts, will be the

subject of guidance issued in conjunction

with the finalization of regulations under

section 672(f).)

The entity classification regulations of

§§301.7701–1 through 301.7701–3 (the

check-the-box regulations) make entity

classification generally elective, in part so

that taxpayers can choose a tax status consistent with their business objectives.

This administrative provision, however,

was not intended to change substantive

law. Particularly in the international area,

however, the ability to more easily

April 20, 1998

achieve fiscal transparency can lead to inappropriate results under certain substantive international provisions of the Code.

Thus, the Treasury and the IRS believe

that it is necessary to provide additional

guidance regarding the use of hybrid entities in the international context. See preamble to T.D. 8697, 61 Fed. Reg. 66585

(December 18, 1996).

II. Controlled Foreign Corporation’s

Distributive Share of Partnership

Income

In Brown Group, Inc. v. Commissioner,

77 F.3d 217 (8th Cir. 1996), vacating and

remanding 104 T.C. 105 (1995), a Cayman Islands partnership with a Cayman

Islands CFC partner earned commission

income from selling footwear purchased

in Brazil on behalf of the CFC’s U.S. parent. This commission income would have

been subpart F income, specifically foreign base company sales income under

section 954(d), to the CFC if it had earned

this commission income directly and

under the same circumstances in which

the partnership earned this income. The

Tax Court held that the CFC’s distributive

share of this commission income was subpart F income. The Eighth Circuit, vacating and remanding the Tax Court’s decision, held that the CFC’s distributive

share of this commission income was not

subpart F income.

In response to the Eighth Circuit’s

opinion, the IRS announced that it intended to issue regulations under subpart

F to confirm its position that whether a

CFC partner’s distributive share of partnership income is subpart F income generally is determined at the CFC partner

level. See Notice 96–39 (1996–2 C.B.

209).

These proposed regulations would address the treatment of a CFC partner’s distributive share of partnership income

under subpart F. These regulations apply

to all categories of subpart F income, not

only to foreign base company sales income, which was at issue in Brown

Group. These regulations would provide

specific rules that apply to determine a

CFC partner’s distributive share of foreign

personal holding company income, foreign base company sales income, foreign

base company services income, and earnings invested in United States property.

The approach taken by these proposed

regulations is based on the provisions of

subchapter K and subpart F and the policies underlying those provisions. The

legislative history of subchapter K indicates that a partnership distributive share

should be characterized by using the approach that best serves the Code or regulations section at issue. Subpart F limits

deferral of U.S. income tax on common

types of passive income received by

CFCs, as well as on certain other types of

easily moveable income. To allow a CFC

to avoid subpart F treatment for items of

income by the simple expedient of receiving them as distributive shares of partnership income, rather than directly, is contrary to the intent of subpart F.

Explanation of Provisions

Under these proposed regulations, income and deductions would be characterized at the partnership level. If any part of

the partnership’s gross income would be

subpart F income if received directly by

partners that are CFCs, it must be separately stated under section 702. Comments are requested as to whether this rule

should not apply for ownership levels

under certain thresholds. The regulations

under section 702 also would be clarified

to expressly provide that an item must be

separately stated when, if separately taken

into account by any partner, the separately

stated item would affect the income tax liability of that partner or any other person.

This clarification incorporates in the regulations the position of the IRS. See Rev.

Rul. 86–138 (1986–2 C.B. 84) (holding

that a subsidiary partnership in a multitiered arrangement must separately state

items which, if separately taken into account by any partner of any partnership in

the multi-tiered arrangement, would affect

the income tax liability of that partner).

The regulations under section 952

would also be clarified to expressly include within the definition of subpart F

income a CFC’s distributive share of any

item of gross income of a partnership to

the extent the income would have been

subpart F income if received by the CFC

partner directly. The proposed regulations would further provide that, generally, in determining whether a distributive

share of partnership income is subpart F

income, whether an entity is a related person and whether activity takes place in or

outside the CFC’s country of incorporation is determined with respect to the CFC

1998–16 I.R.B.

partner and not the partnership. Thus, on

the Brown Group facts, the income in

issue would retain its character as commission income from the sale of shoes

purchased in Brazil on behalf of a U.S.

parent for sale in the U.S. It would be determined at the CFC partner level that the

shoes were manufactured and sold for use

outside of the CFC’s country of incorporation (Cayman Islands), and that the U.S.

parent was a related person with respect

to the CFC. Thus, the income would be

foreign base company sales income.

The proposed and temporary regulations also address the question of whether

a CFC’s distributive share of partnership

income can qualify for the exceptions

from foreign personal holding company

income treatment. Some of these exceptions are based on whether the income is

earned in a transaction with a related person that is incorporated, or uses property,

in the CFC’s country of incorporation.

The proposed and temporary regulations

address the application of those exceptions. Other exceptions are based on the

activities performed by the CFC in connection with the property through which it

earns the income. The proposed regulations would provide that the exceptions

requiring activity will generally apply if

the exception would have applied to the

income had the partnership itself been a

CFC. This requirement is not met if the

partnership can qualify for the exception

only by taking into account the separate

activities of its partners (e.g., the partnership owns property and the CFC provides

the management services).

These proposed regulations would

amend the rules regarding the application

of the manufacturing exception of

§1.954–3(a)(4). The regulations would

clarify the Service’s current position that,

in general, a controlled foreign corporation can apply the exception only if it has

performed the manufacturing activities itself. Thus, manufacturing activities of a

contract manufacturer will not be taken

into account.

Nevertheless, the manufacturing activities of a partnership may be taken into account under the distributive share rules

when the partnership sells the property

that it manufactures. These proposed regulations would clarify how the manufacturing exception of §1.954–3(a)(4) applies in the context of the distributive

1998–16 I.R.B.

share rules. As previously noted, the general rules would provide that income that

could be foreign base company sales income at the CFC partner level is separately stated and that determinations as to

relatedness and the relevant country are

made at the partner level. Consistent with

the framework outlined above, these regulations would allow a CFC’s distributive

share of sales income to be excluded,

under the manufacturing exception of

§1.954–3(a)(4), when the partnership’s

activities with respect to the property it

sells (without regard to the CFC partner’s

activities) would be sufficient to constitute manufacturing.

Treasury and the IRS are considering

applying foreign base company sales income rules in the context of manufacturing branches of partnerships. Comments

are requested as to the appropriate scope

of such rules.

Under the general rule for determining

whether a CFC partner’s distributive

share includes subpart F income, a CFC

partner’s distributive share of partnership

income earned from performing services

for or on behalf of a person that is a related person with respect to the CFC partner will be foreign base company services

income. These proposed regulations also

would describe how the substantial assistance rule of §1.954–4(b)(1)(iv) applies

when the CFC earns services income

through a partnership. When the partnership is performing services for a person

unrelated to the CFC partner but the CFC

partner provides substantial assistance to

the partnership contributing to the performance of those services, the partner and

the partnership would be regarded as

separate entities and the substantial assistance provided from the CFC to the partnership would cause the CFC’s distributive share of the services income to be

treated as foreign base company services

income. Treasury and the IRS are considering applying similar principles to

branches. Comments are requested on

this issue.

Finally, consistent with Rev. Rul. 90–

112 (1990–2 C.B. 186), the regulations

would provide that, for purposes of section

956, a CFC partner’s investment in U.S.

property includes the U.S. property held by

a partnership to the extent of the CFC’s

ownership interest in the partnership.

Comments are requested on this issue.

III. Hybrid Branches

Temporary regulations, published in

T.D. 8767, amend the Income Tax Regulations (26 CFR part 1) relating to sections 952 and 954 by adding rules relating

to the treatment under subpart F of certain

branches of a CFC or a partnership in

which a CFC is a partner that are treated

as separate entities for foreign tax purposes. The text of those temporary regulations also serves as the text of the proposed regulations. The preamble to the

temporary regulations explains the reasons for the addition.

IV. Proposed Effective Date

These regulations are proposed to

apply for taxable years of a controlled foreign corporation beginning on or after the

date the final regulations are published in

the Federal Register. For prior periods,

the IRS will rely on principles and authorities under subpart F and subchapter K to

apply an aggregate approach, including

§1.701–2(e) and (f) of the regulations for

periods for which it is effective.

Special Analyses

It has been determined that this notice

of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It has

also been determined that section 553(b)

of the Administrative Procedures Act (5

U.S.C. chapter 5) does not apply to these

regulations, and, because the regulation

does not impose a collection of information on small entities, the Regulatory

Flexibility Act (5 U.S.C. chapter 6) does

not apply. Pursuant to section 7805(f) of

the Code, this 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 timely submitted

to the IRS. All comments will be available for public inspection and copying.

A public hearing has been scheduled

for July 15, 1998, at 10 a.m., in room

2615, Internal Revenue Building, 1111

April 20, 1998

Constitution Avenue NW, Washington

DC. Because of access restrictions, visitors will not be admitted beyond the

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 written

comments by June 24, 1998, and submit an

outline of topics to be discussed and time

to be devoted to each topic (signed original

and eight (8) copies) by June 24, 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 Valerie Mark of the Office of the

Associate Chief Counsel (International),

IRS. However, other personnel from the

IRS and Treasury Department participated in their development.

that partner did not take the item into account separately. Thus, if any partner is a

controlled foreign corporation, as defined

in section 957, items of income that

would be gross subpart F income if taken

into account by the controlled foreign corporation must be separately stated for all

partners. Under section 911(a), if any

partner is a bona fide resident of a foreign

country who may exclude from gross income the part of the partner’s distributive

share which qualifies as earned income as

defined in section 911(b), the earned income of the partnership for all partners

must be separately stated. Similarly, all

relevant items of income or deduction of

the partnership must be separately stated

for all partners in determining the applicability of section 183 (relating to activities

not engaged in for profit) and the recomputation of tax thereunder for any partner.

(1) * * *

(v) In determining whether the de minimis or full inclusion rules of section

954(b)(3) apply.

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

Par. 3. In §1.952–1, paragraphs (b)

through (f) are redesignated as paragraphs

paragraph (b) is added to read as follows:

PART 1—INCOME TAXES

§1.952–1 Subpart F income defined.

Proposed Amendments to the Regulations

Paragraph 1. The authority citation for

26 CFR part 1 continues to read in part as

follows:

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

Par. 2 Section §1.702–1 is amended as

follows:

1. Paragraph (a)(8)(ii) is revised.

2. A new paragraph (c)(1)(v) is added.

The addition and revision read as follows:

§1.702–1 Income and credits of partner.

(a) * * *

(8) * * *

(ii) Each partner must also take into account separately the partner’s distributive

share of any partnership item which, if

separately taken into account by any partner, would result in an income tax liability

for that partner, or for any other person,

different from that which would result if

April 20, 1998

(b) Treatment of distributive share of

partnership income—(1) In general. A

controlled foreign corporation’s distributive share of any item of income of a partnership is income that falls within a category of subpart F income described in

section 952(a) to the extent the item of income would have been income in such

category if received by the controlled foreign corporation directly. For specific

rules regarding the treatment of a distributive share of partnership income under

certain provisions of subpart F, see

§§1.954–1(g); 1.954–2(a)(5); 1.954–3(a)(6); 1.954–4(b)(2)(iii); and 1.954– 6(g).

(2) Example. The application of this

paragraph (b) may be illustrated by the

following example.

Example. CFC, a controlled foreign corporation,

is an 80-percent partner in PRS, a foreign partner-

ship. PRS earns $100 of interest income that is not

export financing interest, as defined in section

954(c)(2)(B), from a person unrelated to CFC. This

interest income would have been foreign personal

holding company income to CFC, under section

954(c), if it had received this income directly. Accordingly, CFC’s distributive share of this interest

income, $80, is foreign personal holding company

income.

Par. 4. Section 1.954–1 is amended as

follows:

1. Paragraphs (c)(1)(i)(A) through (D)

are redesignated as (c)(1)(i)(A)(1)

through (4), respectively.

2. A new paragraph heading for newly

designated paragraph (c)(1)(i)(A) is

added.

3. New paragraphs (c)(1)(i)(B)

through (E) are added.

4. Paragraph (g) is added.

The additions read as follows:

§1.954–1 Foreign base company income.

(1) * * *

(i) Deductions against gross foreign

base company income—(A) In general.

***

* * * * *

(B) through (E) [The text of the proposed paragraphs (c)(1)(i)(B) through (E)

is the same as the text of §1.954–

1T(c)(1)(i)(B) through (E) published in

T.D. 8767.]

(g) Distributive share of partnership income—(1) Application of related person

and country of organization tests. Unless

otherwise provided, to determine the extent to which a controlled foreign corporation’s distributive share of any item of

gross income of a partnership would have

been subpart F income if received by it directly, under §1.952–1(b), if a provision of

subpart F requires a determination of

whether an entity is a related person,

within the meaning of section 954(d)(3),

or whether an activity occurred within or

outside the country under the laws of

which the controlled foreign corporation is

created or organized, this determination

shall be made by reference to such controlled foreign corporation and not by reference to the partnership.

1998–16 I.R.B.

(2) Example. The application of paragraph (g)(1) of this section is illustrated

by the following example:

Example. (i) CFC1, a controlled foreign corporation organized in Country A, is an 80-percent partner

in Partnership, a partnership organized in Country B.

CFC2, a controlled foreign corporation organized in

Country B, owns the remaining 20 percent interest

in Partnership. CFC1 and CFC2 are owned by a

common U.S. parent, USP. CFC2 manufactures

Product A in Country B. Partnership earns sales income from purchasing Product A from CFC2 and

selling it to third parties located in Country B that

are not related persons with respect to CFC1 or

CFC2. For purposes of determining whether

CFC1’s distributive share of Partnership’s sales income is foreign base company sales income under

section 954(d), CFC1 is treated as if it purchased

Product A from CFC2 and sold it to third parties in

Country B. Under section 954(d)(3), CFC2 is a related person with respect to CFC1. Thus, with respect to CFC1, the sales income is deemed to be derived from the purchase of personal property from a

related person. Because the property purchased is

both manufactured and sold for use outside of Country A, CFC1’s country of organization, CFC1’s distributive share of the sales income is foreign base

company sales income.

(ii) For purposes of determining whether CFC2’s

distributive share of Partnership’s sales income is

foreign base company sales income, CFC2 is treated

as if it directly sold Product A to third parties within

Country B. Therefore, Product A is both manufactured and sold for use within CFC2’s country of organization. Thus, CFC2’s distributive share of Partnership’s sales income is not foreign base company

sales income.

Par. 5. In §1.954–2, paragraph (a)(5)

and (a)(6) are added to read as follows:

§1.954–2 Foreign personal holding

company income.

(a) * * *

(5) Special rules applicable to distributive share of partnership income—(i)

[The text of the proposed paragraph

(a)(5)(i) is the same as the text of §1.954–

2T(a)(5) published in T.D. 8767.]

(ii) Certain other exceptions applicable

to foreign personal holding company income. To determine the extent to which a

controlled foreign corporation’s distributive share of an item of income of a partnership is foreign personal holding company income, the exceptions contained in

sections 954(c)(2) and §1.954–2(b)(2)

and (6), (e)(1)(ii), (f)(1)(ii), (g)(2)(ii), and

(h)(3)(ii), shall apply only if any such exception would have applied to exclude the

income from foreign personal holding

company income if the controlled foreign

1998–16 I.R.B.

corporation had earned the income directly, determined by taking into account

only the activities of, and property owned

by, the partnership and not the separate

activities or property of the controlled foreign corporation or any other person.

(iii) [The text of the proposed paragraph (a)(5)(iii) is the same as the text of

§1.954–2T(a)(5)(iii) published in T.D.

8767.]

(6) Special rules applicable to exceptions from foreign personal holding company income treatment in circumstances

involving hybrid branches—(i) [The text

of the proposed paragraph (a)(6)(i) is the

same as the text of §1.954–2T(a)(6) published in T.D. 8767.]

Par. 6. Section 1.954–3 is amended as

follows:

1. The second sentence of paragraph

(a)(4)(i) is revised.

2. The first sentence of paragraph

(a)(4)(ii) is revised.

3. Paragraph (a)(6) is added.

The revisions and addition read as follows:

§1.954–3 Foreign base company sales

income.

(a) * * *

(4) * * *

(i) * * * A controlled foreign corporation (selling corporation) will be considered, for purposes of this paragraph

(a)(4), to have manufactured, produced,

or constructed personal property that it

sells if, as a result of the operations conducted by such selling corporation in connection with the property that it purchased

and sold, the property sold is in effect not

the property that it purchased. * * *

(ii) * * * If, prior to its sale of property

that it has purchased, a selling corporation

substantially transforms the property, the

selling corporation will be treated as having manufactured, produced, or constructed such property. * * *

(6) Special rule applicable to distributive share of partnership income—(i) In

general. To determine the extent to which

a controlled foreign corporation’s distributive share of any item of gross income of

a partnership would have been foreign

base company sales income if received by

it directly, under §1.952–1(b), the property sold will be considered to be manufactured, produced or constructed by the

controlled foreign corporation within the

meaning of paragraph (a)(4) of this section only if the manufacturing exception

of paragraph (a)(4) of this section would

have applied to exclude the income from

foreign base company sales income if the

controlled foreign corporation had earned

the income directly, determined by taking

into account only the activities of, and

property owned by, the partnership and

not the separate activities or property of

the controlled foreign corporation or any

other person.

* * * * *

Par. 7. In §1.954–4, paragraph

(b)(2)(iii) is added to read as follows:

§1.954–4 Foreign base company

services income.

(b) * * *

(2) * * *

(iii) Special rule applicable to distributive share of partnership income. A controlled foreign corporation’s distributive

share of a partnership’s services income

will be deemed to be derived from services performed for or on behalf of a related person, within the meaning of section 954(e)(1)(A), if the partnership is a

related person with respect to the controlled foreign corporation, under section

954(d)(3), and, in connection with the services performed by the partnership, the

controlled foreign corporation provided

assistance that would have constituted

substantial assistance contributing to the

performance of such services, under paragraph (b)(2)(ii) of this section, if furnished to the controlled foreign corporation by a related person.

* * * *

Par. 8. Section 1.954–9 is added to

read as follows:

§1.954–9 Hybrid branches.

[The text of this proposed section is the

same as the text of §1.954–9T published

in T.D. 8767.]

Par. 9. In §1.956–2, paragraph (a)(3)

is added to read as follows:

April 20, 1998

§1.956–2 Definition of United States

property.

Notice of Proposed Rulemaking

and Notice of Public Hearing

(a) * * *

(3) For purposes of section 956, if a

controlled foreign corporation is a partner

in a partnership that owns property that

would be United States property, within

the meaning of paragraph (a)(1) of this

section, if owned directly by the controlled foreign corporation, the controlled

foreign corporation will be treated as holding an interest in the property equal to its

ownership interest in the partnership and

such ownership interest will be treated as

an interest in United States property.

Allocation and Sourcing of

Income and Deductions Among

Taxpayers Engaged in a Global

Dealing Operation

PART 301—PROCEDURE AND

ADMINISTRATION

Par. 10. The authority citation for 26

CFR part 301 continues to read in part as

follows:

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

Par. 11. Section 301.7701–3 is

amended as follows:

1. Paragraph (a) is amended by adding

a sentence at the end of the paragraph.

2. Paragraph (c)(1)(iv) is amended by

adding a sentence at the end of the paragraph.

The additions read as follows:

§301.7701–3 Classification of certain

business entities.

(a) [The text of the proposed paragraph

(a) of this section is the same as the text of

§301.7701–3T(a) published in T.D.

8767.]

(1) * * *

(iv) [The text of the proposed paragraph (c)(1)(iv) of this section is the same

as the text of §301.7701–3T(c)(1)(iv)

published in T.D. 8767.]

Michael P. Dolan,

Deputy Commissioner of

Internal Revenue.

(Filed by the Office of the Federal Register on

March 23, 1998, 12:58 p.m., and published in the

issue of the Federal Register for March 26, 1998, 63

F.R. 14669)

April 20, 1998

REG–208299–90

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Notice of proposed rulemaking

and notice of public hearing.

SUMMARY: This document contains

proposed rules for the allocation among

controlled taxpayers and sourcing of income, deductions, gains and losses from a

global dealing operation; rules applying

these allocation and sourcing rules to foreign currency transactions and to foreign

corporations engaged in a U.S. trade or

business; and rules concerning the markto-market treatment resulting from hedging activities of a global dealing operation. These proposed rules affect foreign

and domestic persons that are participants

in such operations either directly or indirectly through subsidiaries or partnerships. These proposed rules are necessary

to enable participants in a global dealing

operation to determine their arm’s length

contribution to a global dealing operation.

This document also provides notice of a

public hearing on these proposed regulations.

DATES: Written comments must be received by June 4, 1998. Outlines of oral

comments to be discussed at the public

hearing scheduled for July 9, 1998, must

be received by June 18, 1998.

ADDRESSES: Send submissions to:

CC:DOM:CORP:R (REG–208299–90),

room 5226, Internal Revenue Service,

POB 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be

hand delivered between the hours of 8

a.m. and 5 p.m. to: CC:DOM:CORP:R

(REG–208299–90), Courier’s Desk, Internal Revenue Service, 1111 Constitution

Avenue, NW, Washington, D.C. Alternatively, taxpayers may submit comments

electronically via the Internet by selecting

the “Tax Regs” option on 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 in general, Ginny Chung of the Office of Associate Chief Counsel(International), (202)

622-3870; concerning the mark-to-market

treatment of global dealing operations,

Richard Hoge or JoLynn Ricks of the Office of Assistant Chief Counsel (Financial

Institutions & Products), (202) 622-3920;

concerning submissions and the hearing,

Michael Slaughter, (202) 622-7190 (not

toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained

in this notice of proposed rulemaking have

been submitted to the Office of Management and Budget for review in accordance

with the Paperwork Reduction Act of 1995

(44 U.S.C. 3507(d)). Comments on the

collections of information should be sent to

the Office of Management and Budget,

Attn: Desk Officer for the Department of

the Treasury, Office of Information and

Regulatory Affairs, Washington, DC

20503, with copies to the Internal Revenue

Service, Attn: IRS Reports Clearance officer, T:FS:FP, Washington, DC 20224.

Comments on the collections of information should be received by May 5, 1998.

Comments are specifically requested

concerning:

Whether the proposed collections of information are necessary for the proper

performance of the functions of the Internal Revenue Service, including whether

the information will have practical utility;

The accuracy of the estimated burden associated with the proposed collections 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 collections of information may

be minimized, including through the application of automated collection techniques or other forms of information technology; and

1998–16 I.R.B.

Estimates of capital or start-up costs and

costs of operation, maintenance, and purchase of services to provide information.

The collections of information in these

proposed regulations are in §§1.475(g)–

2(b), 1.482–8(b)(3), 1.482–8(c)(3),

1.482–8(d)(3), 1.482–8(e)(5), 1.482–

8(e)(6), and 1.863–3(h). The information

is required to determine an arm’s length

price. The collections of information are

mandatory. The likely recordkeepers are

business or other for-profit institutions.

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.

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.

Estimated total annual recordkeeping

burden: 20,000 hours. Estimated average

annual burden per recordkeeper is 40

hours. Estimated number of recordkeepers: 500.

Background

In 1990, the IRS issued Announcement

90–106, 1990–38 I.R.B. 29, requesting

comments on how the regulations under

sections 482, 864 and other sections of

the Internal Revenue Code could be improved to address the taxation issues

raised by global trading of financial instruments. Section 482 concerns the allocation of income, deductions, credits and

allowances among related parties. Section 864 provides rules for determining

the income of a foreign person that is “effectively connected” with the conduct of a

U.S. trade or business and therefore can

be taxed on a net income basis in the

United States. Provisions under sections

864(c)(2) and (3) provide rules for determining when U.S. source income is effectively connected income (ECI); section

864(c)(4) provides rules for determining

when foreign source income is ECI.

The rules for determining the source of

income generally are in sections 861, 862,

863 and 865, and the regulations promulgated under those sections. Section

1.863–7 provides a special rule for in-

1998–16 I.R.B.

come from notional principal contracts,

under which such income will be treated

as U.S.-source ECI if it arises from the

conduct of a U.S. trade or business under

principles similar to those that apply

under section 864(c)(2). An identical rule

applies for determining U.S. source ECI

under §1.988–4(c) from foreign exchange

gain or loss from certain transactions denominated in a foreign currency.

Because no regulations were issued in

response to the comments that were received after Announcement 90–106, there

remain a number of uncertainties regarding the manner in which the existing regulations described above apply to financial

institutions that deal in financial instruments through one or more entities or

trading locations. Many financial institutions have sought to resolve these problems by negotiating advance pricing

agreements (APAs) with the IRS. In

1994, the IRS published Notice 94–40,

1994–1 C.B. 351, which provided a

generic description of the IRS’s experience with global dealing operations conducted in a functionally fully integrated

manner. Notice 94–40 specified that it

was not intended to prescribe rules for future APAs or for taxpayers that did not

enter into APAs. Moreover, Notice 94–40

provided no guidance of any kind for financial institutions that do not conduct

their global dealing operations in a functionally fully integrated manner.

Explanation of Provisions

1. Introduction

This document contains proposed regulations relating to the determination of an

arm’s length allocation of income among

participants engaged in a global dealing

operation. For purposes of these regulations, the terms “global dealing operation” and “participant” are specifically

defined. The purpose of these regulations

is to provide guidance on applying the

arm’s length principle to transactions between participants in a global dealing operation. The general rules in the final regulations under section 482 that provide

the best method rule, comparability

analysis, and the arm’s length range are

generally adopted with some modifications to conform these principles to the

global dealing environment. In addition,

the proposed regulations contain new

specified methods with respect to global

dealing operations that replace the specified methods in §§1.482–3 through

1.482–6.

This document also contains proposed

regulations addressing the source of income earned in a global dealing operation

and the circumstances under which such

income is effectively connected to a foreign corporation’s U.S. trade or business.

The regulations proposed under section

863 generally source income earned in a

global dealing operation by reference to

the residence of the participant. For these

purposes, residence is defined under section 988(a)(3)(B) such that global dealing

income may be sourced between separate

qualified business units (QBUs) of a single taxpayer or among separate taxpayers

who are participants, as the case may be.

Exceptions to this general rule are discussed in further detail below.

Proposed amendments to the regulations under section 864 provide that the

principles of the proposed section 482

regulations may be applied to determine

the amount of income, gain or loss from a

foreign corporation’s global dealing operation that is effectively connected to a

U.S. trade or business of a participant.

Similar rules apply to foreign currency

transactions that are part of a global dealing operation.

The combination of these allocation,

sourcing, and effectively connected income rules is intended to enable taxpayers

to establish and recognize on an arm’s

length basis the contributions provided by

separate QBUs to a global dealing operation.

This document also contains proposed

regulations under section 475 to coordinate the accounting rules governing the

timing of income with the allocation,

sourcing, and effectively connected income rules proposed in this document and

discussed above.

2. Explanation of Specific Provisions

A. §1.482–1(a)(1)

Section 1.482–1(a)(1) has been

amended to include expressly transactions

undertaken in the course of a global dealing operation between controlled taxpayers within the scope of transactions covered by section 482. The purpose of this

amendment is to clarify that the principles

of section 482 apply to evaluate whether

global dealing transactions entered into

April 20, 1998

between controlled taxpayers are at arm’s

length.

B. §1.482–(a)—General Requirements

Section 1.482–8(a)(1) lists specified

methods that may be used to determine if

global dealing transactions entered into

between controlled taxpayers are at arm’s

length. The enumerated methods must be

applied in accordance with all of the provisions of §1.482–1, including the best

method rule of §1.482–1(c), the comparability analysis of §1.482–1(d), and the

arm’s length range rule of §1.482–1(e).

The section further requires that any modifications or supplemental considerations

applicable to a global dealing operation

set forth in §1.482–8(a)(3) be taken into

account when applying any of the transfer

pricing methods. Specific modifications

to the factors for determining comparability and the arm’s length range rule are

provided in §1.482–8(a)(3). These modifications and special considerations are

discussed in more detail under their respective headings below.

C. §1.482–8(a)(2)—Definitions

Applicable to a Global Dealing

Operation

Section 1.482–8(a)(2) defines “global

dealing operation,” “participant,” “regular

dealer in securities,” and other terms that

apply for purposes of these regulations.

These definitions supplement the general

definitions provided in §1.482–1(i).

The rules of §1.482–8 apply only to a

global dealing operation. A “global dealing operation” consists of the execution of

customer transactions (including marketing, sales, pricing and risk management

activities) in a particular financial product

or line of financial products, in multiple

tax jurisdictions and/or through multiple

participants. The taking of proprietary positions is not included within the definition

of a global dealing operation unless the

proprietary positions are entered into by a

regular dealer in securities in connection

with its activities as such a dealer. Thus, a

hedge fund that does not have customers

is not covered by these regulations. Positions held in inventory by a regular dealer

in securities, however, are covered by

these regulations even if the positions are

unhedged because the dealer is taking a

view as to future market changes.

Similarly, lending activities are not included within

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