These synopses are intended only as aids to the reader in

Agency decision

Ask Donna

What actually matters in this document.

Text

Bulletin No. 1997–7

February 18, 1997

HIGHLIGHTS

OF THIS ISSUE

These synopses are intended only as aids to the reader in

identifying the subject matter covered. They may not be relied

upon as authoritative interpretations.

INCOME TAX

Rev. Rul. 97–8, page 4.

LIFO; price indexes; department stores. The December 1996 Bureau of Labor Statistics price indexes are

accepted for use by department stores employing the

retail inventory and last-in, first-out inventory methods

for valuing inventories for tax years ended on, or with

reference to, December 31, 1996.

T.D. 8700, page 5.

Final regulations under section 475 of the Code provide

guidance to enable taxpayers to comply with the mark-tomarket requirements applicable to dealers in securities.

T.D. 8701, page 23.

Final regulations provide rules for making the deemed

sale and deemed dividend elections under section 1291

of the Code.

T.D. 8707, page 17.

Final regulations under section 731 of the Code provide

rules for partnership distributions of marketable securities and for determining when those distributions are

taxable to the distributee partner.

REG–209040–88, page 34.

Proposed regulations under section 1295 permit certain

shareholders to make a special election, in lieu of the

election currently provided for under that section, for

certain preferred shares of a passive foreign investment

company (PFIC). A public hearing will be held on May 8,

1997.

REG–209817–96, page 41.

Proposed regulations under section 7701 of the Code

relate to the treatment of certain multiple-party financing

Finding Lists begin on page 59.

Announcement of Disbarments and Suspensions begins on page 57.

transactions in which one party realizes income from

leases or similar agreements and another party claims

deductions related to that income. A public hearing will

be held on April 29, 1997.

REG–249819–96, page 50.

Proposed regulations under sections 354, 355, and 356

of the Code relate to exchanges of stock and securities

in certain reorganizations. A public hearing will be held

on March 25, 1997.

REG–252231–96, page 52.

Proposed regulations under section 368 of the Code

provide that the continuity of shareholder interest requirement for corporate reorganizations is satisfied if

the acquiring corporation furnishes consideration which

represents a proprietary interest in the affairs of the

acquiring corporation and such consideration represents

a substantial part of the value of the stock or properties

transferred. A public hearing will be held on May 7,

1997.

EXEMPT ORGANIZATIONS

Announcement 97–12, page 55.

A list is given of organizations now classified as private

foundations.

ADMINISTRATIVE

T.D. 8698, page 29.

Final regulations under section 6231 of the Code

provide guidance necessary for the designation or selection of a tax matters partner for partnerships, including

limited liability companies classified as partnerships.

Mission of the Service

The purpose of the Internal Revenue Service is to

collect the proper amount of tax revenue at the least

cost; serve the public by continually improving the

quality of our products and services; and perform in a

manner warranting the highest degree of public

confidence in our integrity, efficiency and fairness.

Statement of Principles

of Internal Revenue

Tax Administration

The Service also has the responsibility of applying

and administering the law in a reasonable,

practical manner. Issues should only be raised by

examining of ficers when they have merit, never

arbitrarily or for trading purposes. At the same

time, the examining officer should never hesitate

to raise a meritorious issue. It is also important

that care be exercised not to raise an issue or to

ask a court to adopt a position inconsistent with

an established Service position.

The function of the Internal Revenue Service is to

administer the Internal Revenue Code. Tax policy

for raising revenue is determined by Congress.

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

carry out that policy by correctly applying the laws

enacted by Congress; to determine the reasonable

meaning of various Code provisions in light of the

Congressional purpose in enacting them; and to

perform this work in a fair and impartial manner,

with neither a government nor a taxpayer point of view.

Administration should be both reasonable and

vigorous. It should be conducted with as little

delay as possible and with great cour tesy and

considerateness. It should never try to overreach,

and should be reasonable within the bounds of law

and sound administration. It should, however, be

vigorous in requiring compliance with law and it

should be relentless in its attack on unreal tax

devices and fraud.

At the heart of administration is interpretation of the

Code. It is the responsibility of each person in the

Service, charged with the duty of interpreting the

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

provision and not to adopt a strained construction in

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

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

Introduction

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

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

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

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

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

single-copy basis.

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

cautioned against reaching the same conclusions in

other cases unless the facts and circumstances are

substantially the same.

The Bulletin is divided into four parts as follows:

Part I.—1986 Code.

This part includes rulings and decisions based on

provisions of the Internal Revenue Code of 1986.

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

substantive rulings necessary to promote a uniform

application of the tax laws, including all rulings that

supersede, revoke, modify, or amend any of those

previously published in the Bulletin. All published rulings

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

are not published; however, statements of internal

practices and procedures that affect the rights and

duties of taxpayers are published.

Part II.—Treaties and Tax Legislation.

This part is divided into two subparts as follows:

Subpart A, Tax Conventions, and Subpart B, Legislation

and Related Committee Reports.

Part III.—Administrative, Procedural, and Miscellaneous.

To the extent practicable, pertinent cross references to

these subjects are contained in the other Parts and

Subparts. Also included in this part are Bank Secrecy

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

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

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

stated in the revenue ruling. In those based on positions

taken in rulings to taxpayers or technical advice to

Service field offices, identifying details and information

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

requirements.

Part IV.—Items of General Interest.

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

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

Rulings and procedures reported in the Bulletin do not

have the force and effect of Treasury Department

Regulations, but they may be used as precedents.

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

as precedents by Service personnel in the disposition of

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

The first Bulletin for each month includes an index for

the matters published during the preceding month.

These monthly indexes are cumulated on a quarterly and

semiannual basis, and are published in the first Bulletin

of the succeeding quarterly and semi-annual period,

respectively.

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

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

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

Section 472.—Last-in, First-out

Inventories

26 CFR 1.472–1: Last-in, first-out inventories.

LIFO; price indexes; department

stores. The December 1996 Bureau of

Labor Statistics price indexes are accepted for use by department stores

employing the retail inventory and lastin, first-out inventory methods for valuing inventories for tax years ended on,

or with reference to, December 31,

1996.

Rev. Rul. 97–8

The following Department Store Inventory Price Indexes for December

1996 were issued by the Bureau of

Labor Statistics on January 14, 1997.

The indexes are accepted by the Internal

Revenue Service, under § 1.472–1(k) of

the Income Tax Regulations and Rev.

Proc. 86–46, 1986–2 C.B. 739, for appropriate application to inventories of

department stores employing the retail

inventory and last-in, first-out inventory

methods for tax years ended on, or with

reference to, December 31, 1996.

The Department Store Inventory Price

Indexes are prepared on a national basis

and include (a) 23 major groups of

departments, (b) three special combinations of the major groups - soft goods,

durable goods, and miscellaneous goods,

and (c) a store total, which covers all

departments, including some not listed

separately, except for the following:

candy, foods, liquor, tobacco, and contract departments.

BUREAU OF LABOR STATISTICS, DEPARTMENT STORE

INVENTORY PRICE INDEXES BY DEPARTMENT GROUPS

(January 1941 = 100, unless otherwise noted)

Groups

1. Piece Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2. Domestics and Draperies . . . . . . . . . . . . . . . . . . . . . . . . . . .

3. Women’s and Children’s Shoes . . . . . . . . . . . . . . . . . . . . . .

4. Men’s Shoes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

5. Infants’ Wear. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

6. Women’s Underwear . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7. Women’s Hosiery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

8. Women’s and Girls’ Accessories . . . . . . . . . . . . . . . . . . . . .

9. Women’s Outerwear and Girls’ Wear . . . . . . . . . . . . . . . . .

10. Men’s Clothing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

11. Men’s Furnishings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

12. Boys’ Clothing and Furnishings . . . . . . . . . . . . . . . . . . . . .

13. Jewelry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

14. Notions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

15. Toilet Articles and Drugs. . . . . . . . . . . . . . . . . . . . . . . . . . .

16. Furniture and Bedding . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

17. Floor Coverings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

18. Housewares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

19. Major Appliances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

20. Radio and Television . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

21. Recreation and Education2 . . . . . . . . . . . . . . . . . . . . . . . . . .

22. Home Improvements2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

23. Auto Accessories2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Groups 1 - 15: Soft Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Groups 16 - 20: Durable Goods . . . . . . . . . . . . . . . . . . . . . . . . .

Groups 21 - 23: Misc. Goods2 . . . . . . . . . . . . . . . . . . . . . . . . . .

Store Total3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Dec.

1995

Dec.

1996

Percent Change

from Dec. 1995

to Dec. 19961

532.6

633.5

625.6

891.0

635.6

521.6

290.2

559.9

407.1

602.1

561.6

481.8

978.1

773.6

870.8

669.0

564.5

782.3

246.1

79.1

112.8

123.7

107.5

585.1

462.2

113.3

543.7

538.7

636.6

646.0

894.2

616.8

527.1

287.2

556.4

404.4

610.8

578.6

483.5

965.3

779.4

904.3

664.6

574.8

806.1

245.3

78.1

110.8

132.2

107.3

589.8

466.6

112.9

547.4

1.1

0.5

3.3

0.4

23.0

1.1

21.0

20.6

20.7

1.4

3.0

0.4

21.3

0.7

3.8

20.7

1.8

3.0

20.3

21.3

21.8

6.9

20.2

0.8

1.0

20.4

0.7

Absence of a minus sign before percentage change in this column signifies price increase.

Indexes on a January 1986=100 base.

The store total index covers all departments, including some not listed separately, except for the following: candy, foods, liquor, tobacco, and contract

departments.

DRAFTING INFORMATION

The principal author of this revenue

ruling is Stan Michaels of the Office of

Assistant Chief Counsel (Income Tax

and Accounting). For further information

regarding this revenue ruling, contact

Mr. Michaels on (202) 622-4970 (not a

toll-free call).

Section 475.—Mark to Market

Accounting Method for Dealers in

Securities

26 CFR 1.475(c)–1: Definitions—dealers in securities.

T.D. 8700

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

Mark to Market for Dealers in

Securities

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Final and temporary regulations.

SUMMARY: This document contains final regulations providing guidance to

enable taxpayers to comply with the

mark-to-market requirements applicable

to dealers in securities. The Revenue

Reconciliation Act of 1993 amended the

applicable tax law. These regulations

provide guidance to dealers in securities.

DATES: These final regulations are effective December 24, 1996, except paragraph (a) of § 1.475(c)–1T is removed

effective December 24, 1996, and the

remainder of § 1.475(c)–1T is removed

effective January 23, 1997.

For dates of applicability, see

§ 1.475(e)–1.

FOR FURTHER INFORMATION

CONTACT: Robert B. Williams at

(202) 622–3960 or Jo Lynn Ricks at

(202) 622–3920 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in these final regulations has been

reviewed and approved by the Office of

Management and Budget in accordance

with the Paperwork Reduction Act (44

U.S.C. 3507) under control number

1545–1496. Responses to this collection

of information are required for a taxpayer to obtain the benefit of an exemption from marking to market under

section 475 for those securities (see

§ 1.475(b)–2) and for a consolidated

group of taxpayers to obtain the benefit

of treating inter-member transactions as

customer transactions for purposes of

the definition of dealer in securities (the

intragroup-customer election, § 1.475(c)–1(a)(3)(iii)).

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

respond to, a collection of information

unless the collection of information displays a valid control number.

The estimated annual burden per

recordkeeper regarding § 1.475(b)–2

varies from .25 to 3 hours, depending

on individual circumstances, with an

estimated average of 1 hour. Section

1.475(b)–4 (formerly § 1.475(b)–2T),

which permitted a taxpayer to add or

remove certain identifications on or before January 31, 1994, does not impose

a recordkeeping burden into the future.

The estimated burden per respondent in

making the intragroup-customer election

in §§ 1.475(c)–1(a)(3)(iii) varies from

.25 to 1 hours, depending on individual

circumstances, with an estimated average of .5 hours.

Comments concerning the accuracy of

this burden estimate and suggestions for

reducing this burden should be sent to

the Internal Revenue Service, Attn:

IRS Reports Clearance Officer, T:FP,

Washington, DC 20224, and to the Office of Management and Budget, Attn:

Desk Officer for the Department of the

Treasury, Office of Information and

Regulatory Affairs, Washington, DC

20503.

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

as long as their contents may become

material in the administration of any

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

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

6103.

dealer in securities, and held for investment. Various comments were received

regarding those regulations, and a hearing was held on April 12, 1994.

Additional regulations were proposed

on January 4, 1995 (60 FR 397) (hereinafter sometimes referred to as the 1995

proposed regulations), and on June 20,

1996 (61 FR 31474) (hereinafter sometimes referred to as the 1996 proposed

regulations). The 1995 and 1996 proposed regulations supplemented, and in

a few cases revised, the 1993 proposed

regulations. Hearings on the 1995 and

1996 proposed regulations were held on

May 3, 1995, and October 15, 1996,

respectively.

The final regulations in this document

generally adopt the 1993 proposed regulations, as revised by the 1995 and 1996

proposed regulations, with certain

changes reflecting comments that were

received. These final regulations also

adopt additional portions of the 1995

proposed regulations. The sections that

are not adopted at this time remain

proposed.

The provisions governing mark to

market of debt instruments, which were

proposed in January 1995, attracted substantial comment. The IRS and Treasury

intend to finalize those regulations in a

substantially revised form in response to

those taxpayer comments.

Background

The final regulations adopt without

change the provisions in the 1995 proposed regulations that provide rules for

situations where a dealer in securities

receives a security with a basis in its

hands that is determined, in whole or in

part, either by reference to the basis of

the security in the hands of the

transferor or by reference to other property held at any time by the dealer. In

these cases, section 475(a) applies only

to post-acquisition gain and loss with

respect to the security. That is, section

475(a) applies only to changes in value

of the security occurring after its acquisition. See section 475(b)(3). The character of the mark-to-market gain or loss

is determined as provided under section

475(d)(3). The character of preacquisition gain or loss (that is, the

built-in gain or loss at the date the

dealer acquires the security) and the

time for taking that gain or loss into

account are determined without regard

to section 475. The fact that a security

This document contains final regulations under section 475 (relating to

mark-to-market accounting for dealers in

securities). Section 475 was added by

section 13223 of the Revenue Reconciliation Act of 1993, Public Law 103–66,

107 Stat. 481, and is effective for all

taxable years ending on or after December 31, 1993.

On December 29, 1993, temporary

regulations (T.D. 8505, [1994–1 C.B.

152] 58 FR 68747) (hereinafter sometimes referred to as the temporary regulations) and cross-referenced proposed

regulations (FI–72–93, 58 FR 68798)

(hereinafter sometimes referred to as the

1993 proposed regulations) were published to furnish guidance on several

issues, including the scope of exemptions from the mark-to-market requirements, certain transitional issues relating

to the scope of exemptions, and the

meaning of the statutory terms security,

Explanation of Provisions

Acquisition by a dealer of a security

with a substituted basis

has a substituted basis in the dealer’s

hands does not affect the security’s date

of acquisition for purposes of determining the timeliness of an identification

under section 475(b).

Scope of Exemptions From Mark-ToMarket Requirement

Section 475(b) exempts certain securities from mark-to-market accounting under section 475(a). Among the exempted

securities are those held for investment

and debt securities not held for sale.

Section 1.475(b)–1(a) of the regulations,

like the temporary rule that preceded it,

provides that held for investment, as

used in section 475(b)(1)(A), and not

held for sale, as used in section

475(b)(1)(B), have the same meaning.

The regulations provide that both terms

refer to a security that is not held by a

taxpayer primarily for sale to customers

in the ordinary course of the taxpayer’s

trade or business. By providing that a

security is held for investment (or not

held for sale) if it is not held primarily

for sale to customers in the ordinary

course of a trade or business, the regulations adopt the concept of held for

investment in section 1236(a). Thus,

under these regulations, a dealer in

securities may identify as held for investment a security that it holds primarily for sale to non-customers (for example, a trading security). The IRS and

the Treasury believe that providing a

single standard for purposes of sections

475 and 1236 is consistent with the

purpose of section 475. These rules

apply to taxable years ending on or after

December 31, 1993.

The final regulations require a taxpayer that identifies a security as exempt from being marked to market to

state (on its books and records) whether

the security is, on the one hand, exempt

as held for investment or not held for

sale or, on the other hand, exempt

because it is a hedge of an item not

subject to mark to market. This regulation applies to identifications made on

or after July 1, 1997.

The temporary and 1993 proposed

regulations provide that stock in a 50percent-controlled subsidiary, and interests in 50-percent-controlled partnerships and trusts, are deemed properly

identified as held for investment and

thus are excluded from mark-to-market

accounting. The 1996 proposed regulations reproposed this rule with two

changes. First, the IRS believed that the

rationale for the rule applies equally to

equity interests in most related persons

and not just to persons controlled by the

taxpayer. Second, after considering various comments received, the IRS proposed that this rule prohibiting marking

a security to market should not apply if

two requirements are met: (1) the security is actively traded on a national

securities exchange or through an

interdealer quotation system; and (2) the

taxpayer who marks owns less than 5

percent of all shares or interests of the

same class. Comments were requested

as to whether it is appropriate to allow

any equity interests in related parties to

be marked to market, and, if so, whether

the proposed limitations are the most

appropriate ones.

After considering the comments received in response, the IRS and the

Treasury have decided to adopt the

provisions in the 1996 proposed regulations with certain modifications. First,

the general threshold above which even

actively traded stock in a related party

may not be marked to market has been

increased from 5% to 15%. The 15%

limit, however, includes shares held both

by the dealer and by certain related

parties. Second, shares that a dealer

acquires from a related party cannot be

marked to market unless, after the time

they were acquired, both one full business day has passed and there has been

significant trading in the security involving persons who are not related to the

taxpayer.

Section 475(b)(3) applies when a security has been exempt from marking to

market and the exemption then ceases to

apply. Thus, changes in a security’s

value that occur while section 475(a)

does not apply are suspended. This rule

has additional significance for certain

members of consolidated groups because

§ 1.1502–13(f)(6) disallows certain

losses recognized by members of consolidated groups on common parent

stock if the loss is not taken into

account pursuant to section 475(a).

The final regulations provide that,

except as determined by the Commissioner, notional principal contracts and

derivative securities described in section

475(c)(2)(D) or (E) that are held by a

dealer in those securities are not eligible

to be exempted from mark-to-market

treatment as held for investment.

Under the temporary and 1993 proposed regulations, however, an analogous barrier to exemption from mark-tomarket treatment did not apply if the

taxpayer established unambiguously that

the security was acquired other than in

the taxpayer’s capacity as a dealer in

such securities. It was anticipated that

this exception would apply only in rare

instances. Commenters suggested an

easing of the standard for establishing

that a security was acquired other than

in the taxpayer’s capacity as a dealer in

such securities.

These suggestions are specifically rejected in the final regulations set forth

in § 1.475(b)–1(c). Instead, as described

above, to avoid uncertainty and ambiguity, the rule barring exemption from

mark-to-market treatment for certain notional principal contracts and derivative

securities applies unless the Commissioner explicitly determines otherwise.

For securities acquired or entered into

before January 23, 1997, however, the

final regulations continue the rule found

in the temporary regulations.

Commenters suggested that changes

are needed to allow taxpayers that are

dealers in notional principal contracts

and derivative securities (described in

section 475(c)(2)(D) or (E)) to identify

as exempt from mark-to-market treatment a notional principal contract or

derivative that is held as a hedge of a

position that is not marked to market.

No change was made to the temporary regulations to reflect these comments because none was necessary. Section 1.475(b)–1(c) limits exemptions

only under section 475(b)(1)(A) (concerning securities held for investment).

Section 1.475(b)–1(c) does not limit

exemptions under section 475(b)(1)(C)

(concerning securities that are hedges of

non-mark-to-market positions). Although

the flush language at the end of section

475(b)(1) authorizes analogous regulatory limitations on exemption under section 475(b)(1)(C), as of this time, no

such regulation has been issued or proposed. Accordingly, if a dealer in notional principal contracts or derivatives

enters into a notional principal contract

or derivative as a hedge of a position

that is not marked to market, the dealer

may properly identify it under section

475(b)(1)(C) as exempt from mark-tomarket treatment.

In response to comments, the final

regulations expand the securities that a

taxpayer may identify under section

475(b)(1)(C) as exempt from mark-tomarket accounting. Under the final regulations, a taxpayer can identify as exempt from mark-to-market treatment

under section 475(b)(1)(C) a security

that hedges a position of another member of the taxpayer’s consolidated group

and meets the following three require-

ments: the security is a hedging transaction within the meaning of § 1.1221–

2(b); the security is timely identified as

a hedging transaction under § 1.1221–

2(e) (including satisfaction of the requirement that the hedged item be identified); and the security hedges a

position that is not marked to market

under section 475(a). Although identification of the hedged item is not required

under § 1.1221–2 until some time after

the day the hedging transaction is entered into, the identification of the hedge

under section 475(b)(2) must still be

made no later than the close of the day

on which the hedge is acquired, originated, or entered into.

Permitting taxpayers to identify these

securities as exempt from mark-tomarket accounting is consistent with the

single-entity approach of the consolidated group hedging regulations under

§ 1.1221–2(d)(1). As a result of the

identification, the timing of the gain or

loss on the hedge is matched with the

timing of the gain or loss on the hedged

item without forcing taxpayers to use

back-to-back hedges and the separateentity election under § 1.1221–2(d)(2).

This rule is effective for hedges entered

into on or after January 23, 1997.

Exemptions—Transitional Issues

The final regulations adopt without

substantive change a number of transitional rules relating to various exemption and identification issues. These

transitional rules, now found in

§ 1.475(b)–4, were contained in

§ 1.475(b)–2T of the temporary regulations. A more complete description of

these provisions may be found in the

preamble of T.D. 8505 at 58 FR 68747

(1994–1 C.B. 152).

Dealer in Securities—the

Customer Relationship

Dealer-

The final regulations retain the rules

in the 1995 proposed regulations concerning the dealer-customer relationship.

Thus, the final regulations provide that

determination of whether a transaction is

with a customer is based on all of the

facts and circumstances. Further, under

section 475(c)(1)(B), the term dealer in

securities includes a taxpayer that, in the

ordinary course of its trade or business,

regularly holds itself out as being willing and able to enter into either side of

a transaction enumerated in section

475(c)(1)(B).

The final regulations retain the general rule in the 1996 proposed regula-

tions that transactions with related persons may be transactions with customers

for purposes of section 475. In response

to comments, however, in § 1.475(c)–

1(a)(3) the final regulations provide both

a special rule for members of a consolidated group and an election for the rule

not to apply. If the special rule applies,

then, solely for purposes of determining

whether the taxpayer meets the definition of a dealer in securities, a taxpayer’s transactions with other members of

its consolidated group are not transactions with customers. Thus, a member

whose only customers are other members of its consolidated group generally

is not a dealer in securities. Treating

intragroup transactions as noncustomer

transactions is consistent with the

single-entity approach of §§ 1.1221–

2(d)(1) and 1.1502–13. (The IRS expects to provide additional guidance on

whether there are any circumstances in

which the special rule applies for other

purposes, such as whether a security

may be exempted from mark-to-market

treatment because it is not held for sale

to customers.)

A consolidated group may elect not to

apply the special rule. If a group has

made this intragroup customer election,

a member of a group may be a dealer in

securities even if its only customer

transactions are with other members of

its consolidated group. Once made, the

election continues for all subsequent

taxable years and may be revoked only

with the consent of the Commissioner.

These final regulations significantly

alter the proposed default rule for

intragroup transactions. Under the proposed regulations, a taxpayer’s

intragroup transactions would have been

customer transactions for purposes of

section 475. Because the final regulations reverse this rule (making

noncustomer status the default and requiring an affirmative election to consider intragroup transactions in applying

the dealer definition), the rules for

intragroup transactions are effective for

taxable years beginning on or after

December 24, 1996. (The general rule

for related party transactions other than

intragroup transactions is effective for

taxable years beginning on or after June

20, 1996.) The IRS will soon publish

guidance to assist taxpayers who may

have to change their methods of accounting because their status as a dealer

changes as a result of the application of

§ 1.475(c)–1(a)(3).

For prior years, the Service generally

will not challenge a taxpayer’s treatment

of intragroup transactions as customer or

noncustomer transactions, provided the

taxpayer had a reasonable basis for its

treatment of the transactions and consistently applied that basis from year to

year. In this regard, a taxpayer does not

fail this consistency requirement solely

because it changed its treatment of its

intragroup transactions in order: (1) to

avail itself of the separate-entity election

under the consolidated group hedging

regulations, or (2) to coincide with the

expected effective date of either Notice

96–12 (1996–10 I.R.B. 29) or the related party rules in the 1996 proposed

regulations. (If a taxpayer wishes to

change its treatment of prior open years

to be consistent with its status during

the first year that § 1.475(c)–1(a)(3)

applies, see § 301.9100–1T(a).)

Dealer in Securities—Sellers of Nonfinancial Goods and Services

In general, the final regulations exclude from dealer status any taxpayer

that would not be a dealer in securities

but for its purchases and sales of debt

instruments that, at the time of purchase

or sale, are customer debt with respect

to the taxpayer or another member of

the taxpayer’s consolidated group. A

debt instrument is customer debt at a

particular time with respect to a person

if three conditions are met: (1) the

person’s principal activity is selling

nonfinancial goods or providing

nonfinancial services; (2) the debt instrument was issued by a purchaser of

the goods or services at the time of

purchase of those items in order to

finance their purchase; and (3) at all

times after the debt instrument was

issued, it has been owned by the person

who sold the goods or services or by a

member of its consolidated group. If,

however, a taxpayer is a dealer in

securities despite this provision, customer debt remains a security in the

taxpayer’s hands and must be marked to

market unless exempted by another rule.

The temporary regulations contain a

narrower provision—that a seller of

nonfinancial goods or services is not a

dealer in securities for purposes of section 475 solely by virtue of extending

credit to its nonfinancial customers

(even if it sells the debt instruments so

acquired). In response to comments, the

final regulations extend this principle to

accommodate consolidated groups that

include both a seller of nonfinancial

goods or services and a captive finance

subsidiary.

The rule in the final regulations exempting from dealer status most captive

finance subsidiaries of retailers and

other sellers of nonfinancial goods and

services applies to all taxable years

ending on or after December 31, 1993,

unless the taxpayer elects for the exemption not to apply. If the election is

made, it continues for all subsequent

taxable years and may be revoked only

with the consent of the Commissioner.

Under the final regulations, there are

two additional circumstances in which

this exemption from dealer status does

not apply. The first is when, for purposes of the inventory accounting rules

under section 471, the taxpayer accounts

for any security (as defined in section

475(c)(2)) as inventory. The second circumstance is when the taxpayer is not

itself the seller of nonfinancial goods

and services and the customer debt is

accounted for by the taxpayer or by a

member of its consolidated group under

a method that permits either the recognition of unrealized gains or losses or

deductions for additions to a reserve for

bad debts. This rule does not affect the

seller of nonfinancial goods and services

itself but is designed to prevent groups

from having one captive finance subsidiary that is treated as a nondealer and

another member of the group that is a

dealer or a financial institution that

accounts for customer debt under a

method that takes into account mark-tomarket gains or losses or reserve deductions.

Dealer in Securities—the Negligible

Sales Exemption

Under the final regulations, in general, if a taxpayer purchases securities

from customers (including originating

loans in the ordinary course of the

taxpayer’s trade or business of originating loans) but engages in no more than

negligible sales of the securities so

acquired, the purchases do not cause the

taxpayer to be a dealer in securities.

This negligible sales rule does not apply

if the taxpayer so elects or accounts for

any security as inventory for purposes

of section 471. A taxpayer that would be

a dealer in securities but for the negligible sales rule elects to be a dealer

simply by filing a federal income tax

return reflecting the application of section 475(a) in computing its taxable

income. The final regulations differ

from the proposed regulations by explicitly making the negligible sales rule

elective.

In response to comments, the final

regulations clarify the test for determining negligible sales of debt instruments

acquired from customers. Under this

rule, a taxpayer has engaged in no more

than negligible sales of the debt instruments (or portions of the debt instruments) that it regularly purchases from

customers in the ordinary course of its

business if, and only if, during the year,

either (1) it sells all or part of fewer

than 60 debt instruments (regardless

how acquired), or (2) the total adjusted

basis of the debt instruments or portions

of debt instruments (regardless how acquired) that it sells is less than 5 percent

of the total basis, immediately after

acquisition, of the debt instruments that

it acquires during the year.

This special test replaces the examples in the temporary regulations illustrating the negligible sales provision.

Some

commenters

noted

that

§ 1.475(c)–1T(b)(2) Example 1 of the

temporary regulations is ambiguous because it refers to a taxpayer that both

‘‘retains almost all of the loans that it

acquires’’ and ‘‘sells fewer than 60

loans.’’ The final regulations eliminate

the ambiguity by making no reference to

how many loans are retained.

In response to comments, the final

regulations contain two special rules for

applying the negligible sales test to

members of a consolidated group. Under

the first rule, if a taxpayer is a member

of a consolidated group that has made

the intragroup-customer election, described above, it must apply the negligible sales test for debt instruments by

taking into account all of its sales of

debt instruments to other group members. On the other hand, if the taxpayer

is a member of a consolidated group

that has not made the intragroupcustomer election, the negligible sales

test is satisfied if either of two criteria is

met: first, if the taxpayer satisfies the

negligible sales test, taking into account

all sales of debt instruments including

sales to other group members; or second, if the taxpayer’s consolidated group

would satisfy the test if it were a single

corporation and the members of the

group were divisions of that corporation.

This group-wide approach to the negligible sales test is consistent with the

single-entity approach of §§ 1.1221–

2(d)(1) and 1.1502–13.

Under a new rule in the final regulations, if a debt instrument is qualitatively different from all of the debt

instruments that the taxpayer purchases

from customers, a sale of that debt

instrument does not count as one of the

60 instruments sold, and that debt instrument is not included in either the

numerator or the denominator under the

5% test. The regulations contain an

example that illustrates this principle.

The rules regarding the negligible

sales exemption are generally effective

for taxable years ending on or after

December 31, 1993. The special rules

for members of a consolidated group,

however, are effective for taxable years

beginning on or after January 23, 1997.

Further, a taxpayer may rely on the

rules set out in § 1.475(c)–1T(b) (as

contained in 26 CFR part 1 revised

April 1, 1996) for taxable years beginning before January 23, 1997, provided

the taxpayer applies that paragraph reasonably and consistently.

Dealer in Securities—Issuance of Life

Insurance Products

The final regulations adopt without

change a provision in the 1995 proposed

regulations to clarify that a life insurance company does not become a dealer

in securities solely by selling annuity,

endowment, or life insurance contracts

to its customers.

Under the final regulations and the

December 28, 1993, proposed regulations, a contract that is treated for

federal income tax purposes as an annuity, endowment, or life insurance contract is deemed to have been identified

as held for investment, and is therefore

not marked to market by the policy

holder. This rule was necessary because

variable life and annuity products fall

within the literal language of section

475(c)(2)(E). Because many life insurance companies sell these insurance

contracts to their customers, some commenters on the 1993 proposal had asked

whether these life insurance companies

were dealers in securities. There is no

indication that Congress intended for a

life insurance company that was not

otherwise a dealer in securities to be

characterized as a dealer merely because

it sells life insurance policies to its

customers.

Several commenters requested that

certain activities not cause dealer status

under section 475 because those activities, although described by section 475,

traditionally had not been considered

dealer activities. Those comments were

generally rejected. Congress determined

that section 475 would bestow dealer

status on taxpayers who had not been

thought of as dealers prior to the enact-

ment of section 475. Thus, the final

regulations do not adopt proposals that

making and selling policy loans should

not cause an insurance company to be a

dealer in securities and that sales of

student loans or auto loans and sales of

loan participations should not be taken

into account in determining whether a

taxpayer is a dealer in securities. Of

course, if a lead bank never owns a

particular portion of a loan for tax

purposes (because some other participating lender always had the economic

benefits and burdens of that portion),

then the lead bank cannot sell that

portion to that other participating lender.

Thus, the lead bank is not a dealer in

securities by reason of these participations.

Definition of Security

Under the final regulations, certain

items are not securities within the meaning of section 475(c)(2). These items

include both debt issued by the taxpayer

and any security (determined without

regard to this provision) if section 1032

bars recognition of gain or loss by the

taxpayer with respect to that security.

The final regulations adopt without

change the provisions in the 1995 proposed regulations that exclude from the

definition of security all REMIC residual interests acquired on or after

January 4, 1995. This rule was adopted

because applying section 475 to residual

interests would undermine the Congressional design for taxing REMIC income,

including the intended operation of sections 860C and 860E (relating to excess

inclusions).

Unlike the 1995 proposed regulations,

the temporary regulations excluded only

some residual interests from the definition of security. Specifically, the temporary regulations excluded only negative

value residual interests (NVRIs) in a

REMIC and other arrangements that are

determined to have substantially the

same economic effect as NVRIs. Under

the final regulations, this exclusion continues to apply to NVRIs acquired before January 4, 1995.

One commenter acknowledged the

tension between mark-to-market accounting and the excess inclusion rules,

but proposed to address that problem in

another way. Under the commenter’s

proposal, a dealer would be permitted to

mark to market a residual interest, but

any loss resulting from the mark would

be taken into account only to the extent

that the loss exceeded the amount of

excess inclusion with respect to that

residual interest for the taxable year.

The IRS and Treasury believe that

this comment does not address the tension between mark-to-market accounting

and section 860C. Apart from the excess

inclusion rules, the REMIC provisions

contemplate income inclusions (and corresponding basis increases) that are not

necessarily associated with increases in

the value of the residual interest. Under

the commenter’s proposal, a dealer

could claim a loss by marking to market

a residual interest where the increased

basis in the interest resulted from an

allocation of REMIC income that was

unaccompanied by an increase in value.

Thus, the dealer could avoid its allocable share of REMIC income and

thereby frustrate the taxing regime contemplated for residual interests.

Moreover, adopting this comment

would require additional, complex rules,

and the burden of administering those

rules would not be justified by the

potential benefit. For example, under the

proposal, a taxpayer would have one

basis in a residual interest for purposes

of section 475 and a different basis in

the residual interest for purposes of

section 860C(d). Also, adopting the proposal would require rules to coordinate

losses that are limited under section 475

with losses that are limited under section 860C(e)(2).

Some commenters suggested that certain types of assets should not be

marked to market because they may be

difficult to value. Under section 475,

however, ease of valuation is not relevant in determining whether a security

is required to be marked to market.

Character of Gain or Loss

The regulations adopt without change

the proposed provision to clarify that

marking to market a security that is not

held in connection with a taxpayer’s

activities as a dealer in securities does

not affect the character of gain or loss

from that security.

In addition, under a new provision in

the final regulations that responds to

comments from taxpayers, if a dealer in

certain notional principal contracts or

derivative securities (described in section 475(c)(2)(D) or (E)) marks those

securities to market because it is precluded from identifying them as exempt

from mark-to-market treatment on the

grounds that they are held for invest-

ment, the dealer recognizes ordinary

gain or loss with respect to those securities.

Effective Dates

These final regulations generally apply to taxable years ending on or after

December 31, 1993, except as otherwise

noted.

Miscellaneous

Some of the 1993 and 1995 proposed

regulations are reordered.

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 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. The collection of information required by

§ 1.475(b)–2 was contained in a notice

of proposed rulemaking preceding these

regulations that was issued prior to

March 29, 1996. Moreover, it is hereby

certified that the collection of information required by § 1.475(c)–1 of these

regulations (regarding the intragroup

customer election) does not have a significant economic impact on a substantial number of small entities. This certification is based upon the fact that the

election is generally attractive only to an

affiliated group of taxpayers that files a

consolidated return (generally large

businesses), that has elected separate

entity treatment under § 1.1221–2, and

that has an in-house hedge center or

securities dealer which deals solely with

other group members and which uses

mark-to-market accounting for book

purposes. Thus, the election is likely to

be made only by, and the collection of

information applies only to, a very small

number of large taxpayers. 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, 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 authors of these regulations are Robert B. Williams and Jo

Lynn Ricks, Office of Assistant Chief

Counsel (Financial Institutions and

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

26 CFR Part 602

Reporting and recordkeeping requirements.

Adoption of Amendments to the

Regulations

Accordingly, 26 CFR parts 1 and 602

are amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation

for part 1 is amended by removing the

entries for §§ 1.475(b)–1T, 1.475(b)–2T,

1.475(c)–1T, 1.475(c)–2T, 1.475(d)–1T,

and 1.475(e)–1T and adding entries in

numerical order to read as follows:

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

Section 1.475(a)–3 also issued under

26 U.S.C. 475(e).

Section 1.475(b)–1 also issued under

26 U.S.C. 475(b)(4) and 26 U.S.C.

475(e).

Section 1.475(b)–2 also issued under

26 U.S.C. 475(b)(2) and 26 U.S.C.

475(e).

Section 1.475(b)–4 also issued under

26 U.S.C. 475(b)(2), 26 U.S.C. 475(e),

and 26 U.S.C. 6001.

Section 1.475(c)–1 also issued under

26 U.S.C. 475(e).

Section 1.475(c)–2 also issued under

26 U.S.C. 475(e) and 26 U.S.C.

860G(e).

Section 1.475(d)–1 also issued under

26 U.S.C. 475(e).

Section 1.475(e)–1 also issued under

26 U.S.C. 475(e). * * *

Sections 1.475(b)–1T, 1.475(b)–2T,

1.475(c)–1T, 1.475(c)–2T, 1.475(d)–1T,

and 1.475(e)–1T [Removed]

Par.

2. Sections

1.475(b)–1T,

1.475(b)–2T, 1.475(c)–2T, 1.475(d)–1T,

and 1.475(e)–1T are removed.

Par. 2a. Paragraph (a) of § 1.475(c)–

1T is removed effective December 24,

1996, and the remainder of § 1.475(c)–

1T is removed January 23, 1997.

Par. 3. Sections 1.475–0, 1.475(a)–3,

1.475(b)–1, 1.475(b)–(2), 1.475(b)–4,

1.475(c)–1, 1.475(c)–2, 1.475(d)–1, and

1.475(e)–1 are added to read as follows:

§ 1.475–0 Table of contents.

This section lists the major captions

§§ 1.475(a)–3,

1.475(b)–1,

1.475(b)–2, 1.475(b)–4, 1.475(c)–1,

1.475(c)–2, 1.475(d)–1, and 1.475(e)–1.

(3) Securities held after legging out.

§ 1.475(b)–3 [Reserved]

§ 1.475(a)–1 [Reserved]

§ 1.475(a)–2 [Reserved]

§ 1.475(a)–3 Acquisition by a dealer of

a security with a substituted basis.

(a) Scope.

(b) Rules.

§ 1.475(b)–1 Scope of exemptions from

mark-to-market requirement.

(a) Securities held for investment or

not held for sale.

(b) Securities deemed identified as

held for investment.

(1) In general.

(2) Relationships.

(i) General rule.

(ii) Attribution.

(iii) Trusts treated as partnerships.

(3) Securities traded on certain established financial markets.

(4) Changes in status.

(i) Onset of prohibition against marking.

(ii) Termination of prohibition against

marking.

(iii) Examples.

investment; dealers in notional principal

contracts and derivatives.

(d) Special rule for hedges of another

member’s risk.

(e) Transitional rules.

(1) Stock, partnership, and beneficial

ownership interests in certain controlled

corporations, partnerships, and trusts before January 23, 1997.

(i) In general.

(ii) Control defined.

(iii) Applicability.

(2) Dealers in notional principal contracts and derivatives acquired before

January 23, 1997.

(i) General rule.

(ii) Exception for securities not acquired in dealer capacity.

(iii) Applicability.

§ 1.475(b)–2 Exemptions—identification requirements.

(a) Identification of the basis for exemption.

(b) Time for identifying a security

with a substituted basis.

§ 1.1275–6.

(1) Definitions.

(2) Synthetic debt held by a taxpayer

as a result of legging in.

§ 1.475(b)–4 Exemptions—transitional

issues.

(a) Transitional identification.

(1) Certain securities previously identified under section 1236.

(2) Consistency requirement for other

securities.

(b) Corrections on or before January

31, 1994.

(1) Purpose.

(2) To conform to § 1.475(b)–1(a).

(i) Added identifications.

(ii) Limitations.

(3) To conform to § 1.475(b)–1(c).

§ 1.475(c)–1 Definitions—dealer in securities.

(a) Dealer-customer relationship.

(1) [Reserved].

(2) Transactions described in section

475(c)(1)(B).

(i) In general.

(ii) Examples.

(3) Related parties.

(i) General rule.

(ii) Special rule for members of a

consolidated group.

(iii) The intragroup-customer election.

(A) Effect of election.

(B) Making and revoking the election.

(iv) Examples.

(b) Sellers of nonfinancial goods and

services.

(1) Purchases and sales of customer

paper.

(2) Definition of customer paper.

(3) Exceptions.

(4) Election not to be governed by

the exception for sellers of nonfinancial

goods or services.

(i) Method of making the election.

(A) Taxable years ending after December 24, 1996.

(B) Taxable years ending on or before December 24, 1996.

(ii) Continued applicability of an

election.

from customers but engage in no more

than negligible sales of the securities.

(1) Exemption from dealer status.

(i) General rule.

(ii) Election to be treated as a dealer.

(2) Negligible sales.

(3) Special rules for members of a

consolidated group.

(i) Intragroup-customer election in effect.

(ii) Intragroup-customer election not

in effect.

(4) Special rules.

(5) Example.

(d) Issuance of life insurance products.

§ 1.475(c)–2 Definitions—security.

(a) Items that are not securities.

(b) Synthetic debt that § 1.1275–6(b)

treats the taxpayer as holding.

acquired before January 4, 1995.

(1) Description.

(2) Special rules applicable to negative value REMIC residuals acquired

before January 4, 1995.

§ 1.475(d)–1 Character of gain or loss.

(a) Securities never held in connection with the taxpayer’s activities as a

dealer in securities.

(b) Ordinary treatment for notional

principal contracts and derivatives held

by dealers in notional principal contracts

and derivatives.

§ 1.475(e)–1 Effective dates.

§ 1.475(a)–3 Acquisition by a dealer of

a security with a substituted basis.

(a) Scope. This section applies if—

(1) A dealer in securities acquires a

security that is subject to section 475(a)

and the dealer’s basis in the security is

determined, in whole or in part, by

reference to the basis of that security in

the hands of the person from whom the

security was acquired; or

(2) A dealer in securities acquires a

security that is subject to section 475(a)

and the dealer’s basis in the security is

determined, in whole or in part, by

reference to other property held at any

time by the dealer.

(b) Rules. If this section applies to a

security—

(1) Section 475(a) applies only to

changes in value of the security occurring after the acquisition; and

(2) Any built-in gain or loss with

respect to the security (based on the

difference between the fair market value

of the security on the date the dealer

acquired it and its basis to the dealer on

that date) is taken into account at the

time, and has the character, provided by

the sections of the Internal Revenue

Code that would apply to the built-in

gain or loss if section 475(a) did not

apply to the security.

§ 1.475(b)–1 Scope of exemptions from

mark-to-market requirement.

(a) Securities held for investment or

not held for sale. Except as otherwise

provided by this section and subject to

the identification requirements of section

475(b)(2), a security is held for investment (within the meaning of section

475(b)(1)(A)) or not held for sale

(within the meaning of section

475(b)(1)(B)) if it is not held by the

taxpayer primarily for sale to customers

in the ordinary course of the taxpayer’s

trade or business.

(b) Securities deemed identified as

held for investment— (1) In general.

The following items held by a dealer in

securities are per se held for investment

within the meaning of section

475(b)(1)(A) and are deemed to be

properly identified as such for purposes

of section 475(b)(2)—

(i) Except as provided in paragraph

(b)(3) of this section, stock in a corporation, or a partnership or beneficial ownership interest in a widely held or

publicly traded partnership or trust, to

which the taxpayer has a relationship

specified in paragraph (b)(2) of this

section; or

(ii) A contract that is treated for

federal income tax purposes as an annuity, endowment, or life insurance contract (see sections 72, 817, and 7702).

(2) Relationships—(i) General rule.

The relationships specified in this paragraph (b)(2) are—

(A) Those described in section

267(b)(2), (3), (10), (11), or (12); or

(B) Those described in section

707(b)(1)(A) or (B).

(ii) Attribution. The relationships described in paragraph (b)(2)(i) of this

section are determined taking into account sections 267(c) and 707(b)(3), as

appropriate.

(iii) Trusts treated as partnerships.

For purposes of this paragraph (b)(2),

the phrase partnership or trust is substituted for the word partnership in sections 707(b)(1) and (3), and a reference

to beneficial ownership interest is added

to each reference to capital interest or

profits interest in those sections.

(3) Securities traded on certain established financial markets. Paragraph

(b)(1)(i) of this section does not apply

to a security if—

(i) The security is actively traded

within the meaning of § 1.1092(d)–1(a)

taking into account only established financial

markets

identified

§ 1.1092(d)–1(b)(1)(i) or (ii) (describing

national securities exchanges and

interdealer quotation systems);

(ii) Less than 15 percent of all of the

outstanding shares or interests in the

same class are held by the taxpayer and

all persons having a relationship to the

taxpayer that is specified in paragraph

(b)(2) of this section; and

(iii) If the security was acquired (e.g.,

on original issue) from a person having

a relationship to the taxpayer that is

specified in paragraph (b)(2) of this

section, then, after the time the security

was acquired—

(A) At least one full business day has

passed, and

(B) There has been significant trading

involving persons not having a relationship to the taxpayer that is specified in

paragraph (b)(2) of this section.

(4) Changes in status—(i) Onset of

prohibition against marking—(A) Once

paragraph (b)(1) of this section begins

to apply to the security and for so long

as it continues to apply, section 475(a)

does not apply to the security in the

hands of the taxpayer.

(B) If a security has not been timely

identified under section 475(b)(2) and,

after the last day on which such an

identification would have been timely,

paragraph (b)(1) of this section begins

to apply to the security, then the dealer

must recognize gain or loss on the

security as if it were sold for its fair

market value as of the close of business

of the last day before paragraph (b)(1)

of this section begins to apply to the

security, and gain or loss is taken into

account at that time.

(ii) Termination of prohibition against

marking. If a taxpayer did not timely

identify a security under section

475(b)(2), and paragraph (b)(1) of this

section applies to the security on the last

day on which such an identification

would have been timely but thereafter

ceases to apply—

(A) An identification of the security

under section 475(b)(2) is timely if

made on or before the close of the day

paragraph (b)(1) of this section ceases to

apply; and

(B) Unless the taxpayer timely identifies the security under section 475(b)(2)

(taking into account the additional time

for identification that is provided by

paragraph (b)(4)(ii)(A) of this section),

section 475(a) applies to changes in

value of the security after the cessation

in the same manner as under section

475(b)(3).

(iii) Examples. These examples illustrate this paragraph (b)(4):

Example 1. Onset of prohibition against marking—(A) Facts. Corporation H owns 75 percent of

the stock of corporation D, a dealer in securities

within the meaning of section 475(c)(1). On

December 1, 1995, D acquired less than half of

the stock in corporation X. D did not identify the

stock for purposes of section 475(b)(2). On July

17, 1996, H acquired from other persons 70

percent of the stock of X. As a result, D and X

became related within the meaning of paragraph

(b)(2)(i) of this section. The stock of X is not

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

(concerning some securities traded on certain

established financial markets).

(B) Holding. Under paragraph (b)(4)(i) of this

section, D recognizes gain or loss on its X stock

as if the stock were sold for its fair market value

at the close of business on July 16, 1996, and the

gain or loss is taken into account at that time. As

with any application of section 475(a), proper

adjustment is made in the amount of any gain or

loss subsequently realized. After July 16, 1996,

section 475(a) does not apply to D’s X stock while

paragraph (b)(1)(i) of this section (concerning the

relationship between X and D) continues to apply.

Example 2. Termination of prohibition against

marking; retained securities identified as held for

investment—(A) Facts. On July 1, 1996, corporation H owned 60 percent of the stock of corporation Y and all of the stock of corporation D, a

dealer in securities within the meaning of section

475(c)(1). Thus, D and Y are related within the

meaning of paragraph (b)(2)(i) of this section.

Also on July 1, 1996, D acquired, as an investment, 10 percent of the stock of Y. The stock of Y

is not described in paragraph (b)(3) of this section

(concerning some securities traded on certain

established financial markets). When D acquired

its shares of Y stock, it did not identify them for

purposes of section 475(b)(2). On December 24,

1996, D identified its shares of Y stock as held for

investment under section 475(b)(2). On December

30, 1996, H sold all of its shares of stock in Y to

an unrelated party. As a result, D and Y ceased to

be related within the meaning of paragraph

(b)(2)(i) of this section.

(B) Holding. Under paragraph (b)(4)(ii)(A) of

this section, identification of the Y shares is timely

if done on or before the close of December 30,

1996. Because D timely identified its Y shares

under section 475(b)(2), it continues after December 30, 1996, to refrain from marking to market its

Y stock.

Example 3. Termination of prohibition against

marking; retained securities not identified as held

for investment— (A) Facts. The facts are the same

as in Example 2 above, except that D did not

identify its stock in Y for purposes of section

475(b)(2) on or before December 30, 1996. Thus,

D did not timely identify these securities under

section 475(b)(2) (taking into account the additional time for identification provided in paragraph

(b)(4)(ii)(A) of this section).

(B) Holding. Under paragraph (b)(4)(ii)(B) of

this section, section 475(a) applies to changes in

value of D’s Y stock after December 30, 1996, in

the same manner as under section 475(b)(3). Thus,

any appreciation or depreciation that occurred

while the securities were prohibited from being

marked to market is suspended. Further, section

475(a) applies only to those changes occurring

after December 30, 1996.

Example 4. Acquisition of actively traded stock

from related party—(A) Facts. Corporation P is

the parent of a consolidated group whose taxable

year is the calendar year, and corporation M, a

member of that group, is a dealer in securities

within the meaning of section 475(c)(1). Corpora-

tion M regularly acts as a market maker with

respect to common and preferred stock of corporation P. Corporation P has outstanding 2,000,000

shares of series X preferred stock, which are

traded on a national securities exchange. During

the business day on December 29, 1997, corporation P sold 100,000 shares of series X preferred

stock to corporation M for $100 per share. Subsequently, also on December 29, 1997, persons not

related to corporation M engaged in significant

trading of the series X preferred stock. At the

close of business on December 30, 1997, the fair

market value of series X stock was $99 per share.

At the close of business on December 31, 1997,

the fair market value of series X stock was $98.50

per share. Corporation M sold the series X stock

on the exchange on January 2, 1998. At all

relevant times, corporation M and all persons

related to M owned less than 15% of the outstanding series X preferred stock.

(B) Holding. The 100,000 shares of series X

preferred stock held by corporation M are not

subject to mark-to-market treatment under section

475(a) on December 29, 1997, because at that

time the stock was held for less than one full

business day and is therefore treated as properly

identified as held for investment. At the close of

business on December 30, 1997, that prohibition

on marking ceases to apply, and section 475(b)(3)

begins to apply. The built-in loss is suspended,

and subsequent appreciation and depreciation are

subject to section 475(a). Accordingly, when corporation M marks the series X stock to market at

the close of business on December 31, 1997,

under section 475(a) it recognizes and takes into

account a loss of $.50 per share. Under section

475(b)(3), when corporation M sells the series X

stock on January 2, 1998, it takes into account the

suspended loss, that is, the difference between the

$100 per share it paid corporation P for that stock

and the $99-per-share fair market value when

section 475(b)(1) ceased to be apply to the stock.

No deduction, however, is allowed for that loss.

(See § 1.1502–13(f)(6), under which no deduction

is allowed to a member of a consolidated group

for a loss with respect to a share of stock of the

parent of that consolidated group, if the member

does not take the gain or loss into account

pursuant to section 475(a).)

investment; dealers in notional principal

contracts and derivatives—(1) Except as

otherwise determined by the Commissioner in a revenue ruling, revenue procedure, or letter ruling, section

475(b)(1)(A) (exempting from mark-tomarket accounting certain securities that

are held for investment) does not apply

to a security if—

(i) The security is described in section 475(c)(2)(D) or (E) (describing certain notional principal contracts and derivative securities); and

(ii) The taxpayer is a dealer in such

securities.

(2) See § 1.475(d)–1(b) for a rule

concerning the character of gain or loss

on securities described in this paragraph

(c).

(d) Special rule for hedges of another

member’s risk. A taxpayer may identify

under section 475(b)(1)(C) (exempting

certain hedges from mark-to-market accounting) a security that hedges a position of another member of the taxpayer’s consolidated group if the security

meets the following requirements—

(1) The security is a hedging transaction within the meaning of § 1.1221–

2(b);

(2) The security is timely identified

as a hedging transaction under

§ 1.1221–2(e) (including identification

of the hedged item); and

(3) The security hedges a position

that is not marked to market under

section 475(a).

(e) Transitional rules—(1) Stock,

partnership, and beneficial ownership

interests in certain controlled corporations, partnerships, and trusts before

January 23, 1997— (i) In general. The

following items held by a dealer in

securities are per se held for investment

within the meaning of section

475(b)(1)(A) and are deemed to be

properly identified as such for purposes

of section 475(b)(2)—

(A) Stock in a corporation that the

taxpayer controls (within the meaning of

paragraph (e)(1)(ii) of this section); or

(B) A partnership or beneficial ownership interest in a widely held or

publicly traded partnership or trust that

the taxpayer controls (within the meaning of paragraph (e)(1)(ii) of this section).

(ii) Control defined. Control means

the ownership, directly or indirectly

through persons described in section

267(b) (taking into account section

267(c)), of—

(A) 50 percent or more of the total

combined voting power of all classes of

stock entitled to vote; or

(B) 50 percent or more of the capital

interest, the profits interest, or the beneficial ownership interest in the widely

held or publicly traded partnership or

trust.

(iii) Applicability. The rules of this

paragraph (e)(1) apply only before January 23, 1997.

(2) Dealers in notional principal contracts and derivatives acquired before

January 23, 1997—(i) General rule.

Section 475(b)(1)(A) (exempting certain

securities from mark-to-market accounting) does not apply to a security if—

(A) The security is described in section 475(c)(2)(D) or (E) (describing certain notional principal contracts and derivative securities); and

(B) The taxpayer is a dealer in such

securities.

(ii) Exception for securities not acquired in dealer capacity. This paragraph (e)(2) does not apply if the taxpayer establishes unambiguously that the

security was not acquired in the taxpayer’s capacity as a dealer in such securities.

(iii) Applicability. The rules of paragraph (e)(2) apply only to securities

acquired before January 23, 1997.

§ 1.475(b)–2 Exemptions—identification requirements.

(a) Identification of the basis for exemption. An identification of a security

as exempt from mark to market does not

satisfy section 475(b)(2) if it fails to

state whether the security is described

in—

(1) Either of the first two subparagraphs of section 475(b)(1) (identifying

a security as held for investment or not

held for sale); or

(2) The third subparagraph thereof

(identifying a security as a hedge).

(b) Time for identifying a security

with a substituted basis. For purposes of

determining the timeliness of an identification under section 475(b)(2), the date

that a dealer acquires a security is not

affected by whether the dealer’s basis in

the security is determined, in whole or

in part, either by reference to the basis

of the security in the hands of the

person from whom the security was

acquired or by reference to other property held at any time by the dealer. See

§ 1.475(a)–3 for rules governing how

the dealer accounts for such a security if

this identification is not made.

§ 1.1275–6— (1) Definitions. The following terms are used in this paragraph

them by § 1.1275–6: integrated transaction, legging into, legging out, qualifying debt instrument, § 1.1275–6 hedge,

and synthetic debt instrument.

(2) Synthetic debt held by a taxpayer

as a result of legging in. If a taxpayer is

treated as the holder of a synthetic debt

instrument as the result of legging into

an integrated transaction, then, for purposes of the timeliness of an identification under section 475(b)(2), the synthetic debt instrument is treated as

having the same acquisition date as the

qualifying debt instrument. A pre-leg-in

identification of the qualifying debt instrument under section 475(b)(2) applies

to the integrated transaction as well.

(3) Securities held after legging out.

If a taxpayer legs out of an integrated

transaction, then, for purposes of the

timeliness of an identification under section 475(b)(2), the qualifying debt instrument, or the § 1.1275–6 hedge, that

remains in the taxpayer’s hands is generally treated as having been acquired,

originated, or entered into, as the case

may be, immediately after the leg-out. If

any loss or deduction determined under

§ 1.1275–6(d)(2)(ii)(B) is disallowed by

§ 1.1275–6(d)(2)(ii)(D) (which disallows deductions when a taxpayer legs

out of an integrated transaction within

30 days of legging in), then, for purposes of this section and section

475(b)(2), the qualifying debt instrument

that remains in the taxpayer’s hands is

treated as having been acquired on the

same date that the synthetic debt instrument was treated as having been acquired.

§ 1.475(b)–4 Exemptions—transitional

issues.

(a) Transitional identification—(1)

Certain securities previously identified

under section 1236. If, as of the close of

the last taxable year ending before December 31, 1993, a security was identified under section 1236 as a security

held for investment, the security is

treated as being identified as held for

investment for purposes of section

475(b).

(2) Consistency requirement for other

securities. In the case of a security

(including a security described in section 475(c)(2)(F)) that is not described

in paragraph (a)(1) of this section and

that was held by the taxpayer as of the

close of the last taxable year ending

before December 31, 1993, the security

is treated as having been properly identified under section 475(b)(2) or

475(c)(2)(F)(iii) if the information contained in the dealer’s books and records

as of the close of that year supports the

identification. If there is any ambiguity

in those records, the taxpayer must, no

later than January 31, 1994, place in its

records a statement resolving this ambiguity and indicating unambiguously

which securities are to be treated as

properly identified. Any information that

supports treating a security as having

been properly identified under section

475(b)(2) or (c)(2)(F)(iii) must be applied consistently from one security to

another.

(b) Corrections on or before January

31, 1994—(1) Purpose. This paragraph

(b) allows a taxpayer to add or remove

certain identifications covered by

§ 1.475(b)–1.

(2) To conform to § 1.475(b)–1(a)—

(i) Added identifications. To the extent

permitted by paragraph (b)(2)(ii) of this

section, a taxpayer may identify as being described in section 475(b)(1)(A) or

(B)—

(A) A security that was held for

immediate sale but was not held primarily for sale to customers in the ordinary

course of the taxpayer’s trade or business (for example, a trading security); or

(B) An evidence of indebtedness that

was not held for sale to customers in the

ordinary course of the taxpayer’s trade

or business and that the taxpayer intended to hold for less than one year.

(ii) Limitations. An identification described in paragraph (b)(2)(i) of this

section is permitted only if—

(A) Prior to December 28, 1993, the

taxpayer did not identify as being described in section 475(b)(1)(A) or (B)

any of the securities described in paragraph (b)(2)(i) of this section;

(B) The taxpayer identifies every security described in paragraph (b)(2)(i) of

this section for which a timely identification of the security under section

475(b)(2) cannot be made after the date

on which the taxpayer makes these

added identifications; and

before January 31, 1994.

(3) To conform to § 1.475(b)–1(c).

On or before January 31, 1994, a taxpayer described in § 1.475(b)–

1(e)(2)(i)(B) may remove an identification under section 475(b)(1)(A) of a

security described in § 1.475(b)–

1(e)(2)(i)(A).

(b)(2) of this section is timely for

purposes of section 475(b)(2) or

(c)(2)(F)(iii). An identification removed

under paragraph (a)(2) or (b)(3) of this

section does not subject the taxpayer to

the provisions of section 475(d)(2).

§ 1.475(c)–1 Definitions—dealer in securities.

(a) Dealer-customer relationship.

Whether a taxpayer is transacting business with customers is determined on

the basis of all of the facts and circumstances.

(1) [Reserved].

(2) Transactions described in section

475(c)(1)(B)—(i) In general. For purposes of section 475(c)(1)(B), the term

dealer in securities includes, but is not

limited to, a taxpayer that, in the ordinary course of the taxpayer’s trade or

business, regularly holds itself out as

being willing and able to enter into

either side of a transaction enumerated

in section 475(c)(1)(B).

(ii) Examples. The following examples illustrate the rules of this paragraph (a)(2). In the following examples,

B is a bank and is not a member of a

consolidated group:

Example 1. B regularly offers to enter into

interest rate swaps with other persons in the

ordinary course of its trade or business. B is

willing to enter into interest rate swaps under

which it either pays a fixed interest rate and

receives a floating rate or pays a floating rate and

receives a fixed rate. B is a dealer in securities

under section 475(c)(1)(B), and the counterparties

are its customers.

Example 2. B, in the ordinary course of its

trade or business, regularly holds itself out as

being willing and able to enter into either side of

positions in a foreign currency with other banks in

the interbank market. B’s activities in the foreign

currency make it a dealer in securities under

section 475(c)(1)(B), and the other banks in the

interbank market are its customers.

Example 3. B engages in frequent transactions

in a foreign currency in the interbank market.

Unlike the facts in Example 2, however, B does

not regularly hold itself out as being willing and

able to enter into either side of positions in the

foreign currency, and all of B’s transactions are

driven by its internal need to adjust its position in

the currency. No other circumstances are present

to suggest that B is a dealer in securities for

purposes of section 475(c)(1)(B). B’s activity in

the foreign currency does not qualify it as a dealer

in securities for purposes of section 475(c)(1)(B),

and its transactions in the interbank market are not

transactions with customers.

(3) Related parties—(i) General rule.

Except as provided in paragraph

(a)(3)(ii) of this section (concerning

transactions between members of a consolidated group, as defined in § 1.1502–

1(h)), a taxpayer’s transactions with related persons may be transactions with

customers for purposes of section 475.

For example, if a taxpayer, in the ordinary course of the taxpayer’s trade or

business, regularly holds itself out to its

foreign subsidiaries or other related persons as being willing and able to enter

into either side of transactions enumerated in section 475(c)(1)(B), the taxpayer is a dealer in securities within the

meaning of section 475(c)(1), even if it

engages in no other transactions with

customers.

(ii) Special rule for members of a

consolidated group. Solely for purposes

of paragraph (c)(1) of section 475 (concerning the definition of dealer in securities) and except as provided in paragraph (a)(3)(iii) of this section, a

taxpayer’s transactions with other mem-

bers of its consolidated group are not

with customers. Accordingly, notwithstanding paragraph (a)(2) of this section,

the fact that a taxpayer regularly holds

itself out to other members of its consolidated group as being willing and

able to enter into either side of a

transaction enumerated in section

475(c)(1)(B) does not cause the taxpayer

to be a dealer in securities within the

meaning of section 475(c)(1)(B).

(iii) The intragroup-customer election—(A) Effect of election. If a consolidated group makes the intragroupcustomer election, paragraph (a)(3)(ii) of

this section (special rule for members of

a consolidated group) does not apply to

the members of the group. Thus, a

member of a group that has made this

election may be a dealer in securities

within the meaning of section 475(c)(1)

even if its only customer transactions

are with other members of its consolidated group.

(B) Making and revoking the election. Unless the Commissioner otherwise

prescribes, the intragroup-customer election is made by filing a statement that

says, ‘‘[Insert name and employer identification number of common parent]

hereby makes the Intragroup-Customer

Election (as described in § 1.475(c)–

1(a)(3)(iii) of the income tax regulations) for the taxable year ending [describe the last day of the year] and for

subsequent taxable years.’’ The statement must be signed by the common

parent and attached to the timely filed

federal income tax return for the consolidated group for that taxable year.

The election applies for that year and

continues in effect for subsequent years

until revoked. The election may be

revoked only with the consent of the

Commissioner.

(iv) Examples. The following examples illustrate this paragraph (a)(3):

General Facts. HC, a hedging center, provides

interest rate hedges to all of the members of its

affiliated group (as defined in section 1504(a)(1)).

Because of the efficiencies created by having a

centralized risk manager, group policy prohibits

members other than HC from entering into derivative interest rate positions with outside parties. HC

regularly holds itself out as being willing and able

to, and in fact does, enter into either side of

interest rate swaps with its fellow members. HC

periodically computes its aggregate position and

hedges the net risk with an unrelated party. HC

does not otherwise enter into interest rate positions

with persons that are not members of the affiliated

group. HC attempts to operate at cost, and the

terms of its swaps do not factor in any risk of

default by the affiliate. Thus, HC’s affiliates

receive somewhat more favorable terms then they

would receive from an unrelated swaps dealer (a

fact that may subject HC and its fellow members

to reallocation of income under section 482). No

other circumstances are present to suggest that HC

is a dealer in securities for purposes of section

475(c)(1)(B).

Example 1. General rule for related persons. In

addition to the General Facts stated above, assume that HC’s affiliated group has not elected

under section 1501 to file a consolidated return.

Under paragraph (a)(3)(i) of this section, HC’s

transactions with its affiliates can be transactions

with customers for purposes of section 475(c)(1).

Thus, under paragraph (a)(2)(i) of this section, HC

is a dealer in securities within the meaning of

section 475(c)(1)(B), and the members of the

group with which it does business are its customers.

Example 2. Special rule for members of a

consolidated group. In addition to the General

Facts stated above, assume that HC’s affiliated

group has elected to file consolidated returns and

has not made the intragroup-customer election.

Under paragraph (a)(3)(ii) of this section, HC’s

interest rate swap transactions with the members

of its consolidated group are not transactions with

customers for purposes of determining whether

HC is a dealer in securities within the meaning of

section 475(c)(1). Further, the fact that HC regularly holds itself out to members of its consolidated group as being willing and able to enter into

either side of a transaction enumerated in section

475(c)(1)(B) does not cause HC to be a dealer in

securities within the meaning of section

475(c)(1)(B). Because no other circumstances are

present to suggest that HC is a dealer in securities

for purposes of section 475(c)(1)(B), HC is not a

dealer in securities.

Example 3. Intragroup-customer election. In

addition to the General Facts stated above, assume that HC’s affiliated group has elected to file

a consolidated return but has also made the

intragroup-customer election under paragraph

(a)(3)(iii) of this section. Thus, the analysis and

result are the same as in Example 1.

(b) Sellers of nonfinancial goods and

services— (1) Purchases and sales of

customer paper. Except as provided in

paragraph (b)(3) of this section, if a

taxpayer would not be a dealer in

securities within the meaning of section

475(c)(1) but for its purchases and sales

of debt instruments that, at the time of

purchase or sale, are customer paper

with respect to either the taxpayer or a

corporation that is a member of the

same consolidated group (as defined in

§ 1.1502–1(h)) as the taxpayer, then for

purposes of section 475 the taxpayer is

not a dealer in securities.

(2) Definition of customer paper. A

debt instrument is customer paper with

respect to a person at a point in time

if—

(i) The person’s principal activity is

selling nonfinancial goods or providing

nonfinancial services;

(ii) The debt instrument was issued

by a purchaser of the goods or services

at the time of the purchase of those

goods or services in order to finance the

purchase; and

(iii) At all times since the debt instrument was issued, it has been held either

by the person selling those goods or

services or by a corporation that is a

member of the same consolidated group

as that person.

(3) Exceptions. Paragraph (b)(1) of

this section does not apply if—

(i) For purposes of section 471, the

taxpayer accounts for any security (as

defined in section 475(c)(2)) as inventory;

(ii) The taxpayer is subject to an

election under paragraph (b)(4) of this

section; or

(iii) The taxpayer is not described in

paragraph (b)(2)(i) of this section and

one or more debt instruments that are

customer paper with respect to a corporation that is a member of the same

consolidated group as the taxpayer are

accounted for by the taxpayer, or by a

corporation that is a member of the

same consolidated group as the taxpayer, in a manner that allows recognition of unrealized gains or losses or

deductions for additions to a reserve for

bad debts.

(4) Election not to be governed by

the exception for sellers of nonfinancial

goods or services—(i) Method of making the election. Unless the Commissioner otherwise prescribes, an election

under this paragraph (b)(4) must be

made in the manner, and at the time,

prescribed in this paragraph (b)(4)(i).

The taxpayer must file with the Internal

Revenue Service a statement that says,

‘‘[Insert name and taxpayer identification number of the taxpayer] hereby

elects not to be governed by

§ 1.475(c)–1(b)(1) of the income tax

regulations for the taxable year ending

[describe the last day of the year] and

for subsequent taxable years.’’

(A) Taxable years ending after December 24, 1996. If the first taxable

year subject to an election under this

paragraph (b)(4) ends after December

24, 1996, the statement must be attached

to a timely filed federal income tax

return for that taxable year.

(B) Taxable years ending on or before December 24, 1996. If the first

taxable year subject to an election under

this paragraph (b)(4) ends on or before

December 24, 1996, and the election

changes the taxpayer’s taxable income

for any taxable year the federal income

tax return for which was filed before

February 24, 1997, the statement must

be attached to an amended return for the

earliest such year that is so affected, and

that amended return (and an amended

return for any other such year that is so

affected) must be filed not later than

June 23, 1997. If the first taxable year

subject to an election under this paragraph (b)(4) ends on or before December 24, 1996, but the taxpayer is not

described in the preceding sentence, the

statement must be attached to the first

federal income tax return that is for a

taxable year subject to the election and

that is filed on or after February 24,

1997.

(ii) Continued applicability of an

election. An election under this paragraph (b)(4) continues in effect for

subsequent taxable years until revoked.

The election may be revoked only with

the consent of the Commissioner.

from customers but engage in no more

than negligible sales of the securities—

(1) Exemption from dealer status—(i)

General rule. A taxpayer that regularly

purchases securities from customers in

the ordinary course of a trade or business (including regularly making loans

to customers in the ordinary course of a

trade or business of making loans) but

engages in no more than negligible sales

of the securities so acquired is not a

dealer in securities within the meaning

of section 475(c)(1) unless the taxpayer

elects to be so treated or, for purposes

of section 471, the taxpayer accounts for

any security (as defined in section

475(c)(2)) as inventory.

(ii) Election to be treated as a dealer.

A taxpayer described in paragraph

(c)(1)(i) of this section elects to be

treated as a dealer in securities by filing

a federal income tax return reflecting

the application of section 475(a) in

computing its taxable income.

(2) Negligible sales. Solely for purposes of paragraph (c)(1) of this section,

a taxpayer engages in negligible sales of

debt instruments that it regularly purchases from customers in the ordinary

course of its business if, and only if,

during the taxable year, either—

(i) The taxpayer sells all or part of

fewer than 60 debt instruments, regardless how acquired; or

(ii) The total adjusted basis of the

debt instruments (or parts of debt instruments), regardless how acquired, that

the taxpayer sells is less than 5 percent

of the total basis, immediately after

acquisition, of the debt instruments that

it acquires in that year.

(3) Special rules for members of a

consolidated group— (i) Intragroupcustomer election in effect. If a taxpayer

is a member of a consolidated group

that has made the intragroup-customer

election (described in paragraph

(a)(3)(iii) of this section), the negligible

sales test in paragraph (c)(2) of this

section takes into account all of the

taxpayer’s sales of debt instruments to

other group members.

(ii) Intragroup-customer election not

in effect. If a taxpayer is a member of a

consolidated group that has not made

the intragroup-customer election (described in paragraph (a)(3)(iii) of this

section), the taxpayer satisfies the negligible sales test in paragraph (c)(2) of

this section if either—

(A) The test is satisfied by the taxpayer, taking into account sales of debt

instruments to other group members (as

in paragraph (c)(3)(i) of this section); or

(B) The test is satisfied by the group,

treating the members of the group as if

they were divisions of a single corporation.

(4) Special rules. Whether sales of

securities are negligible is determined

without regard to—

(i) Sales of securities that are necessitated by exceptional circumstances and

that are not undertaken as recurring

business activities;

(ii) Sales of debt instruments that

decline in quality while in the taxpayer’s hands and that are sold pursuant to

an established policy of the taxpayer to

dispose of debt instruments below a

certain quality; or

(iii) Acquisitions and sales of debt

instruments that are qualitatively different from all debt instruments that the

taxpayer purchases from customers in

the ordinary course of its business.

(5) Example. The following example

illustrates paragraph (c)(4)(iii) of this

section:

Example. I, an insurance company, regularly

makes policy loans to its customers but does not

sell them. I, however, actively trades Treasury

securities. No other circumstances are present to

suggest that I is a dealer in securities for purposes

of section 475(c)(1). Since the Treasuries are

qualitatively different from the policy loans that I

originates, under paragraph (c)(4)(iii) of this section, I disregards the purchases and sales of

Treasuries in applying the negligible sales test in

paragraph (c)(2) of this section.

(d) Issuance of life insurance products. A life insurance company that is

not otherwise a dealer in securities

within the meaning of section 475(c)(1)

does not become a dealer in securities

solely because it regularly issues life

insurance products to its customers in

the ordinary course of a trade or business. For purposes of the preceding

sentence, the term life insurance product

means a contract that is treated for

federal income tax purposes as an annuity, endowment, or life insurance contract. See sections 72, 817, and 7702.

§ 1.475(c)–2 Definitions—security.

(a) Items that are not securities. The

following items are not securities within

the meaning of section 475(c)(2) with

respect to a taxpayer and, therefore, are

not subject to section 475—

(1) A security (determined without

regard to this paragraph (a)) if section

1032 prevents the taxpayer from recognizing gain or loss with respect to that

security;

(2) A debt instrument issued by the

taxpayer (including a synthetic debt instrument, within the meaning of

§ 1.1275–6(b)(4), that § 1.1275–6(b)

treats the taxpayer as having issued); or

(3) A REMIC residual interest, or an

interest or arrangement that is determined by the Commissioner to have

substantially the same economic effect,

if the residual interest or the interest or

arrangement is acquired on or after

January 4, 1995.

(b) Synthetic debt that § 1.1275–6(b)

treats the taxpayer as holding. If

§ 1.1275–6 treats a taxpayer as the

holder of a synthetic debt instrument

(within the meaning of § 1.1275–

6(b)(4)), the synthetic debt instrument is

a security held by the taxpayer within

the meaning of section 475(c)(2)(C).

acquired before January 4, 1995. A

REMIC residual interest that is described in paragraph (c)(1) of this section or an interest or arrangement that is

determined by the Commissioner to

have substantially the same economic

effect is not a security within the meaning of section 475(c)(2).

(1) Description. A residual interest in

a REMIC is described in this paragraph

(c)(1) if, on the date the taxpayer acquires the residual interest, the present

value of the anticipated tax liabilities

associated with holding the interest exceeds the sum of—

(i) The present value of the expected

future distributions on the interest; and

(ii) The present value of the anticipated tax savings associated with holding the interest as the REMIC generates

losses.

(2) Special rules applicable to negative value REMIC residuals acquired

before January 4, 1995. Solely for purposes of this paragraph (c)—

(i) If a transferee taxpayer acquires a

residual interest with a basis determined

by reference to the transferor’s basis,

then the transferee is deemed to acquire

the interest on the date the transferor

acquired it (or is deemed to acquire it

under this paragraph (c)(2)(i)).

(ii) Anticipated tax liabilities, expected future distributions, and anticipated tax savings are determined under

the rules in § 1.860E–2(a)(3) and without regard to the operation of section

475.

(iii) Present values are determined

under the rules in § 1.860E–2(a)(4).

§ 1.475(d)–1 Character of gain or loss.

(a) Securities never held in connection with the taxpayer’s activities as a

dealer in securities. If a security is

never held in connection with the taxpayer’s activities as a dealer in securities, section 475(d)(3)(A) does not affect

the character of gain or loss from the

security, even if the taxpayer fails to

identify the security under section

475(b)(2).

(b) Ordinary treatment for notional

principal contracts and derivatives held

by dealers in notional principal contracts and derivatives. Section

475(d)(3)(B)(ii) (concerning the character of gain or loss with respect to a

security held by a person other than in

connection with its activities as a dealer

in securities) does not apply to a security if § 1.475(b)–1(c) and the absence

of a determination by the Commissioner

prevent section 475(b)(1)(A) from applying to the security.

§ 1.475(e)–1 Effective dates.

(a) and (b) [Reserved].

acquisition by a dealer of a security

with a substituted basis) applies to securities acquired, originated, or entered

into on or after January 4, 1995.

(d) Except as provided elsewhere in

this paragraph (d), § 1.475(b)‘‘1 (concerning the scope of exemptions from

the mark-to-market requirement) applies

to taxable years ending on or after

December 31, 1993.

(1) Section 1.475(b)’’1(b) applies as

follows:

(i) Section 1.475(b)‘‘1(b)(1)(i) (concerning equity interests issued by a

related person) applies beginning June

19, 1996. If, on June 18, 1996, a

security is subject to mark-to-market

accounting and, on June 19, 1996,

§ 1.475(b)–1(b)(1) begins to apply to

the security solely because of the effective dates in this paragraph (d) (rather

than because of a change in facts), then

the rules of § 1.475(b)–1(b)(4)(i)(A)

(concerning the prohibition against

marking) apply, but § 1.475(b)–

1(b)(4)(i)(B) (imposing a mark to market on the day before the onset of the

prohibition) does not apply.

(ii) Section 1.475(b)–1(b)(2) (concerning relevant relationships for purposes of determining whether equity

interests in related persons are prohibited from being marked to market) applies beginning June 19, 1996.

(iii) Section 1.475(b)’’1(b)(3) (concerning certain actively traded securities) applies beginning June 19, 1996, to

securities held on or after that date,

except for securities described in

§ 1.475(b)‘‘1(e)(1)(i) (concerning equity

interests issued by controlled entities). If

security

described

§ 1.475(b)’’1(e)(1)(i),

§ 1.475(b)‘‘1(b)(3) applies only on or after January 23, 1997, if the security is held on

or after that date. If § 1.475(b)’’1(b)(1)

ceases to apply to a security by virtue of

the operation of this paragraph

(d)(1)(iii), the rules of § 1.475(b)‘‘1(b)(4)(ii) apply to the cessation.

(iv) Except to the extent provided in

paragraph (d)(1) of this section,

§ 1.475(b)’’1(b)(4) (concerning changes

in status) applies beginning June 19,

1996.

(2) Section 1.475(b)‘‘1(c) (concerning

securities deemed not held for investment by dealers in notional principal

contracts and derivatives) applies to securities acquired on or after January 23,

1997.

(3) Section 1.475(b)–1(d) (concerning

the special rule for hedges of another

member’s risk) is effective for securities

acquired, originated, or entered into on

or after January 23, 1997.

(e) Section 1.475(b)–2 (concerning

identification of securities that are exempt from mark to market treatment)

applies as follows:

(1) Section 1.475(b)–2(a) (concerning

the general rules for identification of

basis for exemption from mark to market treatment) applies to identifications

made on or after July 1, 1997.

(2) Section 1.475(b)–2(b) (concerning

time for identifying a security with a

substituted basis) applies to securities

acquired, originated, or entered into on

or after January 4, 1995.

(3) Section 1.475(b)–2(c) (concerning

identification in the context of integrated

transactions under § 1.1275–6) applies

on and after August 13, 1996 (the

effective date of § 1.1275–6).

(f) [Reserved].

(g) Section 1.475(b)–4 (concerning

transitional issues relating to exemptions) applies to taxable years ending on

or after December 31, 1993.

(h) Section 1.475(c)–1 applies as follows:

(1) Except as otherwise provided in

this paragraph (h)(1), § 1.475(c)–1(a)

(concerning the dealer-customer relationship) applies to taxable years beginning on or after January 1, 1995.

(i) [Reserved].

(ii) Section 1.475(c)–1(a)(2)(ii) (illustrating rules concerning the dealercustomer relationship) applies to taxable

years beginning on or after June 20,

1996.

(iii) (A) Section 1.475(c)–1(a)(3) applies to taxable years beginning on or

after June 20, 1996, except for transactions between members of the same

consolidated group.

(B) For transactions between members of the same consolidated group,

paragraph § 1.475(c)–1(a)(3) applies to

taxable years beginning on or after

December 24, 1996.

(2) Section 1.475(c)–1(b) (concerning

sellers of nonfinancial goods and services) applies to taxable years ending on

or after December 31, 1993.

(3) Except as otherwise provided in

this paragraph (h)(3), § 1.475(c)–1(c)

(concerning taxpayers that purchase securities but engage in no more than

negligible sales of the securities) applies

to taxable years ending on or after

December 31, 1993.

(i) Section 1.475(c)–1(c)(3) (special

rules for members of a consolidated

group) is effective for taxable years

beginning on or after December 24,

1996.

(ii) A taxpayer may rely on the rules

set out in § 1.475(c)–1T(b) (as contained in 26 CFR part 1 revised April 1,

1996) for taxable years beginning before

January 23, 1997, provided the taxpayer

applies that paragraph reasonably and

consistently.

(4) Section 1.475(c)–1(d) (concerning

the issuance of life insurance products)

applies to taxable years beginning on or

after January 1, 1995.

(i) Section 1.475(c)–2 (concerning the

definition of security) applies to taxable

years ending on or after December 31,

1993. By its terms, however,

§ 1.475(c)–2(a)(3) applies only to residual interests or to interests or arrangements that are acquired on or after

January 4, 1995; and the integrated

transactions that are referred to in

§§ 1.475(c)–2(a)(2) and 1.475(c)–2(b)

exist only after August 13, 1996 (the

effective date of § 1.1275–6).

(j) Section 1.475(d)–1 (concerning

the character of gain or loss) applies to

taxable years ending on or after December 31, 1993.

PART 602—OMB CONTROL

NUMBERS UNDER THE

PAPERWORK REDUCTION ACT

Par. 4. The authority citation for part

602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 5. In § 602.101 paragraph (c) is

amended by:

1. Removing the following entry

from the table:

§ 602.101 OMB Control numbers.

CFR part or section where

Current OMB

identified and described

control No.

1.475(b)–2T . . . . . . . . . . . . . . . 1545–1422

Section 731.—Extent of

Recognition of Gain or Loss on

Distribution

26 CFR 1.731–2: Partnership distribution of marketable securities.

T.D. 8707

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

Distribution of Marketable

Securities by a Partnership

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains

final regulations providing rules for

partnership distributions of marketable

securities under section 731(c) of the

Internal Revenue Code of 1986, as

amended, and for determining when

those distributions are taxable to the

distributee partner. The regulations reflect changes to the law made by the

Uruguay Round Agreements Act enacted

on December 8, 1994.

DATES: These regulations are effective

on December 26, 1996.

2. Adding an entry in numerical order

to the table to read as follows:

FOR FURTHER INFORMATION CONTACT: Terri A. Belanger or William M.

Kostak at (202) 622–3080 (not a tollfree number).

§ 602.101 OMB Control numbers.

SUPPLEMENTARY INFORMATION:

CFR part or section where

Current OMB

identified and described

control No.

1.475(b)–4. . . . . . . . . . . . . . . . . 1545–1496

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved December 6, 1996.

Donald C. Lubick,

Acting Assistant Secretary of the

Treasury.

(Filed by the Office of the Federal Register on

December 23, 1996, 8:45 a.m., and published in

the issue of the Federal Register for December 24,

1996, 61 F.R. 67715)

Background

This document amends 26 CFR part 1

to provide rules relating to the treatment

of partnership distributions of marketable securities under section 731(c). Under section 731(a), in the case of a

distribution by a partnership to a partner, gain is recognized to the partner

only to the extent that any money

distributed exceeds the adjusted basis of

the partner’s interest in the partnership.

Prior to the enactment of section 731(c),

marketable securities were not considered money and, therefore, the distribution of marketable securities by a partnership to a partner was not a taxable

event. Section 731(c) now treats a partnership distribution of marketable securities as a distribution of money and as

a taxable event if the value of the

distributed securities exceeds the adjusted basis of the partner’s interest in

the partnership. Section 731(c) also provides several exceptions to the general

rule that a distribution of marketable

securities will be treated as a distribution of money.

On January 2, 1996, the IRS published in the Federal Register (61 FR

28) a notice of proposed rulemaking

(PS–2–95) to provide guidance regarding section 731(c). A number of public

comments were received concerning the

proposed regulations. However, the public hearing scheduled for April 3, 1996,

was cancelled because no one requested

to speak. After consideration of the

written comments received, the proposed

regulations are adopted as revised by

this Treasury decision.

Explanation of Provisions

I. General background

The proposed regulations provide

rules for determining when and the

extent to which a distribution of marketable securities by a partnership to a

partner will be treated as a distribution

of money for purposes of section 731(a).

Although modified in response to comments, the final regulations generally

adopt the rules contained in the proposed regulations.

II. Public comments

Several comments requested that the

IRS reconsider the requirement in

§ 1.731–2(d)(2)(ii) of the proposed

regulations that a marketable security

must be actively traded on the date of

distribution to qualify for the ‘‘nonrecognition transaction’’ exception to section 731(c). Because of this rule, financial instruments (securities) that are

treated as marketable securities under

section 731(c)(2)(B) on the date of

distribution, but that are not actively

traded, would not qualify for this exception. Commentators suggested that the

final regulations should not include this

requirement or should include a more

narrowly drafted provision. In response

to these comments, the final regulations

provide that a security that falls within

the definition of marketable security

may qualify for the exceptions under

§ 1.731–2(d) of the final regulations

even if the security is not actively

traded on the date of distribution. An

anti-stuffing rule has been added to

address the concern to which the

actively-traded requirement of the proposed regulations was directed.

Several comments also suggested that

§ 1.731–2(d)(2) of the proposed regulations should allow a de minimis amount

of cash and marketable securities to be

transferred in a nonrecognition transaction. The final regulations provide that if

the value of money and marketable

securities transferred in a nonrecognition

transaction is less than 20 percent of the

total amount of all property transferred

in exchange for the distributed security,

the entire value of the distributed security will qualify for the nonrecognition

transaction exception under § 1.731–

2(d)(1)(ii) of the final regulations.

Several commentators also suggested

that the five-year rules of § 1.731–

2(d)(2) and (3) of the proposed regulations be eliminated. Section 1.731–

2(d)(2) of the proposed regulations

provided that a marketable security that

was acquired in a nonrecognition transaction in exchange for other property

and distributed within five years by the

partnership would not be subject to

section 731(c). Section 1.731–2(d)(3) of

the proposed regulations provided that a

marketable security that was acquired by

the partnership before it became actively

traded would also not be subject to

section 731(c) if it was distributed by

the partnership within five years of

becoming actively traded. One commentator, for example, argued that a security

is no less a substitute for the underlying

assets in a nonrecognition transaction

after five years than before five years.

These five- year rules were included in

the proposed regulations because of administrative concerns. For example, it

may be difficult, after the passage of

many years, for taxpayers or the IRS to

determine the circumstances in which a

partnership acquired a particular security. Moreover, it is not clear whether

certain exceptions should apply to a

distribution of securities if those securities were acquired by a partnership

many years ago and are now distributed

to a partner who was not a partner at

the time the securities were acquired.

These administrative concerns remain

valid, and a five year time limitation

provides a reasonable and simple solution to such problems. Therefore, the

final regulations retain both five-year

rules.

One comment requested clarification

regarding whether a section 708(b)(1)(B) termination affects a partnership’s

qualification for the exceptions under

§ 1.731–2(d) and (e) of the regulations.

Another commentator suggested that the

regulations be modified to provide that

marketable securities will not be treated

as money when there is a deemed

distribution of marketable securities by

the terminating partnership as the result

of a section 708(b)(1)(B) termination. In

response to these comments, the final

regulations provide that a section

708(b)(1)(B) termination does not have

any effect on a partnership’s qualification for the exceptions under section

731(c). In addition, a deemed distribution occurring as a result of a section

708(b)(1)(B) termination will not be

subject to section 731(c).

Several comments suggested that the

10-percent test in the investment partnership look-through rule under

§ 1.731–2(e)(4) of the proposed regulations should be modified or eliminated.

A partnership can qualify for the investment partnership exception only if it has

never been engaged in a trade or business and substantially all of its assets

are investment assets. Under the proposed regulations, a partnership is

treated as engaged in a trade or business

engaged in by, or as holding a proportionate share of the assets of, a lowertier partnership in which the partnership

holds a partnership interest unless the

upper-tier partnership does not participate in the management of the lowertier partnership and the interest held by

the upper-tier partnership is less than 10

percent of the total profits and capital

interests in the lower-tier partnership.

According to the comments, the requirement that the upper-tier partnership not

participate in the management of the

lower-tier partnership should be sufficient to ensure passive ownership of the

interest in the lower-tier partnership.

The commentators further argued that

ownership of more than 10 percent of

the capital and profits interest in a

lower-tier partnership may still be consistent with passive ownership. After

consideration of these comments, the

final regulations modify the rule in the

proposed regulations to increase the

threshold ownership percentage amount

from 10 to 20 percent.

In response to a comment, the final

regulations clarify that an interest in a

lower-tier partnership that qualifies for

the exception to the investment partnership ‘‘look-through’’ rule is treated as

eligible property for purposes of determining whether the partner who contributed the lower-tier partnership interest is

an eligible partner of the upper-tier

investment partnership.

One commentator recommended that

the regulations include an example that

illustrates the section 732(a)(2) ordering

rules for distributions that include

money, marketable securities and other

property, and to clarify whether market-

able securities are treated as money for

purposes of section 732(a)(2). Because

the statute and the regulations provide

that marketable securities are treated as

money only for purposes of sections

731(a)(1) and 737, no additional examples are necessary.

One comment suggested that the effective date of the regulations should be

the same as the effective date of section

731(c) because the regulations contain

guidance for the various exceptions provided for by the Internal Revenue Code.

In response to this comment, the final

regulations provide that, for the period

between the effective date of the statutory provision and the effective date of

these regulations, taxpayers may apply

the rules contained in these regulations.

Another comment suggested that the

final regulations should make clear that

the rules in the investment partnership

exception apply with respect to all property contributed to, or held by, a partnership at any time (including any period

prior to the enactment of section

731(c)). The IRS and Treasury believe

that this is sufficiently clear from the

statutory language, and an explicit statement to this effect in these regulations is

not necessary and may be confusing.

One comment requested that the regulations provide several examples illustrating abusive transactions intended to

be covered by the anti-abuse rules of

§ 1.731–2(h), and that these rules be

coordinated with the general anti-abuse

rules of § 1.701–2. After consideration

of this comment, it has been determined

that the text of the regulations adequately describes several situations that

would be considered abusive under

these rules, and that additional examples

are unnecessary.

In response to several comments, the

final regulations clarify that the 90 percent test of § 1.731–2(c)(2)(i) and the

20 percent test of § 1.731–2(c)(2)(ii) are

determined using the gross value of the

entity’s assets, disregarding any debt

that may encumber or otherwise be

allocable to those assets, other than debt

that is incurred to acquire property with

a principal purpose of avoiding or reducing the effect of section 731(c).

Finally, the regulations clarify the

interaction of the limitation on gain rule

in section 731(c)(3)(B) and the various

exceptions listed in paragraph (d). The

regulations provide that any gain or loss

on a distributed security that qualifies

for an exception is not taken into account in determining the distributee

partner’s limitation on gain.

III. Effective dates

In general, section 731(c) applies to

distributions made after December 8,

1994. These regulations are effective for

distributions made on or after December

26, 1996. However, taxpayers may apply the rules of this section to distributions made after December 8, 1994, and

before December 26, 1996.

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 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. Pursuant to section 7805(f) of

the Internal Revenue Code, the notice of

proposed rulemaking preceding these

regulations was submitted to the Small

Business Administration for comment on

its impact on small business.

Drafting Information

The principal authors of these regulations are Terri A. Belanger and William

M. Kostak, Office of Assistant Chief

Counsel (Passthroughs and Special Industries), IRS. However, other personnel

from the IRS and Treasury Department

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 is amended by adding an entry in

numerical order to read as follows:

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

Section 1.731–2 also issued under 26

U.S.C. 731(c). * * *

Par. 2. Section 1.731–2 is added to

read as follows:

§ 1.731–2 Partnership distributions of

marketable securities.

(a) Marketable securities treated as

money. Except as otherwise provided in

section 731(c) and this section, for purposes of sections 731(a)(1) and 737, the

term money includes marketable securi-

ties and such securities are taken into

account at their fair market value as of

the date of the distribution.

(b) Reduction of amount treated as

money—(1) Aggregation of securities.

For purposes of section 731(c)(3)(B)

and this paragraph (b), all marketable

securities held by a partnership are

treated as marketable securities of the

same class and issuer as the distributed

security.

(2) Amount of reduction. The amount

of the distribution of marketable securities that is treated as a distribution of

money under section 731(c) and paragraph (a) of this section is reduced (but

not below zero) by the excess, if any,

of—

(i) The distributee partner’s distributive share of the net gain, if any, which

would be recognized if all the marketable securities held by the partnership

were sold (immediately before the transaction to which the distribution relates)

by the partnership for fair market value;

over

(ii) The distributee partner’s distributive share of the net gain, if any, which

is attributable to the marketable securities held by the partnership immediately

after the transaction, determined by using the same fair market value as used

under paragraph (b)(2)(i) of this section.

(3) Distributee partner’s share of net

gain. For purposes of section

731(c)(3)(B) and paragraph (b)(2) of

this section, a partner’s distributive

share of net gain is determined—

(i) By taking into account any basis

adjustments under section 743(b) with

respect to that partner;

(ii) Without taking into account any

special allocations adopted with a principal purpose of avoiding the effect of

section 731(c) and this section; and

(iii) Without taking into account any

gain or loss attributable to a distributed

security to which paragraph (d)(1) of

this section applies.

general. For purposes of section 731(c)

and this section, the term marketable

securities is defined in section 731(c)(2).

(2) Actively traded. For purposes of

section 731(c) and this section, a financial instrument is actively traded (and

thus is a marketable security) if it is of

a type that is, as of the date of distribution, actively traded within the meaning

of section 1092(d)(1). Thus, for example, if XYZ common stock is listed on

a national securities exchange, particular

shares of XYZ common stock that are

distributed by a partnership are market-

able securities even if those particular

shares cannot be resold by the

distributee partner for a designated period of time.

(3) Interests

entity—

(i) Substantially all. For purposes of

section 731(c)(2)(B)(v) and this section,

substantially all of the assets of an

entity consist (directly or indirectly) of

marketable securities, money, or both

only if 90 percent or more of the assets

of the entity (by value) at the time of

the distribution of an interest in the

entity consist (directly or indirectly) of

marketable securities, money, or both.

(ii) Less than substantially all. For

purposes of section 731(c)(2)(B)(vi) and

this section, an interest in an entity is a

marketable security to the extent that the

value of the interest is attributable (directly or indirectly) to marketable securities, money, or both, if less than 90

percent but 20 percent or more of the

assets of the entity (by value) at the

time of the distribution of an interest in

the entity consist (directly or indirectly)

of marketable securities, money, or both.

(4) Value of assets. For purposes of

section 731(c) and this section, the value

of the assets of an entity is determined

without regard to any debt that may

encumber or otherwise be allocable to

those assets, other than debt that is

incurred to acquire an asset with a

principal purpose of avoiding or reducing the effect of section 731(c) and this

section.

(d) Exceptions—(1) In general. Except as otherwise provided in paragraph

(d)(2) of this section, section 731(c) and

this section do not apply to the distribution of a marketable security if—

(i) The security was contributed to

the partnership by the distributee partner;

(ii) The security was acquired by the

partnership in a nonrecognition transaction, and the following conditions are

satisfied—

(A) The value of any marketable securities and money exchanged by the

partnership in the nonrecognition transaction is less than 20 percent of the

value of all the assets exchanged by the

partnership in the nonrecognition transaction; and

(B) The partnership distributed the

security within five years of either the

date the security was acquired by the

partnership or, if later, the date the

security became marketable; or

(iii) The security was not a marketable security on the date acquired by the

partnership, and the following conditions

are satisfied—

(A) The entity that issued the security

had no outstanding marketable securities

at the time the security was acquired by

the partnership;

(B) The security was held by the

partnership for at least six months before the date the security became marketable; and

security within five years of the date the

security became marketable.

(2) Anti-stuffing rule. Paragraph

(d)(1) of this section does not apply to

the extent that 20 percent or more of the

value of the distributed security is attributable to marketable securities or money

contributed (directly or indirectly) by

the partnership to the entity to which the

distributed security relates after the security was acquired by the partnership

(other than marketable securities contributed by the partnership that were

originally contributed to the partnership

by the distributee partner). For purposes

of this paragraph (d)(2), money contributed by the distributing partnership does

not include any money deemed contributed by the partnership as a result of

section 752.

(3) Successor security. Section 731(c)

and this section apply to the distribution

of a marketable security acquired by the

partnership in a nonrecognition transaction in exchange for a security the

distribution of which immediately prior

to the exchange would have been excepted under this paragraph (d) only to

the extent that section 731(c) and this

section otherwise would have applied to

the exchanged security.

(e) Investment partnerships—(1) In

general. Section 731(c) and this section

do not apply to the distribution of

marketable securities by an investment

partnership (as defined in section

731(c)(3)(C)(i)) to an eligible partner (as

defined in section 731(c)(3)(C)(iii)).

(2) Eligible partner—(i) Contributed

services. For purposes of section

731(c)(3)(C)(iii) and this section, a partner is not treated as a partner other than

an eligible partner solely because the

partner contributed services to the partnership.

(ii) Contributed partnership interests.

For purposes of determining whether a

partner is an eligible partner under section 731(c)(3)(C), if the partner has

contributed to the investment partnership

an interest in another partnership that

meets the requirements of paragraph

(e)(4)(i) of this section after the contribution, the contributed interest is treated

as property specified in section

731(c)(3)(C)(i).

(3) Trade or business activities. For

purposes of section 731(c)(3)(C) and

this section, a partnership is not treated

as engaged in a trade or business by

reason of—

(i) Any activity undertaken as an investor, trader, or dealer in any asset

described in section 731(c)(3)(C)(i), including the receipt of commitment fees,

break-up fees, guarantee fees, director’s

fees, or similar fees that are customary

in and incidental to any activities of the

partnership as an investor, trader, or

dealer in such assets;

(ii) Reasonable and customary management services (including the receipt

of reasonable and customary fees in

exchange for such management services)

provided to an investment partnership

(within the meaning of section

731(c)(3)(C)(i)) in which the partnership

holds a partnership interest; or

(iii) Reasonable and customary services provided by the partnership in

assisting the formation, capitalization,

expansion, or offering of interests in a

corporation (or other entity) in which

the partnership holds or acquires a significant equity interest (including the

provision of advice or consulting services, bridge loans, guarantees of obligations, or service on a company’s

board of directors), provided that the

anticipated receipt of compensation for

the services, if any, does not represent a

significant purpose for the partnership’s

investment in the entity and is incidental

to the investment in the entity.

(4) Partnership tiers. For purposes of

section 731(c)(3)(C)(iv) and this section,

a partnership (upper-tier partnership) is

not treated as engaged in a trade or

business engaged in by, or as holding

(instead of a partnership interest) a

proportionate share of the assets of, a

partnership (lower-tier partnership) in

which the partnership holds a partnership interest if—

(i) The upper-tier partnership does

not actively and substantially participate

in the management of the lower-tier

partnership; and

(ii) The interest held by the upper-tier

partnership is less than 20 percent of the

total profits and capital interests in the

lower-tier partnership.

(f) Basis rules—(1) Partner’s basis—

(i) Partner’s basis in distributed securities. The distributee partner’s basis in

distributed marketable securities with respect to which gain is recognized by

reason of section 731(c) and this section

is the basis of the security determined

under section 732, increased by the

amount of such gain. Any increase in

the basis of the marketable securities

attributable to gain recognized by reason

of section 731(c) and this section is

allocated to marketable securities in proportion to their respective amounts of

unrealized appreciation in the hands of

the partner before such increase.

(ii) Partner’s basis in partnership interest. The basis of the distributee partner’s interest in the partnership is determined under section 733 as if no gain

were recognized by the partner on the

distribution by reason of section 731(c)

and this section.

(2) Basis of partnership property. No

adjustment is made to the basis of

partnership property under section 734

as a result of any gain recognized by a

partner, or any step-up in the basis in

the distributed marketable securities in

the hands of the distributee partner, by

reason of section 731(c) and this section.

(g) Coordination with other sections—(1) Sections 704(c)(1)(B) and

737—(i) In general. If a distribution

results in the application of sections

731(c) and one or both of sections

704(c)(1)(B) and 737, the effect of the

distribution is determined by applying

section 704(c)(1)(B) first, section 731(c)

second, and finally section 737.

(ii) Section 704(c)(1)(B). The basis of

the distributee partner’s interest in the

partnership for purposes of determining

the amount of gain, if any, recognized

by reason of section 731(c) (and for

determining the basis of the marketable

securities in the hands of the distributee

partner) includes the increase or decrease, if any, in the partner’s basis that

occurs under section 704(c)(1)(B)(iii) as

a result of a distribution to another

partner of property contributed by the

distributee partner in a distribution that

is part of the same distribution as the

marketable securities.

(iii) Section 737—(A) Marketable securities as other property. A distribution

of marketable securities is treated as a

distribution of property other than

money for purposes of section 737 to

the extent that the marketable securities

are not treated as money under section

731(c). In addition, marketable securities

contributed to the partnership are treated

as property other than money in deter-

mining the contributing partner’s net

precontribution gain under section

737(b).

(B) Basis increase under section 737.

The basis of the distributee partner’s

interest in the partnership for purposes

of determining the amount of gain, if

any, recognized by reason of section

731(c) (and for determining the basis of

the marketable securities in the hands of

the distributee partner) does not include

the increase, if any, in the partner’s

basis that occurs under section 737(c)(1)

as a result of a distribution of property

to the distributee partner in a distribution that is part of the same distribution

as the marketable securities.

(2) Section 708(b)(1)(B). If a partnership termination occurs under section

708(b)(1)(B), the successor partnership

will be treated as if there had been no

termination for purposes of section

731(c) and this section. Accordingly, a

section 708(b)(1)(B) termination will not

affect whether a partnership qualifies for

any of the exceptions in paragraphs (d)

and (e) of this section. In addition, a

deemed distribution that may occur as a

result of a section 708(b)(1)(B) termination will not be subject to section 731(c)

and this section.

(h) Anti-abuse rule. The provisions of

section 731(c) and this section must be

applied in a manner consistent with the

purpose of section 731(c) and the substance of the transaction. Accordingly, if

a principal purpose of a transaction is to

achieve a tax result that is inconsistent

with the purpose of section 731(c) and

this section, the Commissioner can recast the transaction for Federal tax purposes as appropriate to achieve tax

results that are consistent with the purpose of section 731(c) and this section.

Whether a tax result is inconsistent with

the purpose of section 731(c) and this

section must be determined based on all

the facts and circumstances. For example, under the provisions of this paragraph (h)—

(1) A change in partnership allocations or distribution rights with respect

to marketable securities may be treated

as a distribution of the marketable securities subject to section 731(c) if the

change in allocations or distribution

rights is, in substance, a distribution of

the securities;

(2) A distribution of substantially all

of the assets of the partnership other

than marketable securities and money to

some partners may also be treated as a

distribution of marketable securities to

the remaining partners if the distribution

of the other property and the withdrawal

of the other partners is, in substance,

equivalent to a distribution of the securities to the remaining partners; and

(3) The distribution of multiple properties to one or more partners at different times may also be treated as part of

a single distribution if the distributions

are part of a single plan of distribution.

(i) [Reserved]

(j) Examples. The following examples

illustrate the rules of this section. Unless

otherwise specified, all securities held

by a partnership are marketable securities within the meaning of section

731(c); the partnership holds no marketable securities other than the securities

described in the example; all distributions by the partnership are subject to

section 731(a) and are not subject to

sections 704(c)(1)(B), 707(a)(2)(B),

751(b), or 737; and no securities are

eligible for an exception to section

731(c). The examples read as follows:

Example 1. Recognition of gain. (i) A and B

form partnership AB as equal partners. A contributes property with a fair market value of $1,000

and an adjusted tax basis of $250. B contributes

$1,000 cash. AB subsequently purchases Security

X for $500 and immediately distributes the security to A in a current distribution. The basis in A’s

interest in the partnership at the time of distribution is $250.

(ii) The distribution of Security X is treated as a

distribution of money in an amount equal to the

fair market value of Security X on the date of

distribution ($500). (The amount of the distribution that is treated as money is not reduced under

section 731(c)(3)(B) and paragraph (b) of this

section because, if Security X had been sold

immediately before the distribution, there would

have been no gain recognized by AB and A’s

distributive share of the gain would therefore have

been zero.) As a result, A recognizes $250 of gain

under section 731(a)(1) on the distribution ($500

distribution of money less $250 adjusted tax basis

in A’s partnership interest).

Example 2. Reduction in amount treated as

money—in general. (i) A and B form partnership

AB as equal partners. AB subsequently distributes

Security X to A in a current distribution. Immediately before the distribution, AB held securities

with the following fair market values, adjusted tax

bases, and unrecognized gain or loss:

Security X

Security Y

Security Z

Value

Basis

Gain (Loss)

100

110

(10)

(ii) If AB had sold the securities for fair market

value immediately before the distribution to A, the

partnership would have recognized $40 of net gain

($30 gain on Security X plus $20 gain on Security

Y minus $10 loss on Security Z). A’s distributive

share of this gain would have been $20 (one-half

of $40 net gain). If AB had sold the remaining

securities immediately after the distribution of

Security X to A, the partnership would have $10

of net gain ($20 of gain on Security Y minus $10

loss on Security Z). A’s distributive share of this

gain would have been $5 (one-half of $10 net

gain). As a result, the distribution resulted in a

decrease of $15 in A’s distributive share of the net

gain in AB’s securities ($20 net gain before

distribution minus $5 net gain after distribution).

(iii) Under paragraph (b) of this section, the

amount of the distribution of Security X that is

treated as a distribution of money is reduced by

$15. The distribution of Security X is therefore

treated as a distribution of $85 of money to A

($100 fair market value of Security X minus $15

reduction).

Example 3. Reduction in amount treated as

money—carried interest. (i) A and B form partnership AB. A contributes $1,000 and provides substantial services to the partnership in exchange for

a 60 percent interest in partnership profits. B

contributes $1,000 in exchange for a 40 percent

interest in partnership profits. AB subsequently

distributes Security X to A in a current distribution. Immediately before the distribution, AB held

securities with the following fair market values,

adjusted tax bases, and unrecognized gain:

Security X

Security Y

Value

Basis

Gain

100

(ii) If AB had sold the securities for fair market

value immediately before the distribution to A, the

partnership would have recognized $30 of net gain

($20 gain on Security X plus $10 gain on Security

Y). A’s distributive share of this gain would have

been $18 (60 percent of $30 net gain). If AB had

sold the remaining securities immediately after the

distribution of Security X to A, the partnership

would have $10 of net gain ($10 gain on Security

Y). A’s distributive share of this gain would have

been $6 (60 percent of $10 net gain). As a result,

the distribution resulted in a decrease of $12 in

A’s distributive share of the net gain in AB’s

securities ($18 net gain before distribution minus

$6 net gain after distribution).

(iii) Under paragraph (b) of this section, the

amount of the distribution of Security X that is

treated as a distribution of money is reduced by

$12. The distribution of Security X is therefore

treated as a distribution of $88 of money to A

($100 fair market value of Security X minus $12

reduction).

Example 4. Reduction in amount treated as

money—change in partnership allocations. (i) A is

admitted to partnership ABC as a partner with a 1

percent interest in partnership profits. At the time

of A’s admission, ABC held no securities. ABC

subsequently acquires Security X. A’s interest in

partnership profits is subsequently increased to 2

percent for securities acquired after the increase. A

retains a 1 percent interest in all securities acquired before the increase. ABC then acquires

Securities Y and Z and later distributes Security X

to A in a current distribution. Immediately before

the distribution, the securities held by ABC had

the following fair market values, adjusted tax

bases, and unrecognized gain or loss:

Security X

Security Y

Security Z

Value

Basis

Gain (Loss)

1,000

500

800

1,100

500

200

(100)

(ii) If ABC had sold the securities for fair

market value immediately before the distribution

to A, the partnership would have recognized $600

of net gain ($500 gain on Security X plus $200

gain on Security Y minus $100 loss on Security

Z). A’s distributive share of this gain would have

been $7 (1 percent of $500 gain on Security X

plus 2 percent of $200 gain on Security Y minus 2

percent of $100 loss on Security Z).

(iii) If ABC had sold the remaining securities

immediately after the distribution of Security X to

A, the partnership would have $100 of net gain

($200 gain on Security Y minus $100 loss on

Security Z). A’s distributive share of this gain

would have been $2 (2 percent of $200 gain on

Security Y minus 2 percent of $100 loss on

Security Z). As a result, the distribution resulted in

a decrease of $5 in A’s distributive share of the

net gain in ABC’s securities ($7 net gain before

distribution minus $2 net gain after distribution).

(iv) Under paragraph (b) of this section, the

amount of the distribution of Security X that is

treated as a distribution of money is reduced by

$5. The distribution of Security X is therefore

treated as a distribution of $995 of money to A

($1000 fair market value of Security X minus $5

reduction).

Example 5. Basis consequences—distribution of

marketable security. (i) A and B form partnership

AB as equal partners. A contributes nondepreciable

real property with a fair market value and adjusted

tax basis of $100.

(ii) AB subsequently distributes Security X with

a fair market value of $120 and an adjusted tax

basis of $90 to A in a current distribution. At the

time of distribution, the basis in A’s interest in the

partnership is $100. The amount of the distribution

that is treated as money is reduced under section

731(c)(3)(B) and paragraph (b)(2) of this section

by $15 (one- half of $30 net gain in Security X).

As a result, A recognizes $5 of gain under section

731(a) on the distribution (excess of $105 distribution of money over $100 adjusted tax basis in A’s

partnership interest).

(iii) A’s adjusted tax basis in Security X is $95

($90 adjusted basis of Security X determined

under section 732(a)(1) plus $5 of gain recognized

by A by reason of section 731(c)). The basis in A’s

interest in the partnership is $10 as determined

under section 733 ($100 pre-distribution basis

minus $90 basis allocated to Security X under

section 732).

Example 6. Basis consequences—distribution of

marketable security and other property. (i) A and

B form partnership AB as equal partners. A

contributes nondepreciable real property, with a

fair market value of $100 and an adjusted tax

basis of $10.

(ii) AB subsequently distributes Security X with

a fair market value and adjusted tax basis of $40

to A in a current distribution and, as part of the

same distribution, AB distributes Property Z to A

with an adjusted tax basis and fair market value of

$40. At the time of distribution, the basis in A’s

interest in the partnership is $10. A recognizes $30

of gain under section 731(a) on the distribution

(excess of $40 distribution of money over $10

adjusted tax basis in A’s partnership interest).

(iii) A’s adjusted tax basis in Security X is $35

($5 adjusted basis determined under section

732(a)(2) plus $30 of gain recognized by A by

reason of section 731(c)). A’s basis in Property Z

is $5, as determined under section 732(a)(2). The

basis in A’s interest in the partnership is $0 as

determined under section 733 ($10 pre-distribution

basis minus $10 basis allocated between Security

X and Property Z under section 732).

(iv) AB’s adjusted tax basis in the remaining

partnership assets is unchanged unless the partnership has a section 754 election in effect. If AB

made such an election, the aggregate basis of AB’s

assets would be increased by $70 (the difference

between the $80 combined basis of Security X and

Property Z in the hands of the partnership before

the distribution and the $10 combined basis of the

distributed property in the hands of A under

section 732 after the distribution). Under section

731(c)(5), no adjustment is made to partnership

property under section 734 as a result of any gain

recognized by A by reason of section 731(c) or as

a result of any step-up in basis in the distributed

marketable securities in the hands of A by reason

of section 731(c).

Example 7. Coordination with section 737. (i) A

and B form partnership AB. A contributes Property

A, nondepreciable real property with a fair market

value of $200 and an adjusted basis of $100 in

exchange for a 25 percent interest in partnership

capital and profits. AB owns marketable Security

(ii) Within five years of the contribution of

Property A, AB subsequently distributes Security

X, with a fair market value of $120 and an

adjusted tax basis of $100, to A in a current

distribution that is subject to section 737. As part

of the same distribution, AB distributes Property Y

to A with a fair market value of $20 and an

adjusted tax basis of $0. At the time of distribution, there has been no change in the fair market

value of Property A or the adjusted tax basis in

A’s interest in the partnership.

(iii) If AB had sold Security X for fair market

value immediately before the distribution to A, the

partnership would have recognized $20 of gain.

A’s distributive share of this gain would have been

$5 (25 percent of $20 gain). Because AB has no

other marketable securities, A’s distributive share

of gain in partnership securities after the distribution would have been $0. As a result, the distribution resulted in a decrease of $5 in A’s share of

the net gain in AB’s securities ($5 net gain before

distribution minus $0 net gain after distribution).

Under paragraph (b)(2) of this section, the amount

of the distribution of Security X that is treated as a

distribution of money is reduced by $5. The

distribution of Security X is therefore treated as a

distribution of $115 of money to A ($120 fair

market value of Security X minus $5 reduction).

The portion of the distribution of the marketable

security that is not treated as a distribution of

money ($5) is treated as other property for

purposes of section 737.

(iv) A recognizes total gain of $40 on the

distribution. A recognizes $15 of gain under

section 731(a)(1) on the distribution of the portion

of Security X treated as money ($115 distribution

of money less $100 adjusted tax basis in A’s

partnership interest). A recognizes $25 of gain

under section 737 on the distribution of Property Y

and the portion of Security X that is not treated as

money. A’s section 737 gain is equal to the lesser

of (i) A’s precontribution gain ($100) or (ii) the

excess of the fair market value of property

received ($20 fair market value of Property Y plus

$5 portion of Security X not treated as money)

over the adjusted basis in A’s interest in the

partnership immediately before the distribution

($100) reduced (but not below zero) by the

amount of money received in the distribution

($115).

(v) A’s adjusted tax basis in Security X is $115

($100 basis of Security X determined under section 732(a) plus $15 of gain recognized by reason

of section 731(c)). A’s adjusted tax basis in

Property Y is $0 under section 732(a). The basis in

A’s interest in the partnership is $25 ($100 basis

before distribution minus $100 basis allocated to

Security X under section 732(a) plus $25 gain

recognized under section 737).

(k) Effective date. This section applies to distributions made on or after

December 26, 1996. However, taxpayers

may apply the rules of this section to

distributions made after December 8,

1994, and before December 26, 1996.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved November 27, 1996.

Donald C. Lubick,

Assistant Secretary of the

Treasury (Tax Policy).

(Filed by the Office of the Federal Register on

December 24, 1996, 8:45 a.m., and published in

the issue of the Federal Register for December 26,

1996, 61 F.R. 67936)

Section 1291.—Interest on Tax

Deferral

26 CFR 1291–9: Deemed dividend election.

T.D. 8701

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

Treatment of Shareholders of

Certain Passive Foreign Investment

Companies

AGENCY: Internal Revenue Service

(IRS), Treasury

ACTION: Final and temporary regulations.

SUMMARY: This document contains final regulations that provide rules for

making the deemed sale and deemed

dividend elections under section

1291(d)(2). These regulations reflect

changes to the law made by the Tax

Reform Act of 1986 and the Technical

and Miscellaneous Revenue Act of

1988, and apply to a shareholder of a

passive foreign investment company

(PFIC) that elects under section 1295 to

treat the PFIC as a qualified electing

fund (QEF) for a taxable year after the

first taxable year during the shareholder’s holding period that the foreign

corporation was a PFIC.

DATES: These regulations are effective

December 27, 1996.

Applicability: For the specific dates

of applicability, see §§ 1.1291–9(k) and

1.1291–10(i).

FOR FURTHER INFORMATION

CONTACT: Gayle Novig, (202) 622–

3880 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained in these final regulations have

been reviewed and approved by the

Office of Management and Budget in

accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under control

numbers 1545–1028 and 1545– 1304.

All of these paperwork requirements

will be consolidated under control number 1545–1507. Responses to these collections of information are mandatory.

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

respond to, a collection of information

unless the collection of information displays a valid control number.

The estimated annual burden per respondent varies from .75 hour to 1 hour,

depending on individual circumstances,

with an estimated average of .76 hour.

Comments concerning the accuracy of

this burden estimate and suggestions for

reducing this burden should be sent to

the Internal Revenue Service, Attn:

IRS Reports Clearance Officer, T:FP,

Washington, DC 20224, and to the Office of Management and Budget, Attn:

Desk Officer for the Department of the

Treasury, Office of Information and

Regulatory Affairs, Washington, DC

20503.

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

as long as their contents may become

material in the administration of any

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

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

6103.

Background

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

Regulations (26 CFR part 1) under

section 1291(d)(2) of the Internal Revenue Code. The final regulations provide

rules for making a deemed sale or

deemed dividend election to purge a

shareholder’s holding period of stock of

a PFIC of those taxable years during

which the PFIC was not a QEF. The Tax

Reform Act of 1986 added section

1291(d)(2)(A), relating to the deemed

sale election, effective for taxable years

of foreign corporations beginning after

December 31, 1986. The Technical and

Miscellaneous Revenue Act of 1988

amended section 1291(d)(2) to add new

section 1291(d)(2)(B), relating to the

deemed dividend election, effective for

taxable years of foreign corporations

beginning after December 31, 1986.

On March 2, 1988, temporary regulations (T.D. 8178 [1988–1 C.B. 313])

relating to the deemed sale election

under section 1291(d)(2)(A), in addition

to elections under sections 1294, 1295,

and 1297, were published in the Federal

proposed rulemaking (INTL–941–86

[1988–1 C.B. 916]) cross-referencing

the temporary regulations was also published in the Federal Register for the

same day (53 FR 6781).

On April 1, 1992, temporary regulations (T.D. 8404 [1992–1 C.B. 296])

relating to both the deemed sale and

deemed dividend elections under section

1291(d)(2)(A) and (B), were published

in the Federal Register (57 FR 10992).

A notice of proposed rulemaking

(INTL–941–86; INTL–656–87; INTL–

704–87 [1992–1 C.B. 1124]) crossreferencing the temporary regulations

was published in the Federal Register

for the same day (57 FR 11024).

Written comments responding to these

notices were received. No public hearing

was held for the notice of proposed

rulemaking published on March 2, 1988.

A public hearing was held November

23, 1992, for the notice of proposed

rulemaking published April 1, 1992.

After consideration of all the comments,

the proposed regulations under section

1291(d)(2) are adopted as revised by

this Treasury decision, and the corresponding temporary regulations are removed. Substantive revisions are discussed below. All other revisions are

stylistic, and are primarily intended to

conform

the

regulations

under

§ 1.1291–10 to those under § 1.1291–9.

Explanation of Provisions and Revisions

and Summary of Comments

1. Introduction

A shareholder of a foreign corporation

that qualifies as a PFIC under the

income or asset test of section 1296 is

subject to the special interest charge

regime of section 1291 with respect to

certain distributions by the PFIC and

dispositions of the stock of the PFIC.

Provided the PFIC complies with certain

election requirements, a shareholder may

elect under section 1295 to treat the

PFIC as a QEF. If the election is made,

the shareholder is subject to the current

inclusion regime of section 1293. If the

shareholder makes the section 1295

election for the first year of its holding

period for the foreign corporation during

which year the foreign corporation is a

PFIC, the shareholder is only subject to

PFIC taxation under the current inclusion regime. Such a PFIC is a pedigreed

QEF with respect to the shareholder.

However, if the shareholder makes the

section 1295 election for a later year,

the shareholder is subject to both the

interest charge regime of section 1291

and the current inclusion regime of

section 1293. Such a PFIC is an

unpedigreed QEF with respect to the

shareholder. To limit its PFIC taxation

to the current inclusion regime of section 1293, a shareholder that makes the

section 1295 election may also make a

section 1291(d)(2) election to purge its

holding period of the years, or parts of

years, before the effective date of the

QEF election during which the foreign

corporation was a PFIC (nonQEF years).

Thereafter, the PFIC will be treated as a

pedigreed QEF with respect to the

shareholder.

Section 1291(d)(2) provides two

methods to purge the nonQEF years

from a shareholder’s holding period of

PFIC stock. A shareholder may elect

under section 1291(d)(2)(A) to be

treated as having sold the stock of the

PFIC. The gain on the deemed sale is

subject to the interest charge regime and

therefore taxed as an excess distribution

under section 1291. Alternatively, if the

PFIC is a controlled foreign corporation

(CFC), any U.S. person that is a shareholder of the PFIC may elect under

section 1291(d)(2)(B) to be treated as

receiving a dividend in the amount of its

pro rata share of the post-1986 undistributed earnings and profits of the

PFIC. The deemed dividend is taxed to

the shareholder as an excess distribution

under the interest charge regime. If

either election is made, the shareholder’s

holding period is treated, for purposes of

the PFIC rules, as beginning on the date

of the deemed sale or dividend (qualification date).

2. Revisions to the Regulations

Section 1.1291–9 provides the rules

for making the deemed dividend election under section 1291(d)(2)(B) with

respect to a PFIC that is a CFC. Section

1.1291–10 provides the rules for making

the deemed sale election under section

1291(d)(2)(A). The final regulations

generally follow the proposed regulations with the exceptions described below.

a. Qualification Date

The 1988 temporary regulations under

§ 1.1291–10T provided that, in general,

the date of the deemed sale, referred to

as the qualification date, is the first day

of the first taxable year of the corporation that it is treated as a QEF under

section 1295 (first QEF year). However,

the temporary and proposed amendments to § 1.1291–10T published in

1992 changed the qualification date for

elections made after May 1, 1992, to the

first day of the taxable year for which

the shareholder made the QEF election

(shareholder’s election year). Similarly,

under the temporary and proposed

§ 1.1291–9 regulations, the qualification

date is the first day of the shareholder’s

election year.

Commenters described a potential

problem with the designation of the first

day of the shareholder’s election year as

the qualification date where the corporation and the shareholder have different

taxable years. In this circumstance, the

purging election would not avoid application of the interest charge regime to

distributions and dispositions during the

period between the first day of the

corporation’s first QEF year and the first

day of the shareholder’s election year.

In response to comments, the final

regulations adopt the definition of qualification date used in the 1988 temporary

regulations for purposes of both the

deemed sale and deemed dividend elections made on or after January 27, 1997.

For the period after March 31, 1995, to

January 26, 1997, the final regulations

adopt the definition of qualification date

of the 1992 temporary regulations. In

addition, the final regulations permit a

shareholder that made the deemed sale

or deemed dividend election after May

1, 1992 and on or before January 27,

1997, to amend its election and treat the

deemed sale or deemed dividend as

occurring on the first day of the PFIC’s

first QEF year, provided the periods of

limitations on assessment for the taxable

year that includes that date and for the

shareholder’s election year have not expired.

In response to comments, the final

regulations also clarify that if the shareholder’s holding period under section

1223 includes the first day of the first

QEF year, the shareholder will be

treated as holding the stock on that date.

Therefore, the shareholder may make a

section 1291(d)(2) election for the first

QEF year.

b. Elections made with respect to

former PFICs

Section 1.1291–9(h) of the proposed

regulations provides that a shareholder

cannot apply the deemed dividend rules

of section 1291(d)(2)(B) to purge PFIC

taint, pursuant to section 1297(b)(1),

from the stock of a foreign corporation

that no longer is a PFIC under either the

asset or income test of section 1296(a),

but whose stock nevertheless is treated

as stock of a PFIC with respect to a

shareholder pursuant to section

1297(b)(1) (former PFIC). In addition,

the proposed regulations provide that the

section 1291(d)(2)(B) election cannot be

made with respect to a corporation that

will not qualify as a PFIC under section

1296(a)(1) or (2) in the first QEF year.

Several commenters disagreed with

the position taken in § 1.1291–9(h) of

the proposed regulations. Section

1.1291– 9(i)(1) of the final regulations

does not accept these comments and

adopts the rule of the proposed regulation denying application of the rules of

section 1291(d)(2)(B) for purposes of a

section 1297(b)(1) election. In addition,

§ 1.1291–9(i)(2) modifies the rule of

proposed regulation § 1.1291–9(h)(2) to

clarify that the section 1295 and 1291(d)(2)(B) elections cannot be made with

respect to a former PFIC. Section

1.1291–10(h) of the final regulations

adopts a similar rule, clarifying that a

shareholder of a former PFIC cannot

make the section 1295 and 1291(d)(2)(A) elections. Thus, section 1295 and

section 1291(d)(2) elections may only

be made with respect to a foreign

corporation that is a PFIC by definition

under section 1296. Accordingly, the

deemed sale election of section 1297(b)(1) remains the only means by which

a shareholder may purge a former PFIC

of its PFIC taint.

c. Qualification as a CFC

The final regulations, in response to

comments, clarify that a shareholder

may make the deemed dividend election

provided the PFIC qualifies as a CFC

for its first QEF year.

d. Time for making the elections

In response to comments, the final

regulations clarify the time for making

the deemed sale and dividend elections.

The regulations provide that if the

shareholder and the PFIC have the same

taxable year, and therefore the first day

of the shareholder’s election year and

the qualification date are the same, the

shareholder may make the election in

the same return in which it makes the

section 1295 election or in an amended

return. The regulations also provide that

if the shareholder and the PFIC have

different taxable years and therefore the

qualification date precedes the first day

of the shareholder’s election year, the

shareholder must make the deemed sale

or deemed dividend election in an

amended return. If the shareholder is

making the section 1291(d)(2) election

in an amended return, the amended

return must be filed within three years

of the due date, as extended under

section 6081, for the return for the

taxable year that includes the qualification date.

e. Post-1986 accumulated earnings and

profits

The proposed regulations provide that

the shareholder’s old holding period for

purposes of the PFIC rules ends on the

qualification date, but also provide that

its new holding period begins on the

qualification date. These rules may have

caused confusion concerning the last

day of the holding period for purposes

of determining post-1986 accumulated

earnings and profits. The final regulations revise the holding period rules to

provide that the shareholder’s holding

period ends on the day before the

qualification date for purposes of calculating the amount of the deemed dividend.

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 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. These regulations, which have

a retroactive effective date, satisfy the

Administrative Procedure Act’s requirement in section 553(d) for good cause

because they provide necessary guidance

for the period after March 31, 1995, and

because they are not detrimental to

taxpayers. These regulations are necessary because they provide taxpayers

with the rules needed to make the

elections under section 1291(d)(2). Pursuant to section 7805(f) of the Internal

Revenue Code, the notices of proposed

rulemaking preceding these regulations

were submitted to the Small Business

Administration for comment on their

impact on small business.

Drafting Information

The principal author of these regulations is Gayle Novig, Office of the

Associate Chief Counsel (International).

However, other personnel from the IRS

and Treasury Department participated in

their development.

26 CFR Part 602

Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 602

are amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation

for part 1 is amended by removing the

entry for section 1.1291–9T and the

entry for sections 1.1291–10T, 1.1294–

1T, 1.1295–1T, and 1.1297–3T, and by

adding entries in numerical order to read

as follows:

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

Section 1.1291–9 also issued under 26

U.S.C. 1291(d)(2).

Section 1.1291–10 also issued under

26 U.S.C. 1291(d)(2).

Section 1.1294–1T also issued under

26 U.S.C. 1294.

Section 1.1297–3T also issued under

26 U.S.C. 1297(b)(1).***

Par. 2. Section 1.1291–0 is added to

read as follows:

§ 1.1291–0 Treatment of shareholders

of certain passive foreign investment

companies; table of contents.

This section contains a listing of the

headings for §§ 1.1291–9 and 1.1291–

10.

§ 1.1291–9 Deemed dividend election.

(a) Deemed dividend election.

(1) In general.

(2) Post-1986 earnings and profits defined.

(i) In general.

(ii) Pro rata share of post-1986 earnings and profits attributable to shareholder’s stock.

(A) In general.

(B) Reduction for previously taxed

amounts.

(b) Who may make the election.

(d) Manner of making the election.

(1) In general.

(2) Attachment to Form 8621

(e) Qualification date.

(1) In general.

(2) Elections made after March 31,

1995, and before January 27, 1997.

(i) In general.

(ii) Exception.

(3) Examples.

(f) Adjustment to basis.

(g) Treatment of holding period.

(h) Coordination with section 959(e).

(i) Election inapplicable to shareholder of former PFIC.

(1) Coordination

with

section

1297(b)(1).

(2) Former PFIC.

(j) Definitions.

(1) Passive foreign investment company (PFIC).

(2) Types of PFICs.

(i) Qualified electing fund (QEF).

(ii) Pedigreed QEF.

(iii) Unpedigreed QEF.

(iv) Former PFIC.

(3) Shareholder.

(k) Effective date.

§ 1.1291–10 Deemed sale election.

(a) Deemed sale election.

(b) Who may make the election.

(d) Manner of making the election.

(e) Qualification date.

(1) In general.

(2) Elections made after March 31,

1995, and before January 27, 1997.

(i) In general.

(ii) Exception.

(f) Adjustments to basis.

(1) In general.

(2) Adjustment to basis for section

1293 inclusion with respect to deemed

sale election made after March 31,

1995, and before January 27, 1997.

(g) Treatment of

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