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Bulletin No. 1999–5

February 1, 1999

Internal Revenue

bulletin

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

ADMINISTRATIVE

Rev. Rul. 99–7, page 4.

Rev. Proc. 99–14, page 56.

Deductibility of daily transportation expenses. This ruling provides the rules for determining whether daily transportation expenses incurred by a taxpayer in going between

the taxpayer’s residence and a work location are deductible

business expenses under section 162(a) of the Code.

T.D. 8791, page 7.

Final regulations under section 664 of the Code relate to

charitable remainder trusts and to special valuation rules for

transfers of interests in trusts.

T.D. 8797, page 5.

Final regulations relate to start-up expenditures for active

trades or businesses under section 195 of the Code.

T.D. 8805, page 14.

Final regulations and temporary regulations under sections

865 and 904 of the Code relate to the allocation of loss recognized on the disposition of stock and other personal property and the computation of the foreign tax credit limitation.

EMPLOYEE PLANS

Rev. Proc. 99–13, page 52.

Tax-sheltered annuities; operational defects; closing

agreements. A program whereby tax-sheltered annuities

within the meaning of section 403(b) of the Code may correct certain operational defects or enter into closing agreements with the Service is set forth. Rev. Proc. 98–22 modified and amplified.

EXEMPT ORGANIZATIONS

Announcement 99–10, page 63.

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

Finding Lists begin on page 67.

Index for January begins on page 69.

Department of the Treasury

Internal Revenue Service

Automobile owners and lessees. This procedure provides owners and lessees of passenger automobiles (including electric automobiles) with tables detailing the limitations

on depreciation deductions for automobiles first placed in

service during calendar year 1999 and the amounts to be

included in income for automobiles first leased during calendar year 1999. In addition, this procedure provides the maximum allowable value of employer-provided automobiles first

made available to employees for personal use in calendar

year 1999 for which the vehicle cents-per-mile valuation rule

provided under section 1.61–21(e) of the Income Tax

Regulations may be applicable.

Notice 99–8, page 26.

This notice announces that the Service will make certain

changes to the section 1441 withholding regulations, and

provides the text of a model qualified intermediary withholding agreement.

Announcement 99–11, page 64.

This announcement provides guidance for 1997–1998 fiscal

year filers of the 1997 Schedule D for Forms 1040, 1041,

1065, and 1120S.

Announcement 99–12, page 65.

Rev. Proc. 98–44, 1998–32 I.R.B. 11, Specifications for Filing Forms 1042–S, Foreign Person’s U.S. Source Income

Subject to Withholding, Magnetically/Electronically, is corrected.

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Mission of the Service

and by applying the tax law with integrity and fairness to

all.

Provide America’s taxpayers top quality service by helping them understand and meet their tax responsibilities

Statement of Principles

of Internal Revenue

Tax Administration

The Service also has the responsibility of applying and

administering the law in a reasonable, practical manner.

Issues should only be raised by examining officers when

they have merit, never arbitrarily or for trading purposes.

At the same time, the examining officer should never hesitate to raise a meritorious issue. It is also important that

care be exercised not to raise an issue or to ask a court to

adopt a position inconsistent with an established Service

position.

The function of the Internal Revenue Service is to administer the Internal Revenue Code. Tax policy for raising revenue

is determined by Congress.

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

policy by correctly applying the laws enacted by Congress;

to determine the reasonable meaning of various Code provisions in light of the Congressional purpose in enacting them;

and to perform this work in a fair and impartial manner, with

neither a government nor a taxpayer point of view.

Administration should be both reasonable and vigorous. It

should be conducted with as little delay as possible and

with great courtesy and considerateness. It should never

try to overreach, and should be reasonable within the

bounds of law and sound administration. It should, however, be vigorous in requiring compliance with law and it

should be relentless in its attack on unreal tax devices and

fraud.

At the heart of administration is interpretation of the Code. It

is the responsibility of each person in the Service, charged

with the duty of interpreting the law, to try to find the true

meaning of the statutory provision and not to adopt a

strained construction in the belief that he or she is “protecting the revenue.” The revenue is properly protected only

when we ascertain and apply the true meaning of the statute.

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Introduction

The Internal Revenue Bulletin is the authoritative instrument

of the Commissioner of Internal Revenue for announcing official rulings and procedures of the Internal Revenue Service

and for publishing Treasury Decisions, Executive Orders, Tax

Conventions, legislation, court decisions, and other items of

general interest. It is published weekly and may be obtained

from the Superintendent of Documents on a subscription

basis. Bulletin contents of a permanent nature are consolidated semiannually into Cumulative Bulletins, which are sold

on a single-copy basis.

dures must be considered, and Service personnel and others concerned are cautioned against reaching the same conclusions in other cases unless the facts and circumstances

are substantially the same.

The Bulletin is divided into four parts as follows:

Part I.—1986 Code.

This part includes rulings and decisions based on provisions

of the Internal Revenue Code of 1986.

It is the policy of the Service to publish in the Bulletin all substantive rulings necessary to promote a uniform application

of the tax laws, including all rulings that supersede, revoke,

modify, or amend any of those previously published in the

Bulletin. All published rulings apply retroactively unless otherwise indicated. Procedures relating solely to matters of internal management are not published; however, statements

of internal practices and procedures that affect the rights

and duties of taxpayers are published.

Part II.—Treaties and Tax Legislation.

This part is divided into two subparts as follows: Subpart A,

Tax Conventions, and Subpart B, Legislation and Related

Committee Reports.

Part III.—Administrative, Procedural, and Miscellaneous.

To the extent practicable, pertinent cross references to

these subjects are contained in the other Parts and Subparts. Also included in this part are Bank Secrecy Act Administrative Rulings. Bank Secrecy Act Administrative Rulings

are issued by the Department of the Treasury’s Office of the

Assistant Secretary (Enforcement).

Revenue rulings represent the conclusions of the Service on

the application of the law to the pivotal facts stated in the

revenue ruling. In those based on positions taken in rulings

to taxpayers or technical advice to Service field offices,

identifying details and information of a confidential nature

are deleted to prevent unwarranted invasions of privacy and

to comply with statutory requirements.

Part IV.—Items of General Interest.

With the exception of the Notice of Proposed Rulemaking

and the disbarment and suspension list included in this part,

none of these announcements are consolidated in the Cumulative Bulletins.

Rulings and procedures reported in the Bulletin do not have

the force and effect of Treasury Department Regulations,

but they may be used as precedents. Unpublished rulings

will not be relied on, used, or cited as precedents by Service

personnel in the disposition of other cases. In applying published rulings and procedures, the effect of subsequent legislation, regulations, court decisions, rulings, and proce-

The first Bulletin for each month includes a cumulative index

for the matters published during the preceding months.

These monthly indexes are cumulated on a quarterly and

semiannual basis, and are published in the first Bulletin of the

succeeding quarterly and semiannual period, respectively.

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

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

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

Section 162.—Trade or

Business Expenses

26 CFR 1.162–2: Traveling expenses.

(Also sections 262; 1.262–1.)

Deductibility of daily transportation

expenses. This ruling provides the rules

for determining whether daily transportation expenses incurred by a taxpayer in

going between the taxpayer’s residence

and a work location are deductible business expenses under section 162(a) of the

Code.

Rev. Rul. 99–7

ISSUE

Under what circumstances are daily

transportation expenses incurred by a taxpayer in going between the taxpayer’s

residence and a work location deductible

under § 162(a) of the Internal Revenue

Code?

LAW AND ANALYSIS

Section 162(a) allows a deduction for

all the ordinary and necessary expenses

paid or incurred during the taxable year in

carrying on any trade or business. Section 262, however, provides that no deduction is allowed for personal, living, or

family expenses.

A taxpayer’s costs of commuting between the taxpayer’s residence and the

taxpayer’s place of business or employment generally are nondeductible personal expenses under §§ 1.162–2(e) and

1.262–1(b)(5) of the Income Tax Regulations. However, the costs of going between one business location and another

business location generally are deductible

under § 162(a). Rev. Rul. 55–109,

1955–1 C.B. 261.

Section 280A(c)(1)(A) (as amended by

§ 932 of the Taxpayer Relief Act of 1997,

Pub. L. No. 105–34, 111 Stat. 881, effective for taxable years beginning after December 31, 1998) provides, in part, that a

taxpayer may deduct expenses for the

business use of the portion of the taxpayer’s personal residence that is exclusively used on a regular basis as the principal place of business for any trade or

business of the taxpayer. (In the case of

an employee, however, such expenses are

February 1, 1999

deductible only if the exclusive and regular use of the portion of the residence is

for the convenience of the employer.) In

Curphey v. Commissioner, 73 T.C. 766

(1980), the Tax Court held that daily

transportation expenses incurred in going

between an office in a taxpayer’s residence and other work locations were deductible where the home office was the

taxpayer’s principal place of business

within the meaning of § 280A(c)(1)(A)

for the trade or business conducted by the

taxpayer at those other work locations.

The court stated that “[w]e see no reason

why the rule that local transportation expenses incurred in travel between one

business location and another are deductible should not be equally applicable

where the taxpayer’s principal place of

business with respect to the activities involved is his residence.” 73 T.C. at 777–

778 (emphasis in original). Implicit in the

court’s analysis in Curphey is that the deductibility of daily transportation expenses is determined on a business-bybusiness basis.

Rev. Rul. 190, 1953–2 C.B. 303, provides a limited exception to the general

rule that the expenses of going between a

taxpayer’s residence and a work location

are nondeductible commuting expenses.

Rev. Rul. 190 deals with a taxpayer who

lives and ordinarily works in a particular

metropolitan area but who is not regularly

employed at any specific work location.

In such a case, the general rule is that

daily transportation expenses are not deductible when paid or incurred by the taxpayer in going between the taxpayer’s

residence and a temporary work site inside that metropolitan area because that

area is considered the taxpayer’s regular

place of business. However, Rev. Rul.

190 holds that daily transportation expenses are deductible business expenses

when paid or incurred in going between

the taxpayer’s residence and a temporary

work site outside that metropolitan area.

Rev. Rul. 90–23, 1990–1 C.B. 28, distinguishes Rev. Rul. 190 and holds, in

part, that, for a taxpayer who has one or

more regular places of business, daily

transportation expenses paid or incurred

in going between the taxpayer’s residence

and temporary work locations are de-

ductible business expenses under

§ 162(a), regardless of the distance.

Rev. Rul. 94–47, 1994–2 C.B. 18, amplifies and clarifies Rev. Rul. 190 and

Rev. Rul. 90–23, and provides several

rules for determining whether daily transportation expenses are deductible business expenses under § 162(a). Under

Rev. Rul. 94–47, a taxpayer generally

may not deduct daily transportation expenses incurred in going between the taxpayer’s residence and a work location. A

taxpayer, however, may deduct daily

transportation expenses incurred in going

between the taxpayer’s residence and a

temporary work location outside the metropolitan area where the taxpayer lives

and normally works. In addition, Rev.

Rul. 94–47 clarifies Rev. Rul. 90–23 to

provide that a taxpayer must have at least

one regular place of business located

“away from the taxpayer’s residence” in

order to deduct daily transportation expenses incurred in going between the taxpayer’s residence and a temporary work

location in the same trade or business, regardless of the distance. In this regard,

Rev. Rul. 94–47 also states that the Service will not follow the decision in

Walker v. Commissioner, 101 T.C. 537

(1993). Finally, Rev. Rul. 94–47 amplifies Rev. Rul. 190 and Rev. Rul. 90–23 to

provide that, if the taxpayer’s residence is

the taxpayer’s principal place of business

within the meaning of § 280A(c)(1)(A),

the taxpayer may deduct daily transportation expenses incurred in going between

the taxpayer’s residence and another work

location in the same trade or business, regardless of whether the other work location is regular or temporary and regardless of the distance.

For purposes of both Rev. Rul. 90–23

and Rev. Rul. 94–47, a temporary work

location is defined as any location at

which the taxpayer performs services on

an irregular or short-term (i.e., generally a

matter of days or weeks) basis. However,

for purposes of determining whether daily

transportation expense allowances and

per diem travel allowances for meal and

lodging expenses are subject to income

tax withholding under § 3402, Rev. Rul.

59–371, 1959–2 C.B. 236, provides a 1year standard to determine whether a

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work location is temporary. Similarly, for

purposes of determining the deductibility

of travel away-from-home expenses under

§ 162(a)(2), Rev. Rul. 93–86, 1993–2 C.B.

71, generally provides a 1-year standard to

determine whether a work location will be

treated as temporary.

The Service has reconsidered the definition of a temporary work location in Rev.

Rul. 90–23 and Rev. Rul. 94–47, and will

replace the “irregular or short-term (i.e.,

generally a matter of days or weeks)

basis” standard in those rulings with a 1year standard similar to the rules set forth

in Rev. Rul. 59–371 and Rev. Rul. 93–86.

If an office in the taxpayer’s residence

satisfies the principal place of business requirements of § 280A(c)(1)(A), then the

residence is considered a business location for purposes of Rev. Rul. 90–23 or

Rev. Rul. 94–47. In these circumstances,

the daily transportation expenses incurred

in going between the residence and other

work locations in the same trade or business are ordinary and necessary business

expenses (deductible under § 162(a)). See

Curphey; see also Wisconsin Psychiatric

Services v. Commissioner, 76 T.C. 839

(1981). In contrast, if an office in the

taxpayer’s residence does not satisfy the

principal place of business requirements

of § 280A(c)(1)(A), then the business activity there (if any) is not sufficient to

overcome the inherently personal nature

of the residence and the daily transportation expenses incurred in going between

the residence and regular work locations.

In these circumstances, the residence is

not considered a business location for purposes of Rev. Rul. 90–23 or Rev. Rul.

94–47, and the daily transportation expenses incurred in going between the residence and regular work locations are personal expenses (nondeductible under

§§ 1.162–2(e) and 1.262–1(b)(5)). See

Green v. Commissioner, 59 T.C. 456

(1972); Fryer v. Commissioner, T.C. M.

1974–77.

For purposes of determining the deductibility of travel-away-from-home expenses under §162(a)(2), Rev. Rul. 93–86

defines “home” as the “taxpayer’s regular

or principal (if more than one regular)

place of business.” See Daly v. Commissioner, 72 T.C. 190 (1979), aff’d, 662 F.2d

253 (4th Cir. 1981); Flowers v. Commissioner, 326 U.S. 465 (1946), 1946–1 C.B.

57.

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HOLDING

In general, daily transportation expenses incurred in going between a taxpayer’s residence and a work location are

nondeductible commuting expenses.

However, such expenses are deductible

under the circumstances described in

paragraph (1), (2), or (3) below.

(1) A taxpayer may deduct daily transportation expenses incurred in going between the taxpayer’s residence and a temporary work location outside the

metropolitan area where the taxpayer

lives and normally works. However, unless paragraph (2) or (3) below applies,

daily transportation expenses incurred in

going between the taxpayer’s residence

and a temporary work location within that

metropolitan area are nondeductible commuting expenses.

(2) If a taxpayer has one or more regular work locations away from the taxpayer ’s residence, the taxpayer may

deduct daily transportation expenses incurred in going between the taxpayer’s

residence and a temporary work location

in the same trade or business, regardless

of the distance. (The Service will continue not to follow the Walker decision.)

(3) If a taxpayer’s residence is the taxpayer’s principal place of business within

the meaning of § 280A(c)(1)(A), the taxpayer may deduct daily transportation expenses incurred in going between the residence and another work location in the

same trade or business, regardless of

whether the other work location is regular

or temporary and regardless of the distance.

For purposes of paragraphs (1), (2), and

(3), the following rules apply in determining whether a work location is temporary.

If employment at a work location is realistically expected to last (and does in fact

last) for 1 year or less, the employment is

temporary in the absence of facts and circumstances indicating otherwise. If employment at a work location is realistically expected to last for more than 1 year

or there is no realistic expectation that the

employment will last for 1 year or less,

the employment is not temporary, regardless of whether it actually exceeds 1 year.

If employment at a work location initially

is realistically expected to last for 1 year

or less, but at some later date the employment is realistically expected to exceed 1

year, that employment will be treated as

temporary (in the absence of facts and circumstances indicating otherwise) until the

date that the taxpayer’s realistic expectation changes, and will be treated as not

temporary after that date.

The determination that a taxpayer’s

residence is the taxpayer’s principal place

of business within the meaning of

§ 280A(c)(1)(A) is not necessarily determinative of whether the residence is the

taxpayer’s tax home for other purposes,

including the travel-away-from-home deduction under § 162(a)(2).

EFFECT ON OTHER DOCUMENTS

Rev. Rul. 190 and Rev. Rul. 59–371 are

obsoleted. Rev. Rul. 90–23 and Rev. Rul

94–47 are modified (regarding the definition of temporary work location) and superseded. With respect to issues (2) and

(3) in Rev. Rul. 90–23 (regarding the gross

income and employment tax treatment of

reimbursements for employee daily transportation expenses), see § 1.62–2 regarding reimbursements in general, and Rev.

Proc. 97-58 (particularly sections 3, 9, and

10), 1997–2 C.B. 587 (or any successor),

regarding reimbursements using the optional business standard mileage rate.

Rev. Rul. 93–86 is distinguished.

DRAFTING INFORMATION

The principal author of this revenue

ruling is Edwin B. Cleverdon of the Office of Assistant Chief Counsel (Income

Tax and Accounting). For further information regarding this revenue ruling, contact Mr. Cleverdon at (202) 622-4920 (not

a toll-free call).

Section 195.—Start-up

Expenditures

26 CFR 1.195–1: Election to amortize start-up

expenditures.

T.D. 8797

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

Election to Amortize Start-Up

Expenditures for Active Trades

or Businesses

February 1, 1999

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AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains

final regulations concerning start-up expenditures for active trades or businesses

under section 195. These regulations are

necessary to provide rules and procedures

for electing to amortize start-up expenditures under section 195. They affect all

taxpayers wishing to amortize start-up expenditures under section 195.

DATES: Effective Date: These regulations are effective December 17, 1998.

Applicability Date: For the date of applicability of these regulations, see

§1.195–1(d).

FOR FURTHER INFORMATION CONTACT: David Selig, (202) 622-3040 (not

a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in these final regulations has been

reviewed and approved by the Office of

Management and Budget in accordance

with the Paperwork Reduction Act of

1995 (44 U.S.C. 3507(d)) under control

number 1545–1582.

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 .10 hours to .50

hours, depending on individual circumstances, with an estimated average of .25

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, PC: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 mater-

February 1, 1999

ial 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

Section 195 was added to the Internal

Revenue Code of 1954 by section 102 of

the Miscellaneous Revenue Act of 1980,

and was amended by section 94 of the Tax

Reform Act of 1984.

Section 195 generally provides that no

deduction is allowed for start-up expenditures unless the taxpayer elects to amortize the expenditures. Under section

195(b)(1), if the taxpayer elects to amortize start-up expenditures, the expenditures are amortizable over a period of not

less than 60 months beginning with the

month in which the active trade or business begins. Section 195(d) provides that

an election to amortize start-up expenditures must be made not later than the time

prescribed by law for filing the return for

the taxable year in which the active trade

or business begins (including extensions

thereof).

On January 13, 1998, the IRS published a notice of proposed rulemaking

[REG–209373–81, 1998–14 I.R.B. 26] in

the Federal Register (63 F.R. 1933)

proposing amendments to the Income Tax

Regulations (26 CFR part 1) concerning

the election to amortize start-up expenditures under section 195 of the Internal

Revenue Code. A public hearing was

scheduled for June 2, 1998, pursuant to a

notice of public hearing published simultaneously with the notice of proposed

rulemaking. No one requested to speak at

the public hearing, therefore, no public

hearing was held. Written comments responding to the notice were received.

After consideration of all of the comments, the proposed regulations are

adopted as revised by this Treasury decision.

Explanation of Revisions and Discussion

of Comments

The proposed regulations provide that

an election to amortize start-up expenditures is made by attaching a statement to

the taxpayer’s income tax return. The income tax return and statement must be

filed not later than the date prescribed by

law for filing the income tax return (in-

cluding any extensions of time) for the

taxable year in which the active trade or

business begins. Thus, a taxpayer may

file an election for any taxable year prior

to the year in which the taxpayer’s active

trade or business begins, and such election will become effective in the month of

the year in which the taxpayer’s active

trade or business begins.

One commentator suggested that the

provision in the proposed regulations permitting the filing of a revised statement to

include any start-up expenditures not included in the taxpayer’s original election

statement appears to endorse the practice

of those taxpayers who file elections listing token or zero start-up expenditures on

the election statement and subsequently

attempt to increase the amount subject to

amortization by expenditures that taxpayers have been unsuccessful in maintaining

as expansion costs. The provision is not

designed to permit a taxpayer to revise the

election statement to include start-up expenditures omitted by reason of the taxpayer’s claim on the taxpayer’s return that

the expenditures are expansion costs. Accordingly, the regulations have been clarified to provide that the election statement

may not be revised to include expenditures that a taxpayer has treated on the

taxpayer’s tax return in a manner inconsistent with their treatment as start-up expenditures.

Another commentator suggested that a

separate statement to make the election

under section 195 should not be required

for small businesses, but rather a checkthe-box election should be provided. A

separate statement is necessary to ensure

that the expenses listed therein are properly characterized as start-up expenditures, and that amortization of the start-up

expenditures will begin and end at the

proper times. The statement is simple to

complete and the time to prepare the

statement is minimal. Accordingly, the

final regulations retain the requirement

that a separate statement with the requisite information be attached to the taxpayer’s return.

Special Analyses

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

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is hereby certified that these regulations

do not have a significant impact on a substantial number of small entities. This

certification is based upon the fact that the

time required to prepare and file the election statement is minimal and will not

have a significant impact on those small

entities that choose to make the election.

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 Chief Counsel for

Advocacy of the Small Business Administration for comment on its impact on

small business.

Drafting Information

The principal author of these regulations is David Selig, Office of the 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 parts 1 and 602

are amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for

part 1 continues to read in part as follows:

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

Par. 2. Section 1.195–1 is added to

read as follows:

§1.195–1 Election to amortize start-up

expenditures.

(a) In general. Under section 195(b), a

taxpayer may elect to amortize start-up

expenditures (as defined in section

195(c)(1)). A taxpayer who elects to

amortize start-up expenditures must, at

the time of the election, select an amortization period of not less than 60 months,

beginning with the month in which the active trade or business begins. The election applies to all of the taxpayer’s startup expenditures with respect to the trade

or business. The election to amortize

1999–5 I.R.B

start-up expenditures is irrevocable, and

the amortization period selected by the

taxpayer in making the election may not

subsequently be changed.

(b) Time and manner of making election. The election to amortize start-up expenditures under section 195 shall be

made by attaching a statement containing

the information described in paragraph (c)

of this section to the taxpayer’s return.

The statement must be filed no later than

the date prescribed by law for filing the

return (including any extensions of time)

for the taxable year in which the active

trade or business begins. The statement

may be filed with a return for any taxable

year prior to the year in which the taxpayer’s active trade or business begins,

but no later than the date prescribed in the

preceding sentence. Accordingly, an election under section 195 filed for any taxable year prior to the year in which the

taxpayer’s active trade or business begins

(and pursuant to which the taxpayer commenced amortizing start-up expenditures

in that prior year) will become effective in

the month of the year in which the taxpayer’s active trade or business begins.

trade or business to which it relates with

sufficient detail so that expenses relating

to the trade or business can be identified

properly for the taxable year in which the

statement is filed and for all future taxable

years to which it relates. The statement

also shall include the number of months

(not less than 60) over which the expenditures are to be amortized, and to the extent known at the time the statement is

filed, a description of each start-up expenditure incurred (whether or not paid) and

the month in which the active trade or

business began (or was acquired). A revised statement may be filed to include

any start-up expenditures not included in

the taxpayer’s original election statement,

but the revised statement may not include

any expenditures for which the taxpayer

had previously taken a position on a return inconsistent with their treatment as

start-up expenditures. The revised statement may be filed with a return filed after

the return that contained the election.

(d) Effective date. This section applies

to elections filed on or after December 17,

1998.

PART 602—OMB CONTROL

NUMBERS UNDER THE

PAPERWORK REDUCTION ACT

Par. 3. The authority citation for part

602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 4. In §602.101, paragraph (c) is

amended by adding an entry to the table

in numerical order to read as follows:

§602.101 OMB Control numbers.

* * * * *

CFR part or section

where identified

and described

Current OMB

control No.

* * * * *

1.195–1 . . . . . . . . . . . . . . . . . 1545–1582

* * * * *

Bob Wenzel,

Deputy Commissioner of

Internal Revenue.

Donald C. Lubick,

Assistant Secretary of

the Treasury.

(Filed by the Office of the Federal Register on December 16, 1998, 8:45 a.m., and published in the

issue of the Federal Register for December 17, 1998,

63 F.R. 69554)

Section 262.—Personal, Living,

and Family Expenses

26 CFR 1.262–1: Personal, living, and family

expenses.

For the rules to determine whether daily transportation expenses incurred by a taxpayer are deductible business expenses under § 162(a), see Rev.

Rul. 99–7, page 4.

Section 664.—Charitable

Remainder Trusts

26 CFR 1.664–1: Charitable remainder trusts.

T.D. 8791

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1, 25, and 602

February 1, 1999

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Page 8

Guidance Regarding Charitable

Remainder Trusts and Special

Valuation Rules for Transfers of

Interests in Trusts

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains

final regulations relating to charitable remainder trusts and to special valuation

rules for transfers of interests in trusts.

The final regulations provide additional

guidance regarding charitable remainder

trusts. The final regulations affect charitable remainder trusts and their beneficiaries.

DATES: Effective date: These regulations are effective December 10, 1998.

Applicability dates: For dates of applicability of these regulations, see the explanations under SUPPLEMENTARY

INFORMATION.

FOR FURTHER INFORMATION CONTACT: Mary Beth Collins or Jeff Erickson, (202) 622-3080 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in these final regulations has been

reviewed and approved by the Office of

Management and Budget in accordance

with the Paperwork Reduction Act (44

U.S.C. 3507) under control number 15451536. Responses to this collection of information are required to allow taxpayers

alternative means of valuing a charitable

remainder trust’s unmarketable assets.

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 .25 to .75 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

February 1, 1999

Reports Clearance Officer, OP:FS: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.

second method, the unitrust amount is determined under the net income method

plus any amount of income that exceeds

the current year ’s fixed percentage

amount to make up for any shortfall in

payments from prior years when the trust

income was less than the fixed percentage

amount (NIMCRUT method). The shortfall in payments from prior years is commonly referred to as the “make-up

amount.”

The revisions to the proposed regulations are discussed below.

Background

I. Flip Unitrusts

On April 18, 1997, the IRS published in

the Federal Register (62 F.R. 19072) a

notice of proposed rulemaking (REG–

209823–96, 1997–1 C.B. 763) regarding

sections 664 and 2702. Comments responding to the proposed regulations

were received, and a public hearing was

held on November 18, 1997. After considering the comments received and the

statements made at the public hearing, the

proposed regulations are adopted as revised by this Treasury decision.

A. Triggering Events

The proposed regulations provide specific rules for when a trust may convert

from one of the income exception methods of computing the unitrust amount to

the fixed percentage method (flip unitrust). The proposed rule was designed

for taxpayers who ultimately wanted the

unitrust amount to be computed on the

fixed percentage method but funded the

trust with unmarketable assets that generate little annual income. A number of

commentators agreed with the policy underlying the proposed rule. Some commentators requested that we permit flip

unitrusts for all income exception CRUTs

regardless of the marketability of the trust

assets. Other commentators suggested

that the final regulations clarify whether

the proposed rule was a safe harbor or the

exclusive circumstance for which a flip

unitrust would be permitted.

In response, the final regulations expand the availability of the flip unitrust to

certain other situations that the IRS and

Treasury believe are consistent with the

legislative history indicating that a trustee

should not have discretion to change the

method used to calculate the unitrust

amount. H.R. Conf. Rep. No. 782, 91st

Cong., 1st Sess. 296 (1969), 1969–3 C.B.

644, 655.

The final regulations allow the governing instrument of a CRUT to provide that

the CRUT will convert once from one of

the income exception methods to the

fixed percentage method for calculating

the unitrust amount if the date or event

triggering the conversion is outside the

control of the trustees or any other persons. The final regulations include examples of permissible and impermissible

Explanation of Provisions

This document amends 26 CFR parts 1

and 25 to provide additional rules under

sections 664 and 2702. Section 664 contains the rules for charitable remainder

trusts (CRTs). In general, a CRT provides

for a specified periodic distribution to one

or more beneficiaries (at least one of

whom is a noncharitable beneficiary) for

life or for a term of years with an irrevocable remainder interest held for the benefit of charity.

There are two types of CRTs: a charitable remainder annuity trust (CRAT) and a

charitable remainder unitrust (CRUT). A

CRAT pays a sum certain at least annually

to the beneficiaries (the annuity amount).

A CRUT pays a unitrust amount at least

annually to the beneficiaries. Generally,

the unitrust amount is a fixed percentage

of the net fair market value of the CRUT’s

assets valued annually (fixed percentage

CRUT). The unitrust amount can instead

be calculated under one of two income

exception methods (income exception

CRUT). Under the first method, the unitrust amount is the lesser of the fixed percentage amount or the trust’s annual net

income (net income method). Under the

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triggering events. For example, permissible triggering events with respect to any

individual include marriage, divorce,

death, or birth of a child. Also, the sale of

an unmarketable asset such as real estate

is a permissible triggering event. Examples of impermissible triggering events

include the sale of marketable assets and a

request from the unitrust recipient or the

unitrust recipient’s financial advisor that

the trust convert to the fixed percentage

method.

The final regulations also provide that

the conversion to the fixed percentage

method occurs at the beginning of the taxable year that immediately follows the

taxable year in which the triggering date

or event occurs. Any make-up amount

described in section 664(d)(3)(B) is forfeited when the trust converts to the fixed

percentage method.

The proposed regulations define unmarketable assets as assets other than

cash, cash equivalents, or marketable securities (within the meaning of section

731(c)). Commentators asked for clarification of the term unmarketable assets

and recommended changing the scope of

this class of assets. In response, the final

regulations define unmarketable assets as

assets other than cash, cash equivalents,

or assets that can be readily sold or exchanged for cash or cash equivalents. For

example, unmarketable assets include real

property, closely-held stock, and unregistered securities for which there is no

available exemption permitting public

sale.

Commentators requested that the final

regulations permit conversions from the

fixed percentage method to one of the income exception methods and conversions

from a CRAT to a CRUT. The flip unitrust allowed in the final regulations is the

only type of permissible conversion.

Thus, a CRAT cannot convert to a CRUT

without losing its status as a CRT. Similarly, a CRUT using the fixed percentage

method cannot convert to an income exception method without losing its status

as a CRT.

B. Effective Date and Transitional Rules

The rules for flip unitrusts are effective

for CRUTs created on or after December

10, 1998. The proposed regulations allowed reformations in limited circumstances. In response to comments, the

1999–5 I.R.B

final regulations expand the circumstances in which reformation is available.

The final regulations allow income exception CRUTs to be reformed to add provisions allowing a conversion to the fixed

percentage method provided the triggering event does not occur in a year prior to

the year in which the court issues the

order reforming the trust. Adding the

conversion provisions will not cause the

CRUT to fail to function exclusively as a

CRT and will not be an act of self-dealing

under section 4941 if the trustee initiates

legal proceedings to reform the trust by

June 8, 1999.

II. Time for Paying the Annuity Amount

or the Unitrust Amount

The proposed regulations provide that

the payment of the annuity amount or the

unitrust amount determined under the

fixed percentage method must be made by

the close of the taxable year in which it is

due. The rules were proposed in response

to abuses associated with the use of accelerated CRTs described in Notice 94–78

(1994–2 C.B. 555). After receiving a significant number of comments on the proposed rules, the IRS issued Notice 97–68

(1997–48 I.R.B. 11), which provided

guidance on complying with the proposed

rules for the 1997 taxable year.

One commentator recommended applying the proposed rules only to trusts

created after the date the final regulations

are published. Another commentator suggested adopting the rules in Notice 97–68

for all trusts created after a certain date.

Although recent legislative changes have

reduced the potential tax benefits of accelerated CRTs, the IRS and Treasury

continue to be concerned about the potential abuse of the post-year-end grace period to produce a tax-free return of appreciation in the assets contributed to a

CRAT or a fixed percentage CRUT.

Therefore, the final regulations adopt

rules similar to those in Notice 97–68

with certain modifications. The rules are

effective for taxable years ending after

April 18, 1997.

For CRATs and fixed percentage

CRUTs, the annuity or unitrust amount

may be paid within a reasonable time

after the close of the year for which it is

due if (a) the character of the annuity or

unitrust amount in the recipient’s hands is

income under section 664(b)(1), (2), or

(3); and/or (b) the trust distributes property (other than cash) that it owned as of

the close of the taxable year to pay the annuity or unitrust amount and the trustee

elects on Form 5227, “Split-Interest Trust

Information Return,” to treat any income

generated by the distribution as occurring

on the last day of the taxable year for

which the amount is due. In addition, for

CRATs and fixed percentage CRUTs that

were created before December 10, 1998,

the annuity or unitrust amount may be

paid within a reasonable time after the

close of the taxable year for which it is

due if the percentage used to calculate the

annuity or unitrust amount is 15 percent

or less.

III. Appraising Unmarketable Assets

Under section 664(d)(2)(A), a CRUT

must value its assets annually. The proposed regulations provide that, if a CRT

holds unmarketable assets and the only

trustee is the grantor, a noncharitable beneficiary, or a related or subordinate party

to the grantor or the noncharitable beneficiary within the meaning of section

672(c) and the applicable regulations, the

trustee must value those assets using a

current qualified appraisal, as defined in

§1.170A–13(c)(3), from a qualified appraiser, as defined in §1.170A–13(c)(5).

The final regulations follow the proposed regulations and provide that the

trust’s unmarketable assets must be valued by an independent trustee, or by a

qualified appraisal from a qualified appraiser. The proposed regulations define

an independent trustee as a person who is

not the grantor, a noncharitable beneficiary or a related or subordinate party to

the grantor, or the noncharitable beneficiary within the meaning of section

672(c) and the applicable regulations.

The final regulations add the grantor’s

spouse to the list of persons to whom an

independent trustee cannot be related or

subordinate. A co- trustee who is an independent trustee may value the trust’s unmarketable assets.

Finally, in response to comments, the

final regulations define unmarketable assets as assets other than cash, cash equivalents, or assets that can be readily sold or

exchanged for cash or cash equivalents.

For example, unmarketable assets include

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real property, closely-held stock, and unregistered securities for which there is no

available exemption permitting public

sale.

The rules for valuing unmarketable assets are effective for trusts created on or

after December 10, 1998.

IV. Application of Section 2702 to

Certain CRUTs

Under the proposed regulations, unitrust interests in an income exception

CRUT that are retained by the donor or

any applicable family member will be valued at zero when a noncharitable beneficiary of the trust is someone other than (1)

the donor, (2) the donor’s U.S. citizen

spouse, or (3) both the donor and the

donor’s U.S. citizen spouse. Commentators stated that income exception CRUTs

without a make-up provision should be

exempt from section 2702. The IRS and

Treasury believe that, in addition to the

NIMCRUT method, the net income

method can be used to circumvent the intent of section 2702. Therefore, the final

regulations do not exempt from section

2702 CRUTs that use only the net income

method.

Commentators also stated that the proposed rule encompassed other transfers

that section 2702 was not intended to include. A commentator noted that the proposed rule would value a transferor’s interest at zero even though the transferor

merely retained a secondary life estate.

The final regulations clarify that section

2702 will not apply when there are only

two consecutive noncharitable beneficial

interests and the transferor holds the second of the two interests.

Commentators also asked whether section 2702 may apply to flip unitrusts. The

potential abuse associated with income

exception CRUTs also exists with flip

unitrusts. Therefore, under the final regulations, section 2702 applies to a flip unitrust if the CRUT does not fall within one

of the exemptions.

V. Prohibition on Allocating

Precontribution Gain to Trust Income

and Make-up Amount as a Liability

The proposed regulations clarify that

the proceeds from the sale of an income

exception CRUT’s assets, at least to the

extent of the fair market value of the as-

February 1, 1999

sets when contributed to the trust, must be

allocated to trust principal. Some commentators stated that the rule is inconsistent with the rule concerning income

under section 643(b). Other commentators questioned whether the make-up

amount under the NIMCRUT method

should be treated as a liability when valuing the trust’s assets.

The final regulations maintain the prohibition on allocating precontribution

gain to trust income for an income exception CRUT. However, the governing instrument, if permitted under applicable

local law, may allow the allocation of

post-contribution capital gains to trust income. Taxpayers do not have to treat the

make-up amount as a liability when valuing the assets of a NIMCRUT.

VI. Example Illustrating Rule for

Characterizing Distributions from

CRUTs

The proposed regulations contain an

example of how the ordering rule under

section 664(b) operates when the unitrust

amount is computed under an income exception method. No comments were received on this example. Thus, the final

regulations adopt the example without

any changes.

Effect on Other Documents

Notice 97–68 (1997–48 I.R.B. 11) is

obsolete as of December 10, 1998.

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

Regulatory Flexibility Act (5 U.S.C.

chapter 6) does not apply. Therefore, a

Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f), the

notice of proposed rulemaking preceding

these regulations was submitted to the

Chief Counsel for Advocacy of the Small

Business Administration for comment on

its impact on small business.

Drafting Information

The principal authors of these regulations are Mary Beth Collins and Jeff Erickson, Office of the Assistant Chief

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

from offices of the IRS and Treasury Department participated in their development.

* * * * *

Adoption of Amendments to the

Regulations

Accordingly, CFR parts 1, 25, and 602

are amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for

part 1 continues to read in part as follows:

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

Par. 2. In §1.664–1, paragraphs (a)(7)

and (d)(1)(iii) are added, and paragraph

(f)(4) is added following the concluding

text of paragraph (f)(3) to read as follows:

§1.664–1 Charitable remainder trusts.

(a) * * *

(7) Valuation of unmarketable assets—

(i) In general. If unmarketable assets are

transferred to or held by a trust, the trust

will not be a trust with respect to which a

deduction is available under section 170,

2055, 2106, or 2522, or will be treated as

failing to function exclusively as a charitable remainder trust unless, whenever the

trust is required to value such assets, the

valuation is—

(a) Performed exclusively by an independent trustee; or

(b) Determined by a current qualified

appraisal, as defined in §1.170A–13(c)(3), from a qualified appraiser, as defined

in §1.170A–13(c)(5).

(ii) Unmarketable assets. Unmarketable assets are assets that are not cash,

cash equivalents, or other assets that can

be readily sold or exchanged for cash or

cash equivalents. For example, unmarketable assets include real property,

closely-held stock, and an unregistered

security for which there is no available

exemption permitting public sale.

(iii) Independent trustee. An independent trustee is a person who is not the

grantor of the trust, a noncharitable bene-

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ficiary, or a related or subordinate party to

the grantor, the grantor’s spouse, or a noncharitable beneficiary (within the meaning of section 672(c) and the applicable

regulations).

* * * * *

(d) * * * (1) * * *

(iii) Example. The following example

illustrates the application of this paragraph (d)(1):

Example. (i) X is a charitable remainder unitrust

described in section 664(d)(2) and (3). The annual

unitrust amount is the lesser of the amount of trust

income, as defined in §1.664–3(a)(1)(i)(b), or six

percent of the net fair market value of the trust assets

valued annually. The net fair market value of the

trust assets on the valuation date in 1996 is

$150,000. During 1996, X has $7,500 of income

after allocating all expenses. All of X’s income for

1996 is tax-exempt income. At the end of 1996, X’s

ordinary income for the current taxable year and

undistributed ordinary income for prior years are

both zero; X’s capital gain for the current taxable

year is zero and undistributed capital gain for prior

years is $30,000; and X’s tax-exempt income for the

current year is $7,500 and undistributed tax-exempt

income for prior years is $2,500.

(ii) Because the trust income of $7,500 is less

than the fixed percentage amount of $9,000, the

unitrust amount for 1996 is $7,500. The character

of that amount in the hands of the recipient of the

unitrust amount is determined under section 664(b).

Because the unitrust amount is less than X’s undistributed capital gain income, the recipient of the

unitrust amount treats the distribution of $7,500 as

capital gain. At the beginning of 1997, X’s undistributed capital gain for prior years is reduced to

$22,500, and X’s undistributed tax-exempt income is

increased to $10,000.

* * * * *

(f) * * *

(4) Valuation of unmarketable assets.

The rules contained in paragraph (a)(7) of

this section are applicable for trusts created on or after December 10, 1998. A

trust in existence as of December 10,

1998, whose governing instrument requires that an independent trustee value

the trust’s unmarketable assets may be

amended or reformed to permit a valuation method that satisfies the requirements of paragraph (a)(7) of this section

for taxable years beginning on or after

December 10, 1998.

* * * * *

Par. 3. In §1.664–2, paragraph (a)(1)(i)

is revised to read as follows:

§1.664–2 Charitable remainder annuity

trust.

1999–5 I.R.B

(a) * * *

(1) * * * (i) Payment of sum certain at

least annually. The governing instrument

provides that the trust will pay a sum certain not less often than annually to a person or persons described in paragraph

(a)(3) of this section for each taxable year

of the period specified in paragraph (a)(5)

of this section.

(a) General rule applicable to all

trusts. A trust will not be deemed to have

engaged in an act of self-dealing (within

the meaning of section 4941), to have unrelated debt-financed income (within the

meaning of section 514), to have received

an additional contribution (within the

meaning of paragraph (b) of this section),

or to have failed to function exclusively

as a charitable remainder trust (within the

meaning of §1.664–1(a)(4)) merely because the annuity amount is paid after the

close of the taxable year if such payment

is made within a reasonable time after the

close of such taxable year and the entire

annuity amount in the hands of the recipient is characterized only as income from

the categories described in section

664(b)(1), (2), or (3), except to the extent

it is characterized as corpus described in

section 664(b)(4) because—

(1) The trust distributes property (other

than cash) that it owned at the close of the

taxable year to pay the annuity amount;

and

(2) The trustee elects to treat any income generated by the distribution as occurring on the last day of the taxable year

in which the annuity amount is due.

(b) Special rule for trusts created before December 10, 1998. In addition, to

the circumstances described in paragraph

(a)(1)(i)(a) of this section, a trust created

before December 10, 1998, will not be

deemed to have engaged in an act of selfdealing (within the meaning of section

4941), to have unrelated debt-financed income (within the meaning of section

514), to have received an additional contribution (within the meaning of paragraph (b) of this section), or to have failed

to function exclusively as a charitable remainder trust (within the meaning of

§1.664–1(a)(4)) merely because the annuity amount is paid after the close of the

taxable year if such payment is made

within a reasonable time after the close of

such taxable year and the sum certain to

be paid each year as the annuity amount is

15 percent or less of the initial net fair

market value of the property irrevocably

passing in trust as determined for federal

tax purposes.

ordinarily extend beyond the date by

which the trustee is required to file Form

5227, “Split-Interest Trust Information

Return,” (including extensions) for the

taxable year.

(d) Example. The following example

illustrates the rules in paragraph (a)(1)(i)(a) of this section:

Example. X is a charitable remainder annuity

trust described in section 664(d)(1) that was created

after December 10, 1998. The prorated annuity

amount payable from X for Year 1 is $100. The

trustee does not pay the annuity amount to the recipient by the close of Year 1. At the end of Year 1, X

has only $95 in the ordinary income category under

section 664(b)(1) and no income in the capital gain

or tax-exempt income categories under section

664(b)(2) or (3), respectively. By April 15 of Year 2,

in addition to $95 in cash, the trustee distributes to

the recipient of the annuity a capital asset with a $5

fair market value and a $2 adjusted basis to pay the

$100 annuity amount due for Year 1. The trust

owned the asset at the end of Year 1. Under §1.664–

1(d)(5), the distribution is treated as a sale by X, resulting in X recognizing a $3 capital gain. The

trustee elects to treat the capital gain as occurring on

the last day of Year 1. Under §1.664–1(d)(1), the

character of the annuity amount for Year 1 in the recipient’s hands is $95 of ordinary income, $3 of capital gain income, and $2 of trust corpus. For Year 1,

X satisfied paragraph (a)(1)(i)(a) of this section.

(e) Effective date. This paragraph

(a)(1)(i) is applicable for taxable years

ending after April 18, 1997.

* * * * *

Par. 4. Section 1.664–3 is amended as

follows:

1. Paragraphs (a)(1)(i)(a), (a)(1)(i)(b)(1), and (a)(1)(i)(b)(2) are revised.

2. Paragraphs (a)(1)(i)(b)(3), (a)(1)(i)(b)(4), (a)(1)(i)(b)(5), and (a)(1)(i)(c)

through (a)(1)(i)(l) are added.

3. The third sentence of paragraph

(a)(1)(iv) is revised.

The added and revised provisions read

as follows:

§1.664–3 Charitable remainder unitrust.

(a) * * *

(1) * * * (i) * * * (a) General rule. The

governing instrument provides that the

trust will pay not less often than annually

a fixed percentage of the net fair market

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value of the trust assets determined annually to a person or persons described in

paragraph (a)(3) of this section for each

taxable year of the period specified in

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

paragraph (a)(1)(i)(a) is applicable for

taxable years ending after April 18, 1997.

(b) * * *

(1) The amount of trust income for a

taxable year to the extent that such

amount is not more than the amount required to be distributed under paragraph

(a)(1)(i)(a) of this section.

(2) An amount of trust income for a

taxable year that is in excess of the

amount required to be distributed under

paragraph (a)(1)(i)(a) of this section for

such year to the extent that (by reason of

paragraph (a)(1)(i)(b)(1) of this section)

the aggregate of the amounts paid in prior

years was less than the aggregate of such

required amounts.

(3) For this paragraph (a)(1)(i)(b), trust

income means income as defined under

section 643(b) and the applicable regulations.

(4) For this paragraph (a)(1)(i)(b), proceeds from the sale or exchange of any assets contributed to the trust by the donor

must be allocated to principal and not to

trust income at least to the extent of the

fair market value of those assets on the

date of contribution.

(5) The rules in paragraphs (a)(1)(i)(b)(1), (2), and (3) of this section are applicable for taxable years ending after

April 18, 1997, and the rule in paragraph (a)(1)(i)(b)(4) of this section is applicable for sales or exchanges that occur

after April 18, 1997.

of the amount described in paragraph

(a)(1)(i)(a) or (b) of this section, the governing instrument may provide that the

trust will pay not less often than annually

the amount described in paragraph

(a)(1)(i)(b) of this section for an initial period and then pay the amount described in

paragraph (a)(1)(i)(a) of this section (calculated using the same fixed percentage)

for the remaining years of the trust only if

the governing instrument provides that—

(1) The change from the method prescribed in paragraph (a)(1)(i)(b) of this

section to the method prescribed in paragraph (a)(1)(i)(a) of this section is triggered on a specific date or by a single

event whose occurrence is not discre-

February 1, 1999

tionary with, or within the control of, the

trustees or any other persons;

(2) The change from the method prescribed in paragraph (a)(1)(i)(b) of this

section to the method prescribed in paragraph (a)(1)(i)(a) of this section occurs at

the beginning of the taxable year that immediately follows the taxable year during

which the date or event specified under

paragraph (a)(1)(i)(c)(1) of this section

occurs; and

(3) Following the trust’s conversion to

the method described in paragraph

(a)(1)(i)(a) of this section, the trust will

pay at least annually to the permissible recipients the amount described only in

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

not any amount described in paragraph

(a)(1)(i)(b) of this section.

(d) Triggering event. For purposes of

paragraph (a)(1)(i)(c)(1) of this section, a

triggering event based on the sale of unmarketable assets as defined in §1.664–

1(a)(7)(ii), or the marriage, divorce,

death, or birth of a child with respect to

any individual will not be considered discretionary with, or within the control of,

the trustees or any other persons.

(e) Examples. The following examples

illustrate the rules in paragraph (a)(1)(i)(c) of this section. For each example,

assume that the governing instrument of

charitable remainder unitrust Y provides

that Y will initially pay not less often than

annually the amount described in paragraph (a)(1)(i)(b) of this section and then

pay the amount described in paragraph

(a)(1)(i)(a) of this section (calculated

using the same fixed percentage) for the

remaining years of the trust and that the

requirements of paragraphs (a)(1)(i)(c)(2)

and (3) of this section are satisfied. The

examples are as follows:

Example 1. Y is funded with the donor’s former

personal residence. The governing instrument of Y

provides for the change in method for computing the

annual unitrust amount as of the first day of the year

following the year in which the trust sells the residence. Y provides for a combination of methods that

satisfies paragraph (a)(1)(i)(c) of this section.

Example 2. Y is funded with cash and an unregistered security for which there is no available exemption permitting public sale under the Securities and

Exchange Commission rules. The governing instrument of Y provides that the change in method for

computing the annual unitrust amount is triggered on

the earlier of the date when the stock is sold or at the

time the restrictions on its public sale lapse or are otherwise lifted. Y provides for a combination of methods that satisfies paragraph (a)(1)(i)(c) of this section.

Example 3. Y is funded with cash and with a security that may be publicly traded under the Securities and Exchange Commission rules. The governing instrument of Y provides that the change in

method for computing the annual unitrust amount is

triggered when the stock is sold. Y does not provide

for a combination of methods that satisfies the requirements of paragraph (a)(1)(i)(c) of this section

because the sale of the publicly-traded stock is

within the discretion of the trustee.

Example 4. S establishes Y for her granddaughter,

G, when G is 10 years old. The governing instrument

of Y provides for the change in method for computing

the annual unitrust amount as of the first day of the

year following the year in which G turns 18 years old.

Y provides for a combination of methods that satisfies

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

Example 5. The governing instrument of Y provides for the change in method for computing the

annual unitrust amount as of the first day of the year

following the year in which the donor is married. Y

provides for a combination of methods that satisfies

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

Example 6. The governing instrument of Y provides that if the donor divorces, the change in

method for computing the annual unitrust amount

will occur as of the first day of the year following

the year of the divorce. Y provides for a combination of methods that satisfies paragraph (a)(1)(i)(c)

of this section.

Example 7. The governing instrument of Y provides for the change in method for computing the

annual unitrust amount as of the first day of the year

following the year in which the noncharitable beneficiary’s first child is born. Y provides for a combination of methods that satisfies paragraph

(a)(1)(i)(c) of this section.

Example 8. The governing instrument of Y provides for the change in method for computing the

annual unitrust amount as of the first day of the year

following the year in which the noncharitable beneficiary’s father dies. Y provides for a combination of

methods that satisfies paragraph (a)(1)(i)(c) of this

section.

Example 9. The governing instrument of Y provides for the change in method for computing the annual unitrust amount as of the first day of the year

following the year in which the noncharitable beneficiary’s financial advisor determines that the beneficiary should begin receiving payments under the second prescribed payment method. Because the

change in methods for paying the unitrust amount is

triggered by an event that is within a person’s control, Y does not provide for a combination of methods

that satisfies paragraph (a)(1)(i)(c) of this section.

Example 10. The governing instrument of Y provides for the change in method for computing the

annual unitrust amount as of the first day of the year

following the year in which the noncharitable beneficiary submits a request to the trustee that the trust

convert to the second prescribed payment method.

Because the change in methods for paying the unitrust amount is triggered by an event that is within a

person’s control, Y does not provide for a combination of methods that satisfies paragraph (a)(1)(i)(c)

of this section.

(f) Effective date—(1) General rule.

Paragraphs (a)(1)(i)(c), (d), and (e) of this

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section are applicable for charitable remainder trusts created on or after December 10, 1998.

(2) General rule regarding reformations of combination of method unitrusts.

If a trust is created on or after December

10, 1998, and contains a provision allowing a change in calculating the unitrust

amount that does not comply with the

provisions of paragraph (a)(1)(i)(c) of this

section, the trust will qualify as a charitable remainder unitrust only if it is

amended or reformed to use the initial

method for computing the unitrust

amount throughout the term of the trust,

or is reformed in accordance with paragraph (a)(1)(i)(f )(3) of this section. If a

trust was created before December 10,

1998, and contains a provision allowing a

change in calculating the unitrust amount

that does not comply with the provisions

of paragraph (a)(1)(i)(c) of this section,

the trust may be reformed to use the initial

method for computing the unitrust

amount throughout the term of the trust

without causing the trust to fail to function exclusively as a charitable remainder

unitrust under §1.664–1(a)(4), or may be

reformed in accordance with paragraph

(a)(1)(i)(f )(3) of this section. Except as

provided in paragraph (a)(1)(i)(f )(3) of

this section, a qualified charitable remainder unitrust will not continue to qualify as

a charitable remainder unitrust if it is

amended or reformed to add a provision

allowing a change in the method for calculating the unitrust amount.

(3) Special rule for reformations of

trusts that begin by June 8, 1999. Notwithstanding paragraph (a)(1)(i)(f )(2) of

this section, if a trust either provides for

payment of the unitrust amount under a

combination of methods that is not permitted under paragraph (a)(1)(i)(c) of this

section, or provides for payment of the

unitrust amount under only the method

prescribed in paragraph (a)(1)(i)(b) of this

section, then the trust may be reformed to

allow for a combination of methods permitted under paragraph (a)(1)(i)(c) of this

section without causing the trust to fail to

function exclusively as a charitable remainder unitrust under §1.664–1(a)(4) or

to engage in an act of self-dealing under

section 4941 if the trustee begins legal

proceedings to reform by June 8, 1999.

The triggering event under the reformed

governing instrument may not occur in a

1999–5 I.R.B

year prior to the year in which the court

issues the order reforming the trust, except

for situations in which the governing instrument prior to reformation already provided for payment of the unitrust amount

under a combination of methods that is not

permitted under paragraph (a)(1)(i)(c) of

this section and the triggering event occurred prior to the reformation.

(g) Payment under general rule for

fixed percentage trusts. When the unitrust amount is computed under paragraph

(a)(1)(i)(a) of this section, a trust will not

be deemed to have engaged in an act of

self-dealing (within the meaning of section 4941), to have unrelated debt-financed income (within the meaning of

section 514), to have received an additional contribution (within the meaning of

paragraph (b) of this section), or to have

failed to function exclusively as a charitable remainder trust (within the meaning of

§1.664–1(a)(4)) merely because the unitrust amount is paid after the close of the

taxable year if such payment is made

within a reasonable time after the close of

such taxable year and the entire unitrust

amount in the hands of the recipient is

characterized only as income from the

categories described in section 664(b)(1),

(2), or (3), except to the extent it is characterized as corpus described in section

664(b)(4) because—

(1) The trust distributes property (other

than cash) that it owned at the close of the

taxable year to pay the unitrust amount;

and

(2) The trustee elects to treat any income generated by the distribution as occurring on the last day of the taxable year

for which the unitrust amount is due.

(h) Special rule for fixed percentage

trusts created before December 10, 1998.

When the unitrust amount is computed

under paragraph (a)(1)(i)(a) of this section, a trust created before December 10,

1998, will not be deemed to have engaged

in an act of self-dealing (within the meaning of section 4941), to have unrelated

debt-financed income (within the meaning of section 514), to have received an

additional contribution (within the meaning of paragraph (b) of this section), or to

have failed to function exclusively as a

charitable remainder trust (within the

meaning of §1.664–1(a)(4)) merely because the unitrust amount is paid after the

close of the taxable year if such payment

is made within a reasonable time after the

close of such taxable year and the fixed

percentage to be paid each year as the unitrust amount is 15 percent or less of the

net fair market value of the trust assets as

determined under paragraph (a)(1)(iv) of

this section.

(i) Example. The following example illustrates the rules in paragraph (a)(1)(i)(g)

of this section:

Example. X is a charitable remainder unitrust that

calculates the unitrust amount under paragraph

(a)(1)(i)(a) of this section. X was created after December 10, 1998. The prorated unitrust amount

payable from X for Year 1 is $100. The trustee does

not pay the unitrust amount to the recipient by the

end of the Year 1. At the end of Year 1, X has only

$95 in the ordinary income category under section

664(b)(1) and no income in the capital gain or taxexempt income categories under section 664(b)(2)

or (3), respectively. By April 15 of Year 2, in addition to $95 in cash, the trustee distributes to the unitrust recipient a capital asset with a $5 fair market

value and a $2 adjusted basis to pay the $100 unitrust amount due for Year 1. The trust owned the

asset at the end of Year 1. Under §1.664–1(d)(5),

the distribution is treated as a sale by X, resulting in

X recognizing a $3 capital gain. The trustee elects to

treat the capital gain as occurring on the last day of

Year 1. Under §1.664–1(d)(1), the character of the

unitrust amount for Year 1 in the recipient’s hands is

$95 of ordinary income, $3 of capital gain income,

and $2 of trust corpus. For Year 1, X satisfied paragraph (a)(1)(i)(g) of this section.

(j) Payment under income exception.

When the unitrust amount is computed

under paragraph (a)(1)(i)(b) of this section, a trust will not be deemed to have

engaged in an act of self-dealing (within

the meaning of section 4941), to have unrelated debt-financed income (within the

meaning of section 514), to have received

an additional contribution (within the

meaning of paragraph (b) of this section),

or to have failed to function exclusively

as a charitable remainder trust (within the

meaning of §1.664–1(a)(4)) merely because payment of the unitrust amount is

made after the close of the taxable year if

such payment is made within a reasonable

time after the close of such taxable year.

(k) Reasonable time. For paragraphs

(a)(1)(i)(g), (h), and (j) of this section, a

reasonable time will not ordinarily extend

beyond the date by which the trustee is required to file Form 5227, “Split-Interest

Trust Information Return,” (including extensions) for the taxable year.

(l) Effective date. Paragraphs (a)(1)(i)(g), (h), (i), (j), and (k) of this section are

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applicable for taxable years ending after

April 18, 1997.

* * * * *

(iv) * * * If the governing instrument

does not specify the valuation date or

dates, the trustee must select such date or

dates and indicate the selection on the

first return on Form 5227, “Split-Interest

Trust Information Return,” that the trust

must file. * * *

* * * * *

PART 25—GIFT TAX; GIFTS MADE

AFTER DECEMBER 31, 1954

Par. 7. The authority citation for part

602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 8. In §602.101, paragraph (c) is

amended by revising the entry for §1.6641 to read as follows:

§602.101 OMB Control numbers.

* * * * *

CFR part or section

where identified

and described

Current OMB

control No.

Par. 5. The authority citation for part

25 continues to read in part as follows:

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

Par. 6. In §25.2702–1, paragraph (c)(3)

is revised to read as follows:

1.664–1 . . . . . . . . . . . . . . . . . 1545–1536

§25.2702–1 Special valuation rules in the

case of transfers of interests in trust.

Robert E. Wenzel,

* * * * *

Deputy Commissioner of

Internal Revenue.

* * * * *

(3) Charitable remainder trust. (i) For

transfers made on or after May 19, 1997,

a transfer to a pooled income fund described in section 642(c)(5); a transfer to

a charitable remainder annuity trust described in section 664(d)(1); a transfer to

a charitable remainder unitrust described

in section 664(d)(2) if under the terms of

the governing instrument the unitrust

amount can be computed only under section 664(d)(2)(A); and a transfer to a

charitable remainder unitrust if under the

terms of the governing instrument the unitrust amount can be computed under section 664(d)(2) and (3) and either there are

only two consecutive noncharitable beneficial interests and the transferor holds the

second of the two interests, or the only

permissible recipients of the unitrust

amount are the transferor, the transferor’s

U.S. citizen spouse, or both the transferor

and the transferor’s U.S. citizen spouse.

(ii) For transfers made before May 19,

1997, a transfer in trust if the remainder

interest in the trust qualifies for a deduction under section 2522.

* * * * *

PART 602—OMB CONTROL

NUMBERS UNDER THE

PAPERWORK REDUCTION ACT

February 1, 1999

Approved December 1, 1998.

Donald C. Lubick,

Assistant Secretary of

the Treasury,

(Tax Policy).

(Filed by the Office of the Federal Register on December 9, 1998, 8:45 a.m., and published in the

issue of the Federal Register for December 10, 1998,

63 F.R. 68188)

Section 865.—Source Rules for

Personal Property Sales

26 CFR 1.865–1T: Loss with respect to personal

property other than stock (Temporary).

T.D. 8805

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

Allocation of Loss with Respect

to Stock and Other Personal

Property; Application of Section

904 to Income Subject to

Separate Limitations

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Final and temporary regulations.

SUMMARY: This document contains

final and temporary Income Tax Regulations relating to the allocation of loss recognized on the disposition of stock and

other personal property and the computation of the foreign tax credit limitation.

The loss allocation regulations primarily

will affect taxpayers that claim the foreign

tax credit and that incur losses with respect

to personal property and are necessary to

modify existing guidance with respect to

loss allocation. The foreign tax credit limitation regulations will affect taxpayers

claiming foreign tax credits that have passive income or losses and are necessary to

modify existing guidance with respect to

the computation of the limitation.

DATES: Effective dates: These regulations are effective January 11, 1999, except

that §1.904–4(c)(2)(ii)(A) and (B) are effective March 12, 1999 and §1.904–

4(c)(3)(iv) is effective December 31, 1998.

Dates of applicability: For dates of applicability of §§1.865–1T, 1.865–2, and

1.865–2T, see §§1.865–1T(f), 1.865–2(e),

and 1.865–2T(e), respectively. For dates

of applicability of §1.904–4(c), see

§1.904–4(c)(2)(i).

FOR FURTHER INFORMATION CONTACT: Seth B. Goldstein, (202) 6223810, regarding section 865(j); and Rebecca Rosenberg, (202) 622-3850,

regarding section 904(d) (not toll-free

numbers).

SUPPLEMENTARY INFORMATION:

Background

On May 14, 1992, the IRS published a

notice of proposed rulemaking in the Federal Register (REG–209527–92, formerly INTL–1–92 (1992–1 C.B. 1209),

57 F.R. 20660), proposing amendments to

the Income Tax Regulations (26 CFR part

1) under section 904(d). The regulations

included proposed amendments to the

grouping rules under §1.904–4(c)(3) for

purposes of determining whether passive

income is high taxed. The amendments

were proposed to be effective for taxable

years beginning after December 31, 1991.

A public hearing was held on September

24, 1992, but no written or oral comments

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were received with respect to these provisions. These regulations are finalized as

proposed. However, as described below,

the effective date of the regulations has

been modified.

On July 8, 1996, the IRS published proposed amendments (REG–209750–95,

formerly INTL–4–95 (1996–2 C.B. 484),

61 F.R. 35696) to the Income Tax Regulations (26 CFR part 1) under sections 861,

865, and 904 of the Internal Revenue

Code in the Federal Register. The regulations addressed the allocation of loss on

the disposition of stock (§1.865–2) and

other personal property (§1.865–1) and

also contained proposed amendments to

the grouping rules under §1.904–4(c).

The proposed regulations generally allocate loss with respect to stock based upon

the residence of the seller (reciprocal to

gain), but allocate loss on other personal

property based upon the income generated by the property. A public hearing

was held on November 6, 1996, and several written comments were received.

The written comments endorsed the regulations’ general approach with respect to

the allocation of stock loss. In addition,

on June 18, 1997, the Tax Court held in

International Multifoods Corporation v.

Commissioner, 108 T.C. 579 (1997), that

loss on the disposition of stock is generally allocated based on the residence of

the seller, consistent with the approach of

the proposed regulations. After consideration of all the comments, the regulations

proposed by INTL–4–95 with respect to

stock loss and with respect to the grouping rules are adopted as amended by this

Treasury decision. The principal changes

to these regulations, as well as the major

comments and suggestions, are discussed

below. An additional anti-abuse rule, not

previously proposed, is issued as a proposed and temporary regulation.

The written comments criticized the

proposed regulation concerning the allocation of loss on other personal property

(§1.865–1). This proposed regulation is

withdrawn and replaced with a new proposed and temporary regulation that is

more consistent with the approach of the

stock loss allocation rules. The new rules

are issued as a temporary regulation because of the need for immediate guidance

following the International Multifoods

opinion.

1999–5 I.R.B

Explanation of Provisions

Section 1.861-8T(e)(8): Net Operating

Loss

Section 1.861–8T(e)(8) clarifies that a

net operating loss deduction allowed

under section 172 is allocated and apportioned in the same manner as the deductions giving rise to the net operating loss

deduction.

Section 1.865–1T: Loss With Respect to

Personal Property Other Than Stock

Section 1.865–1T(a) provides the general rule that loss with respect to personal

property is allocated in the same manner

in which gain on the sale of the property

would be sourced. Thus, for example, loss

on the sale or worthlessness of a foreign

bond held by a U.S. resident generally

would be allocated against U.S. source income. Notice 89–58 (1989–1 C.B. 699),

which addressed the allocation of loss

with respect to certain bank loans, is revoked as inconsistent with this approach.

Taxpayers may rely on the Notice for loss

recognized prior to the effective date of

the temporary regulations (see discussion

of effective dates, below). Following the

general rule, loss attributable to a foreign

office of a U.S. resident is allocated

against foreign source income where gain

would be foreign source under the foreign

branch rule of section 865(e)(1).

Section 1.865–1T(b) provides special

rules of application. Loss on depreciable

property generally is allocated based upon

the allocation of depreciation deductions

taken with respect to the property, consistent with the depreciation-recapture

source rule of section 865(c)(1). Similarly, loss with respect to a contingent

payment debt instrument subject to Reg.

§1.1275–4(b) is allocated against interest

income because gain on the instrument

generally is treated as interest income.

Section 1.865–1T(c) provides exceptions from the reciprocal-to-gain rule. The

regulations do not apply to certain financial products (to be addressed in a future

guidance project), loss governed by section 988, inventory (which is not governed

by section 865), or trade receivables and

certain interest equivalents (which are

governed by §1.861–9T(b)). When Prop.

§1.863–3(h) (the global dealing sourcing

regulation) is finalized, §1.865–1T will

not apply to any loss sourced under that

regulation. Loss attributable to accruedbut-unpaid interest income is allocated

against interest income. Also, loss on a

debt instrument is allocated against interest income to the extent the taxpayer did

not amortize bond premium to the full extent permitted by the Code. Anti-abuse

exceptions are also provided. Section

1.865–1T(c)(6)(i), which prevents taxpayers from manipulating loss allocation

through related-party transfers, reorganizations, or similar transactions, and

§1.865–1T(c)(6)(ii), which addresses offsetting positions, are similar to the antiabuse rules previously proposed with respect to stock losses. In addition, section

1.865–1T(c)(6)(iii) has been included to

prevent taxpayers from accelerating foreign source income with respect to property and claiming an offsetting U.S. loss.

The temporary regulations are effective

for loss recognized on or after January 11,

1999. A taxpayer may apply the regulations, however, to loss recognized in any

taxable year beginning on or after January

1, 1987, subject to certain conditions.

Section 1.865–2: Stock Loss

The proposed regulations issued in

1996 provide that generally loss with respect to stock is allocated to the residence

of the seller, but contain three major exceptions: an exclusion for dispositions of

portfolio stock and stock in regulated investment companies (RICs) and S corporations, a dividend recapture rule, and a

consistency rule for certain dispositions

of foreign affiliates. The final regulations

modify these exceptions. The principal

comments and changes to the regulations

are discussed below.

Section 1.865–2(a): General Rule for

Allocation of Stock Loss

Commentators criticized the exclusion

of portfolio stock and RIC stock from the

general residence-based rule, arguing that

the rationale for residence-based allocation

applies equally to these classes of stock.

The final regulations eliminate the exception for portfolio stock and RIC stock.

In response to a comment, the final regulations clarify that §1.865–2 does not

apply to stock that constitutes inventory.

The proposed regulations allocate loss

recognized on the “sale or other disposi-

February 1, 1999

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tion” of stock. Proposed §1.865–2(c)(2)

provides that worthlessness giving rise to

a deduction under section 165(g)(3) with

respect to stock is treated as a disposition.

Questions have been raised as to whether

the regulations apply to other recognized

losses that are not the result of a sale or

disposition (for example, loss recognized

under the mark-to-market rules of section

475). The final regulations are intended

to apply to all recognized stock losses. To

avoid confusion, the reference to sales or

other dispositions has been deleted in the

final regulations. The special reference to

worthlessness deductions is therefore unnecessary and also has been deleted.

Section 1.865–2(b)(1): Dividend

Recapture Exception

Some commentators questioned the

dividend recapture rule of §1.865–2(b)(1)

and suggested that the rule should be limited to cases in which the dividends were

fully sheltered from U.S. tax by foreign

tax credits or the taxpayer did not meet a

minimum holding period. Others suggested that the two-year recapture period

defined in §1.865–2(d)(5) of the proposed

regulations should be shortened. Sections

1.865–2(b)(1)(i) and 1.865–2(d)(3) of the

final regulations retain the two-year rule.

Section 1.865–2(b)(1)(iii) of the final

regulations provides an exception from

dividend recapture for passive-basket dividends. This new exception will exempt

most portfolio investors (other than financial services entities) from the dividend

recapture rule. The rule, which will reduce administrative burdens, reflects the

fact that passive income is generally subject to residual U.S. tax and the high-tax

kick-out of section 904(d)(2)(A)(iii)(III)

limits the potential for cross-crediting in

the passive basket, thus reducing the need

for recapture. In addition, allocation of

loss to the passive basket may lead to investment incentives that violate the policies underlying the passive basket. For

example, where a loss allocated to the

passive basket creates a separate limitation loss under section 904(f)(5) that reduces high-taxed income in other baskets,

this creates an incentive in subsequent

years for the taxpayer to earn low-taxed

foreign passive income to utilize the foreign tax credits in the high-taxed basket

(due to the recharacterization rules of section 904(f)(5)(C)).

February 1, 1999

Commentators also suggested alternatives to the de minimis rule of §1.865–

2(b)(1)(ii), which exempts from recapture

dividends that are less than 10 percent of

the recognized loss. The proposed de

minimis rule is retained in the final regulations. The de minimis rule is intended

to exempt from recapture, as a matter of

administrative convenience, dividends

that are relatively insignificant in comparison to the loss.

Two commentators questioned why the

dividend recapture rule and the definition

of the recapture period in §1.865–2(d)(5)

of the proposed regulations refer to realized, rather than recognized, loss. The

wording was intended to avoid confusion

over the application of the rule to loss that

is deferred under section 267(f). The final

regulation refers to “recognized” loss, but

examples have been added in §1.865–

2(b)(1)(iv) of the final regulations to illustrate the application of the dividend recapture rule in the context of section

267(f) and how the result differs in the

context of a consolidated group.

Proposed §1.865–2(b)(2): Consistency

Rule

Proposed §1.865–2(b)(2) requires a taxpayer to allocate loss on the sale of a foreign affiliate to passive-basket foreign

source income if the taxpayer recognized

foreign source gain under section 865(f) at

any time during the 5-year period preceding the loss sale. Commentators criticized

this rule as producing disproportionate results where the foreign source gain is small

in comparison to the subsequent loss. Furthermore, even where the gain and loss are

of similar magnitude, the results may be

disproportionate because sourcing the gain

foreign may provide the taxpayer with

minimal tax benefits (because the gain is

assigned to the passive basket) but the loss

may reduce (sometimes as a separate limitation loss) income that is otherwise sheltered by foreign tax credits. In addition, allocating loss to the passive basket raises

the policy concerns described above with

respect to passive-basket dividend recapture. After consideration of the comments,

the consistency rule has been eliminated

from the final regulations.

Section 1.865–2(b)(2): Anti-abuse Rules

The anti-abuse rules of §1.865–2(b)(3)

of the proposed regulations, finalized as

§1.865–2(b)(4), have been refined and

modified. One commentator requested

examples illustrating the anti-abuse rules.

Examples have been provided. An additional rule is provided in §1.865–2T, discussed below.

Section 1.865–2(e): Effective Date and

Retroactive Election

The proposed regulations are proposed

to be effective for taxable years beginning

61 days after final regulations are promulgated. Because of the immediate need for

guidance following the International

Multifoods opinion, the final regulations

are effective for losses recognized on or

after January 11, 1999.

Several commentators requested that

the regulations clarify the scope of the

retroactive election and reduce the administrative burden of making the election.

In response to these comments, §1.865–

2(e)(2) is amended to provide that a taxpayer need not make a formal election to

retroactively apply the regulations to

losses recognized in any post-1986 year

and all subsequent pre-effective date

years. An amended return will be required only if retroactive application results in a change in tax liability.

One commentator urged that the overall

foreign loss transition rule in §1.904(f)–12

be modified to provide that an overall foreign loss account attributable to a stock

loss recognized in a pre-1987 year be recomputed under the new regulations in the

first election year. This suggestion was rejected because the allocation of a stock

loss is governed by the rules in effect in

the year the loss is recognized, and the

retroactive election is available only with

respect to post-1986 years. Section

1.865–2(e)(3) provides examples to illustrate the effect of the retroactive application of the regulations on overall foreign

loss accounts, capital loss carryovers, and

foreign tax credit carryovers.

Section 1.865–2T: Stock Loss Matching

Rule

Section 1.865–2T(b)(4)(iii) provides a

rule intended to prevent taxpayers from

avoiding the dividend recapture rule of

§1.865–2(b)(1) or from accelerating foreign source income and recognizing an

offsetting U.S. loss. This rule is substan-

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tially the same as the matching rule of

§1.865–1T(c)(6)(iii). The rule is promulgated as a temporary regulation because it

is necessary to prevent abuse of the residence-based general allocation rule.

Section 1.904–4(c): Grouping Rules

The high-tax kick-out grouping rules of

§1.904–4(c) provide rules for determining

when particular groups of passive income

are high-taxed and, therefore, treated as

general limitation income under sections

904(d)(2)(A)(iii)(III) and 904(d)(2)(F).

As described above, the proposed amendments to these rules that were proposed in

1992 are finalized as proposed, but taxpayers are afforded some flexibility with

respect to the effective date. The amendments were proposed to be effective for

taxable years beginning after December

31, 1991. The final regulations are effective for taxable years ending on or after

December 31, 1998, but taxpayers may

apply the amended regulations to any taxable year beginning after December 31,

1991 and all subsequent years. An example is also added to clarify that foreign

taxes that are not creditable (e.g., under

section 901(k)) are not withholding taxes

for purposes of the grouping rules.

The proposed amendments to the

grouping rules that were proposed in 1996

are finalized with two clarifications. Proposed §1.904–4(c)(2)(ii)(B) provides

guidance where deductions allocated to a

group of passive income exceed the income in that group (i.e., a loss group). A

question has been raised as to the proper

treatment of foreign taxes in a group that

has no taxable income or loss (either because the deductions allocated to the

group exactly equal the income in the

group or because the foreign taxes assigned to the group are imposed on U.S.

source income or income that is not currently taken into account under U.S. tax

principles). Consistent with the approach

taken in the proposed regulations with respect to loss groups, the final regulations

clarify that foreign taxes allocated to a

group with no foreign source income are

“kicked out” and treated as related to general limitation income.

Proposed §1.904–4(c)(2)(ii)(A) provides that foreign tax imposed on sales

that result in loss for U.S. tax purposes is

allocated to the group of passive income

to which the loss is allocated. While this

1999–5 I.R.B

correctly states the result where loss on

the disposition of property is allocated to

passive income under a reciprocal-to-gain

rule, under the temporary and final regulations loss may be allocated to reduce the

group of passive income where income

from the property was assigned (for example, dividends or interest under the

anti-abuse rules or the accrued-but-unpaid

interest rule) or a separate category of income other than passive income. Accordingly, §1.904–4(c)(2)(ii)(A) of the final

regulations is clarified to state that foreign

tax imposed on a loss sale is allocated to

the group of passive income to which a

gain would have been assigned. The examples in §1.904–4(c)(8) of the final regulations are modified to reflect the fact

that the consistency rule of §1.865–

2(b)(2) of the proposed regulations has

been deleted.

One commentator inquired whether the

rule of §1.904–4(c)(2)(ii)(A) allocating

foreign tax on a loss sale to a group of

passive income is consistent with the tax

allocation rule of §1.904–6(a)(1)(iv). The

latter rule provides that a foreign tax imposed on an item of income that does not

constitute income under U.S. tax principles (a base difference) shall be treated as

imposed with respect to general limitation

income, whereas a foreign tax imposed on

an item that would be income under U.S.

tax principles in another year (a timing

difference) will be allocated to the appropriate separate category as if the U.S. recognized the income in the same year.

Treasury and the Service believe that a

base difference exists within the meaning

of §1.904–6(a)(1)(iv) only when a foreign

country taxes items that the United States

would never treat as taxable income, for

example, gifts or life insurance proceeds.

A sale that results in gain under foreign

law but in loss for U.S. tax purposes is attributable to differences in basis calculations rather than to a difference in the

concept of taxable income and, therefore,

does not constitute a base difference. The

tax allocation rule of §1.904–4(c)(2)(ii)(A), allocating foreign taxes on a loss

sale to the same group of passive income

to which gain would have been assigned

had the United States recognized gain on

the sale, is conceptually consistent with

the treatment of timing differences in

§1.904–6(a)(1)(iv).

Effect on Other Documents

The following document is obsolete as

of January 11, 1999:

Notice 89–58, 1989–1 C.B. 699.

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.

This Treasury Decision finalizes notices of proposed rulemaking published

May 14, 1992 (57 F.R. 20660) and July 8,

1996 (61 F.R. 35696). It has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)

does not apply to the final regulations issued pursuant to the notice of proposed

rulemaking published on May 14, 1992.

Furthermore, the Regulatory Flexibility

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

those regulations, because the notice of

proposed rulemaking was issued prior to

March 29, 1996.

It also has been determined that section

553(b) of the Administrative Procedure

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

the portion of the notice of proposed rulemaking published on July 8, 1996, relating to section 904 of the Internal Revenue

Code. Because the regulation does not

impose a collection of information on

small entities, the Regulatory Flexibility

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

A final regulatory flexibility analysis

under 5 U.S.C. § 604 has been prepared

for the final regulations portion of this

Treasury Decision with respect to the regulations issued under section 865 of the

Internal Revenue Code. A summary of

the analysis is set forth below under the

heading ‘Summary of Regulatory Flexibility Analysis.’ Because no preceding

notice of proposed rulemaking is required

for the temporary regulations portion of

this Treasury Decision relating to sections

861 and 865 of the Code, the provisions

of the Regulatory Flexibility Act do not

apply. However, an initial Regulatory

Flexibility Analysis was prepared for the

proposed regulations published elsewhere

in this issue of the Federal Register.

Pursuant to section 7805(f) of the Internal Revenue Code, the notices of proposed rulemaking preceding these regulations were submitted to the Small

February 1, 1999

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Page 18

Business Administration for comment on

their impact on small business.

Summary of Regulatory Flexibility

Analysis

It has been determined that a final regulatory flexibility analysis is required

under 5 U.S.C. § 604 with respect to the

final regulations portion of this Treasury

Decision with respect to the regulations

issued under section 865 of the Internal

Revenue Code. These regulations will affect small entities such as small businesses but not other small entities, such as

local government or tax exempt organizations, which do not pay taxes. The IRS

and Treasury Department are not aware of

any federal rules that duplicate, overlap or

conflict with these regulations. The final

regulations address the allocation of loss

with respect to stock. These regulations

are necessary primarily for the proper

computation of the foreign tax credit limitation under section 904 of the Internal

Revenue Code. With respect to U.S. resident taxpayers, the regulations generally

allocate losses against U.S. source income. Generally, this allocation simplifies the computation of the foreign tax

credit limitation. None of the significant

alternatives considered in drafting the

regulations would have significantly altered the economic impact of the regulations on small entities. There are no alternative rules that are less burdensome to

small entities but that accomplish the purposes of the statute.

Drafting Information

The principal author of these regulations is Seth B. Goldstein, of the Office of

the Associate Chief Counsel (International), 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 entries in numerical order to read as follows:

February 1, 1999

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

Section 1.865–1T also issued under 26

U.S.C. 865(j)(1).

Section 1.865–2 also issued under 26

U.S.C. 865(j)(1).

Section 1.865–2T also issued under 26

U.S.C. 865(j)(1). * * *

Par. 2. Section 1.861–8 is amended by

adding paragraph (e)(7)(iii) and revising

paragraph (e)(8) to read as follows:

§1.861–8 Computation of taxable

income from sources within the United

States and from other sources and

activities.

* * * * *

(e) * * *

(7) * * *

(iii) Allocation of loss recognized in

taxable years after 1986. See §§1.865–

1T, 1.865–2, and 1.865–2T for rules regarding the allocation of certain loss recognized in taxable years beginning after

December 31, 1986.

(8) Net operating loss deduction. [Reserved.] For guidance, see §1.861–

8T(e)(8).

* * * * *

Par. 3. Section 1.861–8T is amended

by adding paragraph (e)(8) and a sentence

at the end of paragraph (h) to read as follows:

§1.861–8T Computation of taxable

income from sources within the United

States and from other sources and

activities (Temporary).

* * * * *

(e) * * *

(8) Net operating loss deduction. A net

operating loss deduction allowed under

section 172 shall be allocated and apportioned in the same manner as the deductions giving rise to the net operating loss

deduction.

* * * * *

(h) * * * Paragraph (e)(8) of this section shall cease to be effective January 8,

2002.

Par. 4. Section 1.865–1T is added immediately following §1.864–8T, to read

as follows:

§1.865–1T Loss with respect to personal

property other than stock (Temporary).

(a) General rules for allocation of

loss—(1) Allocation against gain. Except

as otherwise provided in §§1.865–2 and

1.865–2T and paragraph (c) of this section, loss recognized with respect to personal property shall be allocated to the

class of gross income and, if necessary,

apportioned between the statutory grouping of gross income (or among the statutory groupings) and the residual grouping

of gross income, with respect to which

gain from a sale of such property would

give rise in the hands of the seller. Thus,

for example, loss recognized by a United

States resident on the sale of a bond generally is allocated to reduce United States

source income.

(2) Loss attributable to foreign office.

Except as otherwise provided in §§1.865–

2 and 1.865–2T and paragraph (c) of this

section, and except with respect to loss

subject to paragraph (b) of this section, in

the case of loss recognized by a United

States resident with respect to property

that is attributable to an office or other

fixed place of business in a foreign country within the meaning of section

865(e)(3), the loss shall be allocated to reduce foreign source income if a gain on

the sale of the property would have been

taxable by the foreign country and the

highest marginal rate of tax imposed on

such gains in the foreign country is at

least 10 percent. However, paragraph

(a)(1) of this section and not this paragraph (a)(2) will apply if gain on the sale

of such property would be sourced under

section 865(c), (d)(1)(B), or (d)(3).

(3) Loss recognized by United States

citizen or resident alien with foreign tax

home. Except as otherwise provided in

§§1.865–2 and 1.865–2T and paragraph

to loss subject to paragraph (b) of this section, in the case of loss with respect to

property recognized by a United States

citizen or resident alien that has a tax

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

a foreign country, the loss shall be allocated to reduce foreign source income if a

gain on the sale of such property would

have been taxable by a foreign country

and the highest marginal rate of tax imposed on such gains in the foreign country

is at least 10 percent.

(4) Allocation for purposes of section

904. For purposes of section 904, loss

recognized with respect to property that is

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allocated to foreign source income under

this paragraph (a) shall be allocated to the

separate category under section 904(d) to

which gain on the sale of the property

would have been assigned (without regard

to section 904(d)(2)(A)(iii)(III)). For purposes of §1.904–4(c)(2)(ii)(A), any such

loss allocated to passive income shall be

allocated (prior to the application of

§1.904–4(c)(2)(ii)(B)) to the group of passive income to which gain on a sale of the

property would have been assigned had a

sale of the property resulted in the recognition of a gain under the law of the relevant foreign jurisdiction or jurisdictions.

(5) Loss recognized by partnership. A

partner’s distributive share of loss recognized by a partnership with respect to personal property shall be allocated and apportioned in accordance with this section

as if the partner had recognized the loss.

If loss is attributable to an office or other

fixed place of business of the partnership

within the meaning of section 865(e)(3),

such office or fixed place of business

shall be considered to be an office of the

partner for purposes of this section.

(b) Special rules of application—(1)

Depreciable property. In the case of a

loss recognized with respect to depreciable personal property, the gain referred to

in paragraph (a)(1) of this section is the

gain that would be sourced under section

865(c)(1) (depreciation recapture).

(2) Contingent payment debt instrument. Except to the extent provided in

§1.1275–4(b)(9)(iv), loss recognized with

respect to a contingent payment debt instrument to which §1.1275–4(b) applies

(instruments issued for money or publicly

traded property) shall be allocated to the

class of gross income and, if necessary,

apportioned between the statutory grouping of gross income (or among the statutory groupings) and the residual grouping

of gross income, with respect to which interest income from the instrument (in the

amount of the loss subject to this paragraph (b)(2)) would give rise.

and certain financial instruments. This

section does not apply to loss governed by

section 988 and loss recognized with respect to options contracts or derivative financial instruments, including futures

contracts, forward contracts, notional

principal contracts, or evidence of an interest in any of the foregoing.

1999–5 I.R.B

(2) Inventory. This section does not

apply to loss recognized with respect to

property described in section 1221(1).

(3) Interest equivalents and trade receivables. Loss subject to §1.861–9T(b)

(loss equivalent to interest expense and

loss on trade receivables) shall be allocated and apportioned under the rules of

§1.861–9T and not under the rules of this

section.

(4) Unamortized bond premium. To the

extent a taxpayer recognizing loss with

respect to a bond (within the meaning of

§1.171–1(b)) did not amortize bond premium to the full extent permitted by

§§1.171–2 or 1.171–3 (or §1.171–1, as

contained in the 26 CFR part 1 edition revised as of April 1, 1997)(as applicable),

loss recognized with respect to the bond

shall be allocated to the class of gross income and, if necessary, apportioned between the statutory grouping of gross income (or among the statutory groupings)

and the residual grouping of gross income, with respect to which interest income from the bond was assigned.

(5) Accrued interest. Loss attributable

to accrued but unpaid interest on a debt

obligation shall be allocated to the class

of gross income and, if necessary, apportioned between the statutory grouping of

gross income (or among the statutory

groupings) and the residual grouping of

gross income, with respect to which interest income from the obligation was assigned. For purposes of this section,

whether loss is attributable to accrued but

unpaid interest (rather than to principal)

shall be determined under the principles

of §§1.61–7(d) and 1.446–2(e).

(6) Anti-abuse rules—(i) Transactions

involving built-in losses. If one of the

principal purposes of a transaction is to

change the allocation of a built-in loss

with respect to personal property by transferring the property to another person,

qualified business unit, office or other

fixed place of business, or branch that

subsequently recognizes the loss, the loss

shall be allocated by the transferee as if it

were recognized by the transferor immediately prior to the transaction. If one of

the principal purposes of a change of residence is to change the allocation of a

built-in loss with respect to personal property, the loss shall be allocated as if the

change of residence had not occurred. If

one of the principal purposes of a transac-

tion is to change the allocation of a builtin loss on the disposition of personal

property by converting the original property into other property and subsequently

recognizing loss with respect to such

other property, the loss shall be allocated

as if it were recognized with respect to the

original property immediately prior to the

transaction. Transactions subject to this

paragraph shall include, without limitation, reorganizations within the meaning

of section 368(a), liquidations under section 332, transfers to a corporation under

section 351, transfers to a partnership

under section 721, transfers to a trust, distributions by a partnership, distributions

by a trust, transfers to or from a qualified

business unit, office or other fixed place

of business, or branch, or exchanges

under section 1031. A person may have a

principal purpose of affecting loss allocation even though this purpose is outweighed by other purposes (taken together or separately).

(ii) Offsetting positions. If a taxpayer

recognizes loss with respect to personal

property and the taxpayer (or any person

described in section 267(b) (after application of section 267(c)), 267(e), 318 or 482

with respect to the taxpayer) holds (or

held) offsetting positions with respect to

such property with a principal purpose of

recognizing foreign source income and

United States source loss, the loss shall be

allocated and apportioned against such

foreign source income. For purposes of

this paragraph (c)(6)(ii), positions are offsetting if the risk of loss of holding one or

more positions is substantially diminished

by holding one or more other positions.

(iii) Matching rule. To the extent a taxpayer (or a person described in section

1059(c)(3)(C) with respect to the taxpayer) recognizes foreign source income

for tax purposes that results in the creation of a corresponding loss with respect

to personal property, the loss shall be allocated and apportioned against such income. For examples illustrating a similar

rule with respect to stock loss, see Examples 3 through 6 of §1.865–2T(b)(4)(iv).

(d) Definitions—(1) Contingent payment debt instrument. A contingent payment debt instrument is any debt instrument that is subject to §1.1275–4.

(2) Depreciable personal property. Depreciable personal property is any property described in section 865(c)(4)(A).

February 1, 1999

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(3) Terms defined in §1.861–8. See

§1.861–8 for the meaning of class of

gross income, statutory grouping of gross

income, and residual grouping of gross

income.

(e) Examples. The application of this

section may be illustrated by the following examples:

Example 1. On January 1, 1997, A, a domestic

corporation, purchases for $1,000 a machine that

produces widgets, which A sells in the United States

and throughout the world. Throughout A’s holding

period, the machine is located and used in Country

X. During A’s holding period, A incurs depreciation

deductions of $400 with respect to the machine.

Under §1.861–8, A allocates and apportions depreciation deductions of $250 against foreign source general limitation income and $150 against U.S. source

income. On December 12, 1999, A sells the machine and recognizes a loss of $500. Because the

machine was used predominantly outside the United

States, under section 865(c)(1)(B) and (c)(3)(B)(ii),

gain on the disposition of the machine would be foreign source general limitation income to the extent

of the depreciation adjustments. Therefore, under

paragraph (b)(1) of this section, the entire $500 loss

is allocated against foreign source general limitation

income.

Example 2. On January 1, 1997, A, a domestic

corporation, loans $2,000 to N, its wholly-owned

controlled foreign corporation, in exchange for a

contingent payment debt instrument subject to

§1.1275–4(b). During 1997 through 1999, A accrues and receives interest income of $630, $150 of

which is foreign source general limitation income

and $480 of which is foreign source passive income

under section 904(d)(3). Assume there are no positive or negative adjustments pursuant to §1.1275–

4(b)(6) in 1997 through 1999. On January 1, 2000,

A disposes of the debt instrument and recognizes a

$770 loss. Under §1.1275–4(b)(8)(ii), $630 of the

loss is treated as ordinary loss and $140 is treated as

capital loss. Assume that $140 of interest income

earned in 2000 with respect to the debt instrument

would be foreign source passive income under section 904(d)(3). Under §1.1275–4(b)(9)(iv), $150 of

the ordinary loss is allocated against foreign source

general limitation income and $480 of the ordinary

loss is allocated against foreign source passive income. Under paragraph (b)(2) of this section, the

$140 capital loss is allocated against foreign source

passive income.

Example 3. On January 1, 1997, A, a domestic

corporation, purchases for $1,000 a bond maturing

January 1, 2009, with a stated principal amount of

$1,000, payable at maturity. The bond provides for

unconditional payments of interest of $100, payable

December 31 of each year. The issuer of the bond is

a foreign corporation and interest on the bond is thus

foreign source. Between 1997 and 2001, A accrues

and receives foreign source interest income of $500

with respect to the bond. On January 1, 2002, A

sells the bond and recognizes a $500 loss. Under

paragraph (a)(1) of this section, the $500 loss is allocated against U.S. source income. Paragraph

(c)(6)(iii) of this section is not applicable because

A’s recognition of the foreign source income did not

February 1, 1999

result in the creation of a corresponding loss with respect to the bond.

Example 4. On January 1, 1999, A, a domestic

corporation on the accrual method of accounting,

purchases for $1,000 a bond maturing January 1,

2009, with a stated principal amount of $1,000,

payable at maturity. The bond provides for unconditional payments of interest of $100, payable December 31 of each year. The issuer of the bond is a foreign corporation and interest on the bond is thus

foreign source. On June 10, 1999, after A has accrued $44 of interest income, but before any interest

has been paid, the issuer suddenly becomes insolvent and declares bankruptcy. A sells the bond (including the accrued interest) for $20. Assuming that

A properly accrued $44 interest income, A treats the

$20 proceeds from the sale of the bond as payment

of interest previously accrued and recognizes a

$1000 loss with respect to the bond principal and a

$24 loss with respect to the accrued interest. See

§1.61–7(d). Under paragraph (a)(1) of this section,

the $1000 loss with respect to the principal is allocated against U.S. source income. Under paragraph

(c)(5) of this section, the $24 loss with respect to accrued but unpaid interest is allocated against foreign

source interest income.

(f) Effective date—(1) In general. Except as provided in paragraph (f)(2) of this

section, this section is effective for loss

recognized on or after January 11, 1999.

For purposes of this paragraph (f), loss

that is recognized but deferred (for example, under section 267 or 1092) shall be

treated as recognized at the time the loss is

taken into account. This section shall

cease to be effective January 8, 2002.

(2) Application to prior periods. A taxpayer may apply the rules of this section

to losses recognized in any taxable year

beginning on or after January 1, 1987, and

all subsequent years, provided that—

(i) The taxpayer’s tax liability as shown

on an original or amended tax return is

consistent with the rules of this section for

each such year for which the statute of

limitations does not preclude the filing of

an amended return on June 30, 1999; and

(ii) The taxpayer makes appropriate adjustments to eliminate any double benefit

arising from the application of this section

to years that are not open for assessment.

(3) Examples. See §1.865–2(e)(3) for

examples illustrating an effective date

provision similar to the effective date provided in this paragraph (f).

Par. 5. Section 1.865–2 is added immediately after §1.865–1T, to read as follows:

§1.865–2 Loss with respect to stock.

(a) General rules for allocation of loss

with respect to stock—(1) Allocation

against gain. Except as otherwise provided in paragraph (b) of this section, loss

recognized with respect to stock shall be

allocated to the class of gross income and,

if necessary, apportioned between the

statutory grouping of gross income (or

among the statutory groupings) and the

residual grouping of gross income, with

respect to which gain (other than gain

treated as a dividend under section

964(e)(1) or 1248) from a sale of such

stock would give rise in the hands of the

seller (without regard to section 865(f)).

Thus, for example, loss recognized by a

United States resident on the sale of stock

generally is allocated to reduce United

States source income.

(2) Stock attributable to foreign office.

Except as otherwise provided in paragraph (b) of this section, in the case of

loss recognized by a United States resident with respect to stock that is attributable to an office or other fixed place of

business in a foreign country within the

meaning of section 865(e)(3), the loss

shall be allocated to reduce foreign source

income if a gain on the sale of the stock

would have been taxable by the foreign

country and the highest marginal rate of

tax imposed on such gains in the foreign

country is at least 10 percent.

(3) Loss recognized by United States

citizen or resident alien with foreign tax

home—(i) In general. Except as otherwise provided in paragraph (b) of this section, in the case of loss with respect to

stock that is recognized by a United States

citizen or resident alien that has a tax

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

a foreign country, the loss shall be allocated to reduce foreign source income if a

gain on the sale of the stock would have

been taxable by a foreign country and the

highest marginal rate of tax imposed on

such gains in the foreign country is at

least 10 percent.

(ii) Bona fide residents of Puerto Rico.

Except as otherwise provided in paragraph (b) of this section, in the case of

loss with respect to stock in a corporation

described in section 865(g)(3) recognized

by a United States citizen or resident alien

that is a bona fide resident of Puerto Rico

during the entire taxable year, the loss

shall be allocated to reduce foreign source

income.

(4) Stock constituting a United States

real property interest. Loss recognized

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by a nonresident alien individual or a foreign corporation with respect to stock that

constitutes a United States real property

interest shall be allocated to reduce

United States source income. For additional rules governing the treatment of

such loss, see section 897 and the regulations thereunder.

(5) Allocation for purposes of section

904. For purposes of section 904, loss

recognized with respect to stock that is allocated to foreign source income under

this paragraph (a) shall be allocated to the

separate category under section 904(d) to

which gain on a sale of the stock would

have been assigned (without regard to

section 904(d)(2)(A)(iii)(III)). For purposes of §1.904–4(c)(2)(ii)(A), any such

loss allocated to passive income shall be

allocated (prior to the application of

§1.904–4(c)(2)(ii)(B)) to the group of

passive income to which gain on a sale of

the stock would have been assigned had a

sale of the stock resulted in the recognition of a gain under the law of the relevant

foreign jurisdiction or jurisdictions.

(b) Exceptions—(1) Dividend recapture exception—(i) In general. If a taxpayer recognizes a loss with respect to

shares of stock, and the taxpayer (or a

person described in section 1059(c)(3)(C)

with respect to such shares) included in

income a dividend recapture amount (or

amounts) with respect to such shares at

any time during the recapture period,

then, to the extent of the dividend recapture amount (or amounts), the loss shall

be allocated and apportioned on a proportionate basis to the class or classes of

gross income or the statutory or residual

grouping or groupings of gross income to

which the dividend recapture amount was

assigned.

(ii) Exception for de minimis amounts.

Paragraph (b)(1)(i) of this section shall

not apply to a loss recognized by a taxpayer on the disposition of stock if the

sum of all dividend recapture amounts

(other than dividend recapture amounts

eligible for the exception described in

paragraph (b)(1)(iii) of this section (passive limitation dividends)) included in income by the taxpayer (or a person described in section 1059(c)(3)(C)) with

respect to such stock during the recapture

period is less than 10 percent of the recognized loss.

1999–5 I.R.B

(iii) Exception for passive limitation

dividends. Paragraph (b)(1)(i) of this section shall not apply to the extent of a dividend recapture amount that is treated as

income in the separate category for passive income described in section

904(d)(2)(A) (without regard to section

904(d)(2)(A)(iii)(III)). The exception

provided for in this paragraph (b)(1)(iii)

shall not apply to any dividend recapture

amount that is treated as income in the

separate category for financial services

income described in section 904(d)(2)(C).

(iv) Examples. The application of this

paragraph (b)(1) may be illustrated by the

following examples:

Example 1. (i) P, a domestic corporation, is a

United States shareholder of N, a controlled foreign

corporation. N has never had any subpart F income

and all of its earnings and profits are described in

section 959(c)(3). On May 5, 1998, N distributes a

dividend to P in the amount of $100. The dividend

gives rise to a $5 foreign withholding tax, and P is

deemed to have paid an additional $45 of foreign income tax with respect to the dividend under section

902. Under the look-through rules of section

904(d)(3) the dividend is general limitation income

described in section 904(d)(1)(I).

(ii) On February 6, 2000, P sells its shares of N

and recognizes a $110 loss. In 2000, P has the following taxable income, excluding the loss on the

sale of N:

(A) $1,000 of foreign source income that is general limitation income described in section

904(d)(1)(I);

(B) $1,000 of foreign source capital gain from

the sale of stock in a foreign affiliate that is sourced

under section 865(f) and is passive income described in section 904(d)(1)(A); and

(iii) The $100 dividend paid in 1998 is a dividend

recapture amount that was included in P’s income

within the recapture period preceding the disposition

of the N stock. The de minimis exception of paragraph (b)(1)(ii) of this section does not apply because the $100 dividend recapture amount exceeds

10 percent of the $110 loss. Therefore, to the extent

of the $100 dividend recapture amount, the loss

must be allocated under paragraph (b)(1)(i) of this

section to the separate limitation category to which

the dividend was assigned (general limitation income).

(iv) P’s remaining $10 loss on the disposition of

the N stock is allocated to U.S. source income under

paragraph (a)(1) of this section.

(v) After allocation of the stock loss, P’s foreign

source taxable income in 2000 consists of $900 of

foreign source general limitation income and $1,000

of foreign source passive income.

Example 2. (i) P, a domestic corporation, owns

all of the stock of N1, which owns all of the stock of

N2, which owns all of the stock of N3. N1, N2, and

N3 are controlled foreign corporations. All of the

corporations use the calendar year as their taxable

year. On February 5, 1997, N3 distributes a divi-

dend to N2. The dividend is foreign personal holding company income of N2 under section

954(c)(1)(A) that results in an inclusion of $100 in

P’s income under section 951(a)(1)(A)(i) as of December 31, 1997. Under section 904(d)(3)(B) the

inclusion is general limitation income described in

section 904(d)(1)(I). The income inclusion to P results in a corresponding increase in P’s basis in the

stock of N1 under section 961(a).

(ii) On March 5, 1999, P sells its shares of N1

and recognizes a $110 loss. The $100 1997 subpart

F inclusion is a dividend recapture amount that was

included in P’s income within the recapture period

preceding the disposition of the N1 stock. The de

minimis exception of paragraph (b)(1)(ii) of this

section does not apply because the $100 dividend recapture amount exceeds 10 percent of the $110 loss.

Therefore, to the extent of the $100 dividend recapture amount, the loss must be allocated under paragraph (b)(1)(i) of this section to the separate limitation category to which the dividend recapture

amount was assigned (general limitation income).

The remaining $10 loss is allocated to U.S. source

income under paragraph (a)(1) of this section.

Example 3. (i) P, a domestic corporation, owns

all of the stock of N1, which owns all of the stock of

N2. N1 and N2 are controlled foreign corporations.

All the corporations use the calendar year as their

taxable year and the U.S. dollar as their functional

currency. On May 5, 1998, N2 pays a dividend of

$100 to N1 out of general limitation earnings and

profits.

(ii) On February 5, 2000, N1 sells its N2 stock to

an unrelated purchaser. The sale results in a loss to

N1 of $110 for U.S. tax purposes. In 2000, N1 has

the following current earnings and profits, excluding

the loss on the sale of N2:

(A) $1,000 of non-subpart F foreign source general limitation earnings and profits described in section 904(d)(1)(I);

(B) $1,000 of foreign source gain from the sale of

stock that is taken into account in determining foreign personal holding company income under section 954(c)(1)(B)(i) and which is passive limitation

earnings and profits described in section

904(d)(1)(A);

(C) $1,000 of foreign source interest income received from an unrelated person that is foreign personal holding company income under section

954(c)(1)(A) and which is passive limitation earnings and profits described in section 904(d)(1)(A).

(iii) The $100 dividend paid in 1998 is a dividend

recapture amount that was included in N1’s income

within the recapture period preceding the disposition

of the N2 stock. The de minimis exception of paragraph (b)(1)(ii) of this section does not apply because the $100 dividend recapture amount exceeds

10 percent of the $110 loss. Therefore, to the extent

of the $100 dividend recapture amount, the loss

must be allocated under paragraph (b)(1)(i) of this

section to the separate limitation category to which

the dividend was assigned (general limitation earnings and profits).

(iv) N1’s remaining $10 loss on the disposition of

the N2 stock is allocated to foreign source passive

limitation earnings and profits under paragraph

(a)(1) of this section.

(v) After allocation of the stock loss, N1’s current

earnings and profits for 1998 consist of $900 of for-

February 1, 1999

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eign source general limitation earnings and profits

and $1,990 of foreign source passive limitation earnings and profits.

(vi) After allocation of the stock loss, N1’s subpart F income for 2000 consists of $1,000 of foreign

source interest income that is foreign personal holding company income under section 954(c)(1)(A) and

$890 of foreign source net gain that is foreign personal holding company income under section

954(c)(1)(B)(i). P includes $1,890 in income under

section 951(a)(1)(A)(i) as passive income under sections 904(d)(1)(A) and 904(d)(3)(B).

Example 4. P, a foreign corporation, has two

wholly-owned subsidiaries, S, a domestic corporation, and B, a foreign corporation. On January 1,

2000, S purchases a one-percent interest in N, a foreign corporation, for $100. On January 2, 2000, N

distributes a $20 dividend to S. The $20 dividend is

foreign source financial services income. On January 3, 2000, S sells its N stock to B for $80 and recognizes a $20 loss that is deferred under section

267(f). On June 10, 2008, B sells its N stock to an

unrelated person for $55. Under section 267(f) and

§1.267(f)–1(c)(1), S’s $20 loss is deferred until

2008. Under this paragraph (b)(1), the $20 loss is

allocated to reduce foreign source financial services

income in 2008 because the loss was recognized (albeit deferred) within the 24-month recapture period

following the receipt of the dividend. See

§§1.267(f)–1(a)(2)(i)(B) and 1.267(f)–1(c)(2).

Example 5. The facts are the same as in Example

4, except P, S, and B are domestic corporations and

members of the P consolidated group. Under the

matching rule of §1.1502–13(c)(1), the separate entity attributes of S’s intercompany items and B’s corresponding items are redetermined to the extent necessary to produce the same effect on consolidated

taxable income as if S and B were divisions of a single corporation and the intercompany transaction

was a transaction between divisions. If S and B were

divisions of a single corporation, the transfer of N

stock on January 3, 2000 would be ignored for tax

purposes, and the corporation would be treated as

selling that stock only in 2008. Thus, the corporation’s entire $45 loss would have been allocated

against U.S. source income under paragraph (a)(1)

of this section because a dividend recapture amount

was not received during the corporation’s recapture

period. Accordingly, S’s $20 loss and B’s $25 loss

are allocated to reduce U.S. source income.

(2) Exception for inventory. This section does not apply to loss recognized

with respect to stock described in section

1221(1).

(3) Exception for stock in an S corporation. This section does not apply to loss

recognized with respect to stock in an S

corporation (as defined in section 1361).

(4) Anti-abuse rules—(i) Transactions

involving built-in losses. If one of the

principal purposes of a transaction is to

change the allocation of a built-in loss

with respect to stock by transferring the

stock to another person, qualified business unit (within the meaning of section

989(a)), office or other fixed place of

February 1, 1999

business, or branch that subsequently recognizes the loss, the loss shall be allocated by the transferee as if it were recognized with respect to the stock by the

transferor immediately prior to the transaction. If one of the principal purposes of

a change of residence is to change the allocation of a built-in loss with respect to

stock, the loss shall be allocated as if the

change of residence had not occurred. If

one of the principal purposes of a transaction is to change the allocation of a builtin loss with respect to stock (or other personal property) by converting the original

property into other property and subsequently recognizing loss with respect to

such other property, the loss shall be allocated as if it were recognized with respect

to the original property immediately prior

to the transaction. Transactions subject to

this paragraph shall include, without limitation, reorganizations within the meaning

of section 368(a), liquidations under section 332, transfers to a corporation under

section 351, transfers to a partnership

under section 721, transfers to a trust, distributions by a partnership, distributions

by a trust, or transfers to or from a qualified business unit, office or other fixed

place of business. A person may have a

principal purpose of affecting loss allocation even though this purpose is outweighed by other purposes (taken together or separately).

(ii) Offsetting positions. If a taxpayer

recognizes loss with respect to stock and

the taxpayer (or any person described in

section 267(b) (after application of section 267(c)), 267(e), 318 or 482 with respect to the taxpayer) holds (or held) offsetting positions with respect to such

stock with a principal purpose of recognizing foreign source income and United

States source loss, the loss will be allocated and apportioned against such foreign source income. For purposes of this

paragraph (b)(4)(ii), positions are offsetting if the risk of loss of holding one or

more positions is substantially diminished

by holding one or more other positions.

(iii) Matching rule. [Reserved] For further guidance, see §1.865–2T(b)(4)(iii).

(iv) Examples. The application of this

paragraph (b)(4) may be illustrated by the

following examples. No inference is intended regarding the application of any

other Internal Revenue Code section or

judicial doctrine that may apply to disal-

low or defer the recognition of loss. The

examples are as follows:

Example 1. (i) Facts. On January 1, 2000, P, a

domestic corporation, owns all of the stock of N1, a

controlled foreign corporation, which owns all of the

stock of N2, a controlled foreign corporation. N1’s

basis in the stock of N2 exceeds its fair market

value, and any loss recognized by N1 on the sale of

N2 would be allocated under paragraph (a)(1) of this

section to reduce foreign source passive limitation

earnings and profits of N1. In contemplation of the

sale of N2 to an unrelated purchaser, P causes N1 to

liquidate with principal purposes of recognizing the

loss on the N2 stock and allocating the loss against

U.S. source income. P sells the N2 stock and P recognizes a loss.

(ii) Loss allocation. Because one of the principal

purposes of the liquidation was to transfer the stock

to P in order to change the allocation of the built-in

loss on the N2 stock, under paragraph (b)(4)(i) of

this section the loss is allocated against P’s foreign

source passive limitation income.

Example 2. (i) Facts. On January 1, 2000, P, a

domestic corporation, forms N and F, foreign corporations, and contributes $1,000 to the capital of each.

N and F enter into offsetting positions in financial

instruments that produce financial services income.

Holding the N stock substantially diminishes P’s

risk of loss with respect to the F stock (and vice

versa). P holds N and F with a principal purpose of

recognizing foreign source income and U.S. source

loss. On March 31, 2000, when the financial instrument held by N is worth $1,200 and the financial instrument held by F is worth $800, P sells its F stock

and recognizes a $200 loss.

(ii) Loss allocation. Because P held an offsetting

position with respect to the F stock with a principal

purpose of recognizing foreign source income and

U.S. source loss, the $200 loss is allocated against

foreign source financial services income under paragraph (b)(4)(ii) of this section.

partner’s distributive share of loss recognized by a partnership shall be allocated

and apportioned in accordance with this

section as if the partner had recognized

the loss. If loss is attributable to an office

or other fixed place of business of the

partnership within the meaning of section

865(e)(3), such office or fixed place of

business shall be considered to be an office of the partner for purposes of this section.

(d) Definitions—(1) Terms defined in

§1.861–8. See §1.861–8 for the meaning

of class of gross income, statutory grouping of gross income, and residual grouping of gross income.

(2) Dividend recapture amount. A dividend recapture amount is a dividend (except for an amount treated as a dividend

under section 78), an inclusion described

in section 951(a)(1)(A)(i) (but only to the

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extent attributable to a dividend (including a dividend under section 964(e)(1))

included in the earnings of a controlled

foreign corporation (held directly or indirectly by the person recognizing the loss)

that is included in foreign personal holding company income under section

954(c)(1)(A)) and an inclusion described

in section 951(a)(1)(B).

(3) Recapture period. A recapture period is the 24-month period preceding the

date on which a taxpayer recognizes a loss

with respect to stock, increased by any period of time in which the taxpayer has diminished its risk of loss in a manner described in section 246(c)(4) and the

regulations thereunder and by any period

in which the assets of the corporation are

hedged against risk of loss with a principal

purpose of enabling the taxpayer to hold

the stock without significant risk of loss

until the recapture period has expired.

(4) United States resident. See section

865(g) and the regulations thereunder for

the definition of United States resident.

(e) Effective date—(1) In general.

This section is effective for loss recognized on or after January 11, 1999. For

purposes of this paragraph (e), loss that is

recognized but deferred (for example,

under section 267 or 1092) shall be

treated as recognized at the time the loss

is taken into account.

(2) Application to prior periods. A taxpayer may apply the rules of this section

to losses recognized in any taxable year

beginning on or after January 1, 1987, and

all subsequent years, provided that—

(i) The taxpayer’s tax liability as shown

on an original or amended tax return is

consistent with the rules of this section

and §1.865–2T for each such year for

which the statute of limitations does not

preclude the filing of an amended return

on June 30, 1999; and

(ii) The taxpayer makes appropriate adjustments to eliminate any double benefit

arising from the application of this section

to years that are not open for assessment.

(3) Examples. The rules of this paragraph (e) may be illustrated by the following examples:

Example 1. (i) P, a domestic corporation, has a

calendar taxable year. On March 10, 1985, P recognizes a $100 capital loss on the sale of N, a foreign

corporation. Pursuant to sections 1211(a) and

1212(a), the loss is not allowed in 1985 and is carried over to the 1990 taxable year. The loss is allo-

1999–5 I.R.B

cated against foreign source income under §1.861–

8(e)(7). In 1999, P chooses to apply this section to

all losses recognized in its 1987 taxable year and in

all subsequent years.

(ii) Allocation of the loss on the sale of N is not

affected by the rules of this section because the loss

was recognized in a taxable year that did not begin

after December 31, 1986.

Example 2. (i) P, a domestic corporation, has a

calendar taxable year. On March 10, 1988, P recognizes a $100 capital loss on the sale of N, a foreign

corporation. Pursuant to sections 1211(a) and

1212(a), the loss is not allowed in 1988 and is carried back to the 1985 taxable year. The loss is allocated against foreign source income under §1.861–

8(e)(7) on P’s federal income tax return for 1985

and increases an overall foreign loss account under

§1.904(f)–1.

(ii) In 1999, P chooses to apply this section to all

losses recognized in its 1987 taxable year and in all

subsequent years. Consequently, the loss on the sale

of N is allocated against U.S. source income under

paragraph (a)(1) of this section. Allocation of the

loss against U.S. source income reduces P’s overall

foreign loss account and increases P’s tax liability in

2 years: 1990, a year that will not be open for assessment on June 30, 1999, and 1997, a year that will be

open for assessment on June 30, 1999. Pursuant to

paragraph (e)(2)(i) of this section, P must file an

amended federal income tax return that reflects the

rules of this section for 1997, but not for 1990.

Example 3. (i) P, a domestic corporation, has a

calendar taxable year. On March 10, 1989, P recognizes a $100 capital loss on the sale of N, a foreign

corporation. The loss is allocated against foreign

source income under §1.861–8(e)(7) on P’s federal

income tax return for 1989 and results in excess foreign tax credits for that year. The excess credit is

carried back to 1988, pursuant to section 904(c). In

1999, P chooses to apply this section to all losses

recognized in its 1989 taxable year and in all subsequent years. On June 30, 1999, P’s 1988 taxable

year is closed for assessment, but P’s 1989 taxable

year is open with respect to claims for refund.

(ii) Because P chooses to apply this section to its

1989 taxable year, the loss on the sale of N is allocated against U.S. source income under paragraph

(a)(1) of this section. Allocation of the loss against

U.S. source income would have permitted the foreign tax credit to be used in 1989, reducing P’s tax

liability in 1989. Nevertheless, under paragraph

(e)(2)(ii) of this section, because the credit was carried back to 1988, P may not claim the foreign tax

credit in 1989.

Par. 6. Section 1.865–2T is added immediately after §1.865–2, to read as follows:

§1.865–2T Loss with respect to stock

(Temporary).

(a) through (b)(4)(ii) [Reserved] For

further guidance, see §1.865–2(a) through

(b)(4)(ii).

(b)(4)(iii) Matching rule. To the extent

a taxpayer (or a person described in section 1059(c)(3)(C) with respect to the tax-

payer) recognizes foreign source income

for tax purposes that results in the creation of a corresponding loss with respect

to stock, the loss shall be allocated and

apportioned against such income. This

paragraph (b)(4)(iii) shall not apply to the

extent a loss is related to a dividend recapture amount and §1.865–2(b)(1)(ii)

(de minimis exception) or (b)(1)(iii) (passive dividend exception) exempts the loss

from §1.865–2(b)(1)(i) (dividend recapture rule), unless the stock is held with a

principal purpose of producing foreign

source income and corresponding loss.

(iv) Examples. The application of this

paragraph (b)(4) may be illustrated by the

following examples. No inference is intended regarding the application of any

other Internal Revenue Code section or

judicial doctrine that may apply to disallow or defer the recognition of loss. The

examples are as follows:

Examples 1 and 2. [Reserved] For further guidance, see §1.865–2(b)(4)(iv).

Example 3. (i) Facts. On January 1, 1999, P and

Q, domestic corporations, form R, a domestic partnership. The corporations and partnership use the

calendar year as their taxable year. P contributes

$900 to R in exchange for a 90- percent partnership

interest and Q contributes $100 to R in exchange for

a 10-percent partnership interest. R purchases a

dance studio in country X for $1,000. On January 2,

1999, R enters into contracts to provide dance

lessons in Country X for a 5-year period beginning

January 1, 2000. These contracts are prepaid by the

dance studio customers on December 31, 1999, and

R recognizes foreign source taxable income of $500

from the prepayments (R’s only income in 1999). P

takes into income its $450 distributive share of partnership taxable income. On January 1, 2000, P’s

basis in its partnership interest is $1,350 ($900 from

its contribution under section 722, increased by its

$450 distributive share of partnership income under

section 705). On September 22, 2000, P contributes

its R partnership interest to S, a newly-formed domestic corporation, in exchange for all the stock of

S. Under section 358, P’s basis in S is $1,350. On

December 1, 2000, P sells S to an unrelated party for

$1050 and recognizes a $300 loss.

(ii) Loss allocation. Because P recognized foreign source income for tax purposes that resulted in

the creation of a corresponding loss with respect to

the S stock, the $300 loss is allocated against foreign

source income under paragraph (b)(4)(iii) of this

section.

Example 4. (i) Facts. On January 1, 2000, P, a

domestic corporation that uses the calendar year as

its taxable year forms N, a foreign corporation. P

contributes $1,000 to the capital of N in exchange

for 100 shares of common stock. P contributes an

additional $1,000 to the capital of N in exchange for

100 shares of preferred stock. Each preferred share

is entitled to 15- percent dividend but is redeemable

by N on or after January 1, 2010, for $1. Prior to

February 1, 1999

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January 10, 2005, P receives a total of $750 of distributions from N with respect to its preferred shares,

which P treats as foreign source general limitation

dividends. On January 10, 2005, P sells its 100 preferred shares in N to an unrelated purchaser for

$600. Assume that this arrangement is not recharacterized under Notice 97–21 (1997–1 C.B. 407).

(ii) Loss allocation. Because P recognized foreign source income for tax purposes that resulted in

the creation of a corresponding loss with respect to

the N stock, the $400 loss is allocated against foreign source general limitation income under paragraph (b)(4)(iii) of this section.

Example 5. (i) Facts. On January 1, 2000, P, a

domestic corporation that uses the calendar year as

its taxable year, and F, a newly-formed controlled

foreign corporation wholly-owned by P, form N, a

foreign corporation. P contributes $1,000 to the

capital of N in exchange for 100 shares of common

stock and $1,000 to the capital of F in exchange for

100 shares of common stock. F contributes

LC1,000 to the capital of N in exchange for 100

shares of preferred stock. Each preferred share is

entitled to a 65-percent LC dividend. At the time of

the contributions, $1=LC1. The LC is expected to

depreciate significantly in relation to the U.S. dollar.

Prior to June 10, 2005, P receives a total of $1,900

of distributions from F, which it treats as foreign

source general limitation dividends. On June 10,

2005, the N preferred stock has a fair market value

of $25 and P sells F for $25 to an unrelated person.

Assume that this arrangement is not recharacterized

under Notice 97–21 (1997–1 C.B. 407).

(ii) Loss allocation. Because P recognized foreign source income for tax purposes that resulted in

the creation of a corresponding loss with respect to

the F stock, the $975 loss is allocated against foreign

source general limitation income under paragraph

(b)(4)(iii) of this section.

Example 6. (i) Facts. On January 1, 1998, P, a

domestic corporation, purchases N, a foreign corporation, for $1000. On March 1, 1998, N sells its operating assets, distributes a $400 general limitation

dividend to P, and invests its remaining $600 in

short term government securities. N earns interest

income from the securities. The income constitutes

subpart F income that is included in P’s income

under section 951, increasing P’s basis in the N

stock under section 961(a). On March 1, 2002, P

sells N and recognizes a $400 loss.

(ii) Loss allocation. The $400 dividend received

by P resulted in a $400 built-in loss in the N stock,

which was locked in for P’s four-year holding period.

Because P recognized foreign source income for tax

purposes that resulted in the creation of a corresponding loss with respect to the N stock, under paragraph

(b)(4)(iii) of this section the $400 loss is allocated

against foreign source general limitation income.

(e) Effective date—(1) In general.

This section is effective for loss recognized on or after January 11, 1999. For

purposes of this paragraph (e), loss that is

recognized but deferred (for example,

under section 267 or 1092) shall be

treated as recognized at the time the loss

is taken into account. This section shall

cease to be effective January 8, 2002.

February 1, 1999

(2) Application to prior periods. A taxpayer may apply the rules of this section

to losses recognized in any taxable year

beginning on or after January 1, 1987, and

all subsequent years, provided that—

(i) The taxpayer’s tax liability as shown

on an original or amended tax return is

consistent with the rules of this section

and §1.865–2 for each such year for

which the statute of limitations does not

preclude the filing of an amended return

on June 30, 1999; and

(ii) The taxpayer makes appropriate adjustments to eliminate any double benefit

arising from the application of this section

to years that are not open for assessment.

Par. 7. Section 1.904–0 is amended by

revising the entry for §1.904–4(c)(2)(i)

and (ii) and adding entries for paragraphs

(c)(2)(i)(A), (c)(2)(i)(B), (c)(2)(ii)(A) and

(c)(2)(ii)(B) to read as follows:

§1.904–0 Outline of regulation

provisions for section 904.

* * * * *

§1.904–4 Separate application of section

904 with respect to certain categories of

income.

* * * * *

(c)

(2)

(i)

(A)

(B)

(ii)

(A)

(B)

***

Effective dates.

In general.

Application to prior periods.

Grouping rules.

Initial allocation and apportionment

of deductions and taxes.

Reallocation of loss groups.

* * * * *

Par. 8. Section 1.904–4 is amended by:

1. Revising paragraphs (c)(1) and

(c)(2),

2. Revising paragraph (c)(3)(iii),

3. Adding paragraph (c)(3)(iv), and

4. Amending paragraph (c)(8) by

adding Example 11, Example 12 and Example 13.

5. The additions and revisions read as

follows:

§1.904–4 Separate application of section

904 with respect to certain categories of

income.

* * * * *

Income received or accrued by a United

States person that would otherwise be

passive income shall not be treated as passive income if the income is determined

to be high-taxed income. Income shall be

considered to be high-taxed income if,

after allocating expenses, losses and other

deductions of the United States person to

that income under paragraph (c)(2)(ii) of

this section, the sum of the foreign income taxes paid or accrued by the United

States person with respect to such income

and the foreign taxes deemed paid or accrued by the United States person with respect to such income under section 902 or

section 960 exceeds the highest rate of tax

specified in section 1 or 11, whichever applies (and with reference to section 15 if

applicable), multiplied by the amount of

such income (including the amount

treated as a dividend under section 78).

If, after application of this paragraph (c),

income that would otherwise be passive

income is determined to be high-taxed income, such income shall be treated as

general limitation income, and any taxes

imposed on that income shall be considered related to general limitation income

under §1.904–6. If, after application of

this paragraph (c), passive income is zero

or less than zero, any taxes imposed on

the passive income shall be considered related to general limitation income. For

additional rules regarding losses related to

passive income, see paragraph (c)(2) of

this section. Income and taxes shall be

translated at the appropriate rates, as determined under sections 986, 987 and 989

and the regulations under those sections,

before application of this paragraph (c).

For purposes of allocating taxes to groups

of income, United States source passive

income is treated as any other passive income. In making the determination

whether income is high-taxed, however,

only foreign source income, as determined under United States tax principles,

is relevant. See paragraph (c)(8) Examples 10 through 13 of this section for examples illustrating the application of this

paragraph (c)(1) and paragraph (c)(2) of

this section.

(2) Grouping of items of income in

order to determine whether passive income is high-taxed income—(i) Effective

dates—(A) In general. For purposes of

determining whether passive income is

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high-taxed income, the grouping rules of

paragraphs (c)(3)(i) and (ii), (c)(4), and

(c)(5) of this section apply to taxable

years beginning after December 31, 1987.

Except as provided in paragraph

(c)(2)(i)(B) of this section, the rules of

paragraph (c)(3)(iii) apply to taxable

years beginning after December 31, 1987,

and ending before December 31, 1998,

and the rules of paragraph (c)(3)(iv) apply

to taxable years ending on or after December 31, 1998. See Notice 87–6 (19871 C.B.417) for the grouping rules applicable to taxable years beginning after

December 31, 1986 and before January 1,

1988. The fourth sentence of paragraph

(c)(2)(ii)(A) and paragraph (c)(2)(ii)(B)

of this section are effective for taxable

years beginning after March 12, 1999.

(B) Application to prior periods. A

taxpayer may apply the rules of paragraph

(c)(3)(iv) to any taxable year beginning

after December 31, 1991, and all subsequent years, provided that—

(1) The taxpayer ’s tax liability as

shown on an original or amended tax return is consistent with the rules of this

section for each such year for which the

statute of limitations does not preclude

the filing of an amended return on June

30, 1999; and

(2) The taxpayer makes appropriate adjustments to eliminate any double benefit

arising from the application of this section

to years that are not open for assessment.

(ii) Grouping rules—(A) Initial allocation and apportionment of deductions and

taxes. For purposes of determining

whether passive income is high-taxed, expenses, losses and other deductions shall

be allocated and apportioned initially to

each of the groups of passive income (described in paragraphs (c)(3), (4), and (5)

of this section) under the rules of

§§1.861–8 through 1.861–14T and 1.865–

1T through 1.865–2T. Taxpayers that allocate and apportion interest expense on

an asset basis may nevertheless apportion

passive interest expense among the

groups of passive income on a gross income basis. Foreign taxes are allocated to

groups under the rules of §1.904–6(a)(iii).

If a loss on a disposition of property gives

rise to foreign tax (i.e., the transaction

1999–5 I.R.B

giving rise to the loss is treated under foreign law as having given rise to a gain),

the foreign tax shall be allocated to the

group of passive income to which gain on

the sale would have been assigned under

paragraph (c)(3) or (4) of this section. A

determination of whether passive income

is high-taxed shall be made only after application of paragraph (c)(2)(ii)(B) of this

section (if applicable).

(B) Reallocation of loss groups. If,

after allocation and apportionment of expenses, losses and other deductions under

paragraph (c)(2)(ii)(A) of this section, the

sum of the allocable deductions exceeds

the gross income in one or more groups,

the excess deductions shall proportionately reduce income in the other groups

(but not below zero).

(3) * * *

(iii) For taxable years ending before

December 31, 1998 (except as provided

in paragraph (c)(2)(i)(B) of this section),

all passive income received during the

taxable year that is subject to no withholding tax shall be treated as one item of

income.

(iv) For taxable years ending on or after

December 31, 1998, all passive income

received during the taxable year that is

subject to no withholding tax or other foreign tax shall be treated as one item of income, and all passive income received

during the taxable year that is subject to

no withholding tax but is subject to a foreign tax other than a withholding tax shall

be treated as one item of income.

* * * * *

(8) * * *

allocated to foreign source passive limitation income under §1.865–2(a)(3)(i). The $700 capital loss

is initially allocated to the group of passive income

subject to no withholding tax but subject to foreign

tax other than withholding tax. The $300 amount by

which the capital loss exceeds the income in the

group must be reapportioned to the other groups

under paragraph (c)(2)(ii)(B) of this section. The

royalty income is thus reduced by $100 to $100

($200 – ($300 ⫻ (200/600))) and the rental income

is thus reduced by $200 to $200 ($400 – ($300 ⫻

(400/600))). The $100 royalty income is not hightaxed and remains passive income because the foreign taxes do not exceed the highest United States

rate of tax on that income. Under the high-tax kickout, the $200 of rental income and the $325 of associated foreign tax are assigned to the general limitation category.

Example 12. The facts are the same as in Example 11 except the amount of the capital loss that is allocated under §1.865–2(a)(3)(i) and paragraph (c)(2)

of this section to the group of foreign source passive

income subject to no withholding tax but subject to

foreign tax other than withholding tax is $1,200.

Under paragraph (c)(2)(ii)(B) of this section, the excess deductions of $800 must be reapportioned to

the $200 of net royalty income subject to a 5 percent

withholding tax and the $400 of net rental income

subject to a 15 percent or greater withholding tax.

The income in each of these groups is reduced to

zero, and the foreign taxes imposed on the rental and

royalty income are considered related to general

limitation income. The remaining loss of $200 constitutes a separate limitation loss with respect to passive income.

Example 13. In 2001, P, a domestic corporation,

earns a $100 dividend that is foreign source passive

limitation income subject to a 30-percent withholding tax. A foreign tax credit for the withholding tax

on the dividend is disallowed under section 901(k).

A deduction for the tax is allowed, however, under

sections 164 and 901(k)(7). In determining whether

P’s passive income is high-taxed, the $100 dividend

and the $30 deduction are allocated to the first group

of income described in paragraph (c)(3)(iv) of this

section (passive income subject to no withholding

tax or other foreign tax).

* * * * *

Example 11. In 2001, P, a U.S. citizen with a tax

home in Country X, earns the following items of

gross income: $400 of foreign source, passive limitation interest income not subject to foreign withholding tax but subject to Country X income tax of

$100, $200 of foreign source, passive limitation royalty income subject to a 5 percent foreign withholding tax (foreign tax paid is $10), $1,300 of foreign

source, passive limitation rental income subject to a

25 percent foreign withholding tax (foreign tax paid

is $325), $500 of foreign source, general limitation

income that gives rise to a $250 foreign tax, and

$2,000 of U.S. source capital gain that is not subject

to any foreign tax. P has a $900 deduction allocable

to its passive rental income. P’s only other deduction is a $700 capital loss on the sale of stock that is

Robert E. Wenzel,

Deputy Commissioner of

Internal Revenue.

Approved December 15, 1998.

Donald C. Lubick,

Assistant Secretary of

the Treasury.

(Filed by the Office of the Federal Register on January 8, 1999, 8:45 a.m., and published in the issue of

the Federal Register for January 11, 1999, 64 F.R.

1505)

February 1, 1999

IRB 1999-5

1/27/99 3:27 PM

Page 26

Part III. Administrative, Procedural, and Miscellaneous

Proposed Changes to Final

Withholding Regulations Under

Section 1441; Proposed Model

Qualified Intermediary

Withholding Agreement

NOTICE 99–8

Background and Scope

On October 14, 1997, the Department

of the Treasury (the “Treasury”) and the

Internal Revenue Service (the “IRS”) issued final Income Tax Regulations (the

“final withholding regulations”) under

chapter 3 (sections 1441-1464) and subpart G of subchapter A of chapter 61 (sections 6041-6050S) of the Internal Revenue Code (the

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