Bulletin No. 2003–19

Bulletin No. 2003–19

May 12, 2003

HIGHLIGHTS

OF THIS ISSUE

These synopses are intended only as aids to the reader in

identifying the subject matter covered. They may not be

relied upon as authoritative interpretations.

INCOME TAX

EMPLOYEE PLANS

Ct. D. 2077, page 868.

Research and development expenses; accounting. The Supreme Court holds that section 1.861–8(e)(3) is a proper exercise of the Secretary of the Treasury’s rulemaking authority.

Boeing Co., et al. v. United States.

Rev. Rul. 2003–47, page 866.

Length of service award plan. This ruling provides an example to eligible employers of a type of length-of-service award

program (LOSAP) that would qualify as a valid LOSAP plan described in section 457(e)(11)(A)(ii) of the Code.

Rev. Rul. 2003–45, page 876.

Federal rates; adjusted federal rates; adjusted federal longterm rate and the long-term exempt rate. For purposes of

sections 382, 1274, 1288, and other sections of the Code,

tables set forth the rates for May 2003.

T.D. 9052, page 879.

Final regulations provide guidance on the notification requirements under section 4980F of the Code and section 204(h) of

the Employee Retirement Income Security Act of 1974 (ERISA).

Rev. Rul. 2003–47, page 866.

Length of service award plan. This ruling provides an example to eligible employers of a type of length-of-service award

program (LOSAP) that would qualify as a valid LOSAP plan described in section 457(e)(11)(A)(ii) of the Code.

Rev. Rul. 2003–48, page 863.

Demutualization. This ruling provides guidance as to the tax

consequences when, as described in the specific facts presented, a mutual savings bank converts to a stock savings bank

and a holding company structure is created.

Notice 2003–20, page 894.

This notice describes the withholding and reporting requirements applicable to eligible deferred compensation plans described in section 457(b) of the Code for periods after December

31, 2001. Notice 2000–38 modified.

Finding Lists begin on page ii.

Notice 2003–20, page 894.

This notice describes the withholding and reporting requirements applicable to eligible deferred compensation plans described in section 457(b) of the Code for periods after December

31, 2001. Notice 2000–38 modified.

EXEMPT ORGANIZATIONS

Announcement 2003–28, page 899.

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

(Continued on the next page)

EMPLOYMENT TAX

Rev. Rul. 2003–46, page 878.

Federal Insurance Contributions Act (FICA); Medicare. This

ruling provides that for the continuing employment exception to

the Medicare portion of the Federal Insurance Contributions Act

tax to apply to service performed by an employee of a state, political subdivision, or instrumentality thereof, such employee must

be a member of a retirement system pursuant to section

3121(b)(7)(F) of the Code. Rev. Ruls. 86–88 and 88–36 supplemented.

Rev. Rul. 2003–47, page 866.

Length of service award plan. This ruling provides an example to eligible employers of a type of length-of-service award

program (LOSAP) that would qualify as a valid LOSAP plan described in section 457(e)(11)(A)(ii) of the Code.

Notice 2003–20, page 894.

This notice describes the withholding and reporting requirements applicable to eligible deferred compensation plans described in section 457(b) of the Code for periods after December

31, 2001. Notice 2000–38 modified.

ADMINISTRATIVE

Notice 2003–20, page 894.

This notice describes the withholding and reporting requirements applicable to eligible deferred compensation plans described in section 457(b) of the Code for periods after December

31, 2001. Notice 2000–38 modified.

Notice 2003–27, page 898.

Credit for sales of fuel produced from a nonconventional

source, inflation adjustment factor, and reference price.

This notice publishes the nonconventional source fuel credit, inflation adjustment factor, and reference price under section 29

of the Code for calendar year 2002. This data is used to determine the credit allowable on sales of fuel produced from a nonconventional source.

May 12, 2003

2003–19 I.R.B.

The IRS Mission

Provide America’s taxpayers top quality service by helping them

understand and meet their tax responsibilities and by applying

the tax law with integrity and fairness to all.

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

are consolidated semiannually into Cumulative Bulletins, which

are sold on a single-copy basis.

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.

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.

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

circumstances are substantially the same.

The Bulletin is divided into four parts as follows:

Part I.—1986 Code.

This part includes rulings and decisions based on provisions of

the Internal Revenue Code of 1986.

Part II.—Treaties and Tax Legislation.

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

Conventions and Other Related Items, 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).

Part IV.—Items of General Interest.

This part includes notices of proposed rulemakings, disbarment and suspension lists, and announcements.

The first Bulletin for each month includes a cumulative index for

the matters published during the preceding months. These

monthly indexes are cumulated on a semiannual basis, and are

published in the first Bulletin of the succeeding semiannual period, respectively.

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

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

2003–19 I.R.B.

May 12, 2003

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

Section 42.—Low-Income

Housing Credit

The adjusted applicable federal short-term,

mid-term, and long-term rates are set forth for the

month of May 2003. See Rev. Rul. 2003–45, page

876.

Section 280G.—Golden

Parachute Payments

Federal short-term, mid-term, and long-term

rates are set forth for the month of May 2003. See

Rev. Rul. 2003–45, page 876.

Section 368.—Definitions

Relating to Corporate

Reorganizations

26 CFR 1.368–1: Purpose and scope of exception

of reorganization exchanges.

Demutualization. This ruling provides

guidance as to the tax consequences when,

as described in the specific facts presented,

a mutual savings bank converts to a stock

savings bank and a holding company structure is created.

Rev. Rul. 2003–48

ISSUE

What are the tax consequences when, as

described in the facts below, a mutual savings bank converts to a stock savings bank?

FACTS

State Y Mutual Bank is a State Y mutual savings bank engaged in banking and

banking related activities. State Y Mutual

Bank is regulated by State Y, and State Y

Mutual Bank’s deposits are insured by the

FDIC. A membership interest in State Y

Mutual Bank arises from the ownership of

a bank deposit account in State Y Mutual

Bank and is inextricably tied to the bank

deposit account from the time of deposit.

A membership interest in State Y Mutual

Bank entitles the member to vote for the

board of directors and to receive assets and

other consideration in the event of the liquidation, dissolution, or winding up of State

Y Mutual Bank. The rights inherent in each

2003–19 I.R.B.

membership interest are created by operation of State Y law solely as a result of the

member’s ownership of a bank deposit account in State Y Mutual Bank and cannot

be transferred separately from that bank deposit account. Further, if a bank deposit account is surrendered by the member, the

membership interest ceases to exist, having no continuing value.

Mutual Holding Company is a State Y

mutual bank holding company. A membership interest in Mutual Holding Company

arises from the ownership of a bank deposit account in a bank that is a direct or

indirect, wholly owned subsidiary of Mutual Holding Company. Such a membership interest is inextricably tied to the bank

deposit account from the time of deposit.

A membership interest in Mutual Holding Company entitles the member to vote

for the board of directors of Mutual Holding Company and to receive assets or other

consideration in the event of the liquidation, dissolution, or winding up of Mutual Holding Company. The rights inherent

in each membership interest are created by

operation of State Y law solely as a result of the member’s bank deposit account

and cannot be transferred separately from

that bank deposit account. Further, if a bank

deposit account is surrendered by the member, the membership interest ceases to exist, having no continuing value.

Stock Holding Company is a State Y

stock company the articles of incorporation and by-laws of which authorize the issuance of capital stock. Stock Holding

Company has one class of voting stock outstanding.

Transitory is a transitory State Y stock

savings bank.

Each transaction described below is undertaken for a valid business purpose.

Situation 1. Pursuant to State Y law and

pursuant to an integrated business plan to

convert State Y Mutual Bank from a State

Y-chartered mutual savings bank to a State

Y-chartered stock savings bank and create a holding company structure, the following events occur. State Y Mutual Bank

incorporates Mutual Holding Company for

the sole purpose of engaging in the following transactions. Mutual Holding Company initially is organized in stock form.

Although Mutual Holding Company is temporarily organized as a stock corporation

863

solely due to regulatory requirements, the

parties intend at the time Mutual Holding

Company is organized that Mutual Holding Company will operate and function in

mutual form. In turn, Mutual Holding Company incorporates two wholly owned subsidiaries, Stock Holding Company and

Transitory. Thereafter, the following events

occur substantially contemporaneously: State

Y Mutual Bank exchanges its State Y mutual bank charter for a State Y stock savings bank charter (which permits the bank

to issue equity interests in the form of stock)

and changes its name to Stock Bank; Mutual Holding Company cancels its outstanding stock and exchanges its charter for a

State Y mutual holding company charter;

and Transitory merges with and into Stock

Bank with Stock Bank surviving as a

wholly owned subsidiary of Mutual Holding Company and State Y Mutual Bank’s

members receiving Mutual Holding Company membership interests in place of their

former State Y Mutual Bank membership

interests. Mutual Holding Company then

transfers all of its Stock Bank stock to Stock

Holding Company in exchange for voting

stock of Stock Holding Company. Pursuant to the same plan, Stock Holding Company issues more than 20 percent but less

than 50 percent of its common stock to the

public in a qualified underwriting transaction as defined in § 1.351–1(a)(3) (the

“Stock Offering”).

Under State Y law, Stock Bank’s corporate existence as a stock savings bank is

a continuation of State Y Mutual Bank’s

corporate existence as a mutual savings

bank.

Situation 2. The facts are the same as in

Situation 1, except that Stock Holding Company issues no more than 20 percent of its

common stock in the Stock Offering.

LAW

Section 351(a) provides that no gain or

loss will be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such

corporation and immediately after the exchange such person or persons are in control (as defined in § 368(c)) of the

corporation.

Section 1.351–1(a)(3) of the Income Tax

Regulations provides that, for purposes of

§ 351, if a person acquires stock of a corporation from an underwriter in exchange

May 12, 2003

for cash in a qualified underwriting transaction, the person who acquires stock from

the underwriter is treated as transferring

cash directly to the corporation in exchange

for stock of the corporation and the underwriter is disregarded. A qualified underwriting transaction is a transaction in which

a corporation issues stock for cash in an underwriting in which either the underwriter

is an agent of the corporation or the underwriter’s ownership of the stock is transitory.

Section 354(a) provides that, in general, no gain or loss shall be recognized if

stock or securities in a corporation a party

to a reorganization are, in pursuance of the

plan of reorganization, exchanged solely for

stock or securities in such corporation or

in another corporation a party to the reorganization.

Section 368(a)(1)(A) states that the term

“reorganization” means a statutory merger

or consolidation. Section 368(a)(2)(E) provides that a transaction otherwise qualifying under § 368(a)(1)(A) will not be

disqualified by reason of the fact that stock

of a corporation (the “controlling corporation”) that before the merger was in control of the merged corporation is used in the

transaction, if (1) after the transaction, the

corporation surviving the merger holds substantially all of its properties and of the

properties of the merged corporation (other

than stock of the controlling corporation distributed in the transaction), and (2) in the

transaction, former shareholders of the surviving corporation exchanged, for an

amount of voting stock of the controlling

corporation, an amount of stock in the surviving corporation that constitutes control of such corporation (the control-forvoting-stock requirement).

Section 368(a)(1)(B) provides that the

term reorganization means the acquisition

by one corporation, in exchange solely for

all or a part of its voting stock (or in exchange solely for all or a part of the voting stock of a corporation which is in

control of the acquiring corporation), of

stock of another corporation if, immediately after the acquisition, the acquiring corporation has control of such other

corporation (whether or not such acquiring corporation had control immediately before the acquisition).

For purposes of §§ 368(a)(1)(B) and

368(a)(2)(E), control is defined in § 368(c).

Section 368(c) defines the term “control”

May 12, 2003

to mean the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock

entitled to vote and at least 80 percent of

the total number of shares of all other

classes of stock of the corporation.

Section 368(a)(1)(E) provides that the

term reorganization includes a recapitalization. In Helvering v. Southwest Consol. Corp., 315 U.S. 194, 202 (1942), the

Supreme Court defined a recapitalization as

a “reshuffling of a capital structure within

the framework of an existing corporation.”

Section 368(a)(1)(F) provides that the

term reorganization means a mere change

in identity, form, or place of organization

of one corporation, however effected.

Section 368(a)(2)(C) states, in relevant

part, that a transaction otherwise qualifying under § 368(a)(1)(A) or 368(a)(1)(B)

will not be disqualified by reason of the fact

that part or all of the assets or stock which

were acquired in the transaction are transferred to a corporation controlled by the corporation acquiring such assets or stock.

Section 1.368–2(k)(1) of the Income Tax

Regulations restates the general rule of

§ 368(a)(2)(C) but permits the assets or

stock acquired in certain types of reorganizations, including reorganizations under

§ 368(a)(1)(A) or (B), to be successively

transferred to one or more corporations controlled (as defined in § 368(c)) in each transfer by the transferor corporation without

disqualifying the reorganization. Additionally, § 1.368–2(k)(2) provides that a transaction qualifying under §§ 368(a)(1)(A) and

368(a)(2)(E) is not disqualified by reason

of the fact that part or all of the stock of

the surviving corporation is transferred or

successively transferred to one or more corporations controlled in each transfer by the

transferor corporation.

Generally, to qualify as a reorganization under § 368(a)(1), a transaction must

satisfy the continuity of business enterprise (COBE) requirement. Section 1.368–

1(d)(1) provides that COBE requires the

issuing corporation (generally the acquiring corporation) in a potential reorganization to either continue the target

corporation’s historic business or use a significant portion of the target’s historic business assets in a business. Pursuant to

§ 1.368–1(d)(4)(i), the issuing corporation is treated as holding all of the businesses and assets of all members of its

qualified group. Section 1.368–1(d)(4)(ii)

864

defines a qualified group as one or more

chains of corporations connected through

stock ownership with the issuing corporation, but only if the issuing corporation

owns directly stock meeting the requirements of § 368(c) in at least one other corporation, and stock meeting the

requirements of § 368(c) in each of the corporations (except the issuing corporation)

is owned directly by one of the other corporations. Continuity of business enterprise is not required for a recapitalization

to qualify as a reorganization under

§ 368(a)(1)(E). See Rev. Rul. 82–34, 1982–1

C.B. 59.

Generally, to qualify as a reorganization under § 368(a)(1), a transaction must

satisfy the continuity of interest requirement. Section 1.368–1(e)(1)(i) provides that

continuity of interest requires that in substance a substantial part of the value of the

proprietary interests in the target corporation be preserved in the reorganization. All

facts and circumstances must be considered in determining whether, in substance,

a proprietary interest in the target corporation is preserved. Continuity of interest

is not a requirement for reorganizations under § 368(a)(1)(E). See Rev. Rul. 77–415,

1977–2 C.B. 311.

In Paulsen v. Commissioner, 469 U.S.

131 (1985), a state-chartered stock savings and loan association merged into a

federally-chartered non-stock mutual savings and loan association. The stockholders exchanged all of their stock in the statechartered stock savings and loan association

for passbook savings accounts and certificates of deposit in the federally-chartered

non-stock mutual savings and loan association. The Supreme Court determined that

the passbooks and certificates of deposit in

the federally-chartered non-stock mutual

savings and loan association had a predominantly cash-equivalent component and

an insubstantial equity component. Because the passbooks and certificates of deposit essentially represented cash with an

insubstantial equity component, the Court

held that the transaction did not satisfy the

continuity of interest requirement and, therefore, did not qualify as a tax-free reorganization.

In Rev. Rul. 69–3, 1969–1 C.B. 103, X,

a mutual savings and loan association,

merged into Y, another mutual savings and

loan association. In the merger, Y issued to

each share account holder of X a share ac-

2003–19 I.R.B.

count equal to the dollar amount evidenced

by such holder’s passbook. Because the

share account holders of X received proprietary interests in Y that were equivalent to their equity interests in X before the

exchange, the exchange was solely an

equity-for-equity exchange that satisfied the

continuity of interest requirement. Accordingly, the Service ruled that the transaction qualified as a tax-free reorganization

under § 368(a)(1)(A).

ANALYSIS

Situation 1. Because Stock Bank is a

continuation of State Y Mutual Bank under State Y law, the conversion from State

Y Mutual Bank to Stock Bank qualifies as

a reorganization under § 368(a)(1)(E) as

well as a reorganization under

§ 368(a)(1)(F). Because Stock Bank is a

continuation of State Y Mutual Bank, tax

attributes of State Y Mutual Bank (such as

a bad debt reserve maintained under § 585

and a suspended reserve described in

§ 593(g)(2)(A)(ii)) continue as tax attributes

of Stock Bank. Finally, neither the subsequent transfer of Stock Bank stock to Stock

Holding Company nor the Stock Offering

prevents the conversion from qualifying as

a reorganization under § 368(a)(1)(E) as

well as a reorganization under

§ 368(a)(1)(F). See § 1.368–1(e)(1); Rev.

Rul. 96–29, 1996–1 C.B. 50; Rev. Rul. 77–

415, 1977–2 C.B. 311.

Because the status of Mutual Holding

Company as a stock holding company is

transitory, the conversion of Mutual Holding Company from a stock holding company to a mutual holding company is

disregarded.

Because the former owners of the bank

are in control (within the meaning of

§ 368(c)) of Mutual Holding Company, their

transfer of their equity interests in the bank

to Mutual Holding Company, in exchange

for membership interests in Mutual Holding Company, qualifies as a transfer described in § 351. Furthermore, that

transaction qualifies as a transfer described

in § 351, even though Mutual Holding

Company transfers all of its Stock Bank

stock to Stock Holding Company. See Rev.

Rul. 77–449, 1977–2 C.B. 110; Rev. Rul.

83–34, 1983–1 C.B. 79. However, the same

transaction (in which Transitory merges into

Stock Bank) does not qualify as a reorganization either under §§ 368(a)(1)(A) and

368(a)(2)(E) or under § 368(a)(1)(B) be-

2003–19 I.R.B.

cause at the end of the planned series of

transactions Stock Holding Company is not

a controlled corporation.

Finally, Mutual Holding Company’s contribution of the stock of Stock Bank to

Stock Holding Company in exchange for

Stock Holding Company’s voting stock constitutes a transfer described in § 351. The

subsequent Stock Offering by Stock Holding Company does not prevent the transaction from qualifying as a transfer

described in § 351 because the persons to

whom the stock is issued pursuant to the

Stock Offering, together with Mutual Holding Company, are transferors to Stock Holding Company under § 351. See § 1.351–

1(a)(3).

Situation 2. For the reasons described in

the analysis of Situation 1, the conversion from State Y Mutual Bank to Stock

Bank qualifies as a reorganization under

§ 368(a)(1)(E) as well as a reorganization

under § 368(a)(1)(F). Because Stock Bank

is a continuation of State Y Mutual Bank,

tax attributes of State Y Mutual Bank (such

as a bad debt reserve maintained under

§ 585 and a suspended reserve described

in § 593(g)(2)(A)(ii)) continue as tax attributes of Stock Bank.

Because the status of Mutual Holding

Company as a stock holding company is

transitory, the conversion of Mutual Holding Company from a stock holding company to a mutual holding company is

disregarded.

For the reasons described in Situation 1,

the exchange by the former bank owners

of their equity interests in the bank for

membership interests in Mutual Holding

Company qualifies as a transfer described

in § 351.

In addition, each of the membership interests in State Y Mutual Bank and Mutual Holding Company constitutes a

proprietary interest in the entities that is

treated as voting stock for federal income

tax purposes. See Rev. Rul. 69–3, 1969–1

C.B. 103. Because Mutual Holding Company acquires, in exchange solely for membership interests in Mutual Holding

Company, the actual stock of Stock Bank,

and, immediately after that acquisition Mutual Holding Company controls Stock Bank,

that acquisition qualifies as a reorganization under § 368(a)(1)(B), provided that the

continuity of business enterprise and continuity of interest requirements are satisfied. Because Stock Bank continues to

865

provide the same services as State Y Mutual Bank after the transactions described

herein, the continuity of business enterprise requirement is satisfied. See § 1.368–

1(d)(1). In addition, the acquisition satisfies

the continuity of interest requirement because, in the overall transaction, the State

Y Mutual Bank members receive Mutual

Holding Company membership interests in

place of their former Mutual Bank membership interests. See Rev. Rul. 69–3; cf.

Paulsen v. Commissioner, 469 U.S. 131

(1985). Thus, the acquisition qualifies as a

reorganization within the meaning of

§ 368(a)(1)(B). Moreover, neither the subsequent transfer by Mutual Holding Company of Stock Bank stock to Stock Holding

Company nor the Stock Offering prevents

the acquisition from qualifying as a reorganization under § 368(a)(1)(B). See

§ 368(a)(2)(C); § 1.368–1(d)(4)(i); § 1.368–

2(k).

For purposes of § 354, the former State

Y Mutual Bank’s members’ exchange of

their ownership interests for Mutual Holding Company’s membership interests is pursuant to that reorganization.

In addition, the merger of Transitory into

Stock Bank qualifies as a reorganization under §§ 368(a)(1)(A) and 368(a)(2)(E) because the owners of the bank exchanged,

for membership interests in Mutual Holding Company, an amount of stock in the

bank that constitutes control of Stock Bank.

Neither the subsequent transfer by Mutual Holding Company of the Stock Bank

stock to Stock Holding Company nor the

Stock Offering (of no more than 20 percent of the stock of Stock Holding Company) prevents the merger from so

qualifying. See § 1.368–2(k).

Furthermore, for the reasons described

in Situation 1, Mutual Holding Company’s contribution of the stock of Stock Bank

to Stock Holding Company in exchange for

Stock Holding Company’s voting stock constitutes a transfer described in § 351.

The analyses in Situations 1 and 2, in

general, would also apply if State Y Mutual Bank and Stock Bank were incorporated in different jurisdictions. However, in

that case, the conversion would not qualify

as a reorganization under § 368(a)(1)(E), but

would qualify as a reorganization under

§ 368(a)(1)(F). In a reorganization under

§ 368(a)(1)(F), Stock Bank takes into account the items of State Y Mutual Bank as

provided in § 381.

May 12, 2003

HOLDING

This revenue ruling describes the tax

consequences that occur when, as described

in the facts set forth in this ruling, a mutual savings bank converts to a stock savings bank.

DRAFTING INFORMATION

The principal authors of this revenue ruling are Jeffrey B. Fienberg and Emidio J.

Forlini, Jr., of the Office of Associate Chief

Counsel (Corporate). For further information regarding this revenue ruling, contact either Mr. Fienberg or Mr. Forlini at

(202) 622–7930 (not a toll-free call).

Section 382.—Limitation on

Net Operating Loss

Carryforwards and Certain

Built-In Losses Following

Ownership Change

The adjusted applicable federal long-term rate

is set forth for the month of May 2003. See Rev.

Rul. 2003–45, page 876.

Section 412.—Minimum

Funding Standards

The adjusted applicable federal short-term,

mid-term, and long-term rates are set forth for the

month of May 2003. See Rev. Rul. 2003–45, page

876.

Section 457.—Deferred

Compensation Plans of State

and Local Governments and

Tax Exempt Organizations

Length of service award plan. This ruling provides an example to eligible employers of a type of length-of-service award

program (LOSAP) that would qualify as a

valid LOSAP plan described in section

457(e)(11)(A)(ii) of the Code.

Rev. Rul. 2003–47

ISSUES:

(1) Is the plan described below a length

of service award plan described in

§ 457(e)(11)(A)(ii) of the Internal Revenue Code?

May 12, 2003

(2) When are benefits under the plan includible in gross income?

(3) Are benefits paid under the plan

wages for purposes of FICA taxes?

FACTS

Pursuant to State S law, the County C

Fire Department has adopted a written plan

(the “Plan”) to implement County C’s volunteer fire fighters’ and rescue squad workers’ service award program. County C and

its fire department intend the Plan to be a

length of service award plan described in

§ 457(e)(11)(A)(ii). The County C Fire Department is an agency or instrumentality of

County C which is an eligible employer

within the meaning of § 457(e)(1) and maintains the plan. The County C Fire Department employs both professional and

volunteer fire fighters.

The Plan has been established for the

benefit of long-term bona fide volunteers

who perform fire fighting, prevention, and

rescue squad services for the fire department, including related essential services,

such as services performed by dispatchers, mechanics, ambulance drivers, and certified instructors. The Plan provides length

of service awards to participating volunteers in recognition of their volunteer services to the fire department.

The Plan provides that benefits are only

provided to a volunteer who does not receive compensation from the department for

performing fire fighting and prevention services, emergency medical and ambulance

services, and related essential services, other

than reimbursement for (or reasonable allowance for) reasonable expenses incurred

in the performance of such services, or reasonable benefits (including length of service awards) and nominal fees for such

services, customarily paid by the department in connection with the performance

of such services by volunteers.

Under the Plan, a bookkeeping account

is established for each participating volunteer and, when a participating volunteer satisfies the Plan’s age and service

requirements for distribution of benefits, the

volunteer automatically receives the balance of the volunteer’s account, payable in

60 monthly installments beginning on the

tenth day of the first month following the

month in which the requirements are satisfied. If a participating volunteer dies prior

to satisfying the Plan’s age and service requirements, the balance of the volunteer’s

866

account is paid to the volunteer’s beneficiary in a single sum within 60 days after

the date of the volunteer’s death. If a participating volunteer dies after payments under the Plan have commenced, but before

receiving all monthly installments under the

Plan, the balance of the volunteer’s account is paid to the volunteer’s beneficiary for the remainder of the 60 monthly

installments.

Under the Plan, County C and its fire department each periodically provide credits to the accounts of participating

volunteers. Each account is also credited

with deemed earnings in accordance with

the Plan and State S law. The deemed earnings are based on an index that does not exceed a rate of return on a predetermined

actual investment or a reasonable rate of return, as defined under § 31.3121(v)(2)–

1(d)(2)(i) of the regulations. The Plan

provides that the combined amount credited to any account with respect to any participating volunteer, other than deemed

earnings, cannot exceed $3,000 for any year

of service credit.

The Plan provides that all amounts credited to the bookkeeping accounts, and all

deemed earnings attributable to such

amounts, remain solely the property of

County C and its fire department, and, until paid or made available to a participant

or beneficiary, are subject to the claims of

County C’s and the fire department’s general creditors. The Plan also provides that

a participating volunteer (or beneficiary) has

only an unsecured right to an award under the Plan. The rights of a participating

volunteer (or beneficiary) to an award under the Plan cannot be assigned and are

nontransferable. If a participating volunteer ceases to provide services to the fire

department prior to satisfying the Plan’s age

and service requirements for distribution of

benefits (other than by reason of the volunteer’s death or disability), the volunteer’s rights to an award under the Plan are

forfeited and County C and its fire department cease to have any liability regarding the volunteer’s account.

LAW AND ANALYSIS

Section 451(a) and § 1.451–1(a) provide that generally an item of gross income is includible in gross income for the

taxable year in which it is actually or constructively received by a cash basis taxpayer. Section 1.451–2(a) provides that

2003–19 I.R.B.

income is constructively received in the taxable year during which it is credited to the

taxpayer’s account, set apart, or otherwise made available so that the taxpayer

may draw on it at any time. However, income is not constructively received if the

taxpayer’s control of its receipt is subject

to substantial limitations or restrictions.

Rev. Rul. 60–31, 1960–1 C.B. 174, holds

that a mere promise by the service recipient to pay the service provider, not represented by notes or secured in any way, does

not constitute receipt of income within the

meaning of the cash receipts and disbursements method of accounting. See also, Rev.

Rul. 69–650, 1969–2 C.B. 106, and Rev.

Rul. 69–649, 1969–2 C.B. 106.

Section 457 governs the taxation of deferred compensation plans of eligible employers. The term “eligible employer” is

defined in § 457(e)(1) as a state, political

subdivision of a state, and any agency or

instrumentality of a state or political subdivision of a state, and any other organization (other than a governmental unit)

exempt from tax under subtitle A of the

Code. Deferred compensation plans maintained by eligible employers to which § 457

applies are either eligible plans or ineligible plans. An “eligible deferred compensation plan,” as defined in § 457(b), must,

among other things, provide that the maximum amount which may be deferred under the plan for a taxable year will not

exceed the lesser of the applicable dollar

amount ($12,000 in 2003) or 100 percent

of the participant’s includible compensation. Section 457(a)(1) provides that compensation (and income attributable to such

compensation) deferred under an eligible deferred compensation plan maintained by a

political subdivision of a State is includible in a participant’s gross income in the

taxable year in which the compensation (and

income attributable to such compensation) is paid to the participant.

Section 457(f)(1)(A) provides that generally if a plan of an eligible employer providing for a deferral of compensation is not

an eligible deferred compensation plan,

compensation deferred under such plan is

included in the participant’s gross income

for the first taxable year in which there is

no substantial risk of forfeiture of the rights

to such compensation.

Section 457(e)(11)(A)(ii) provides that

a plan paying solely length of service

awards to bona fide volunteers or their ben-

2003–19 I.R.B.

eficiaries on account of qualified services

performed by such volunteers is treated as

not providing for the deferral of compensation under § 457. Section 457(e)(11)(C)

defines qualified services as fire fighting and

prevention services, emergency medical services, and ambulance services.

Section 457(e)(11)(B) provides special

rules applicable to a length of service award

plan. Section 457(e)(11)(B)(i) defines a

bona fide volunteer to include only persons whose only compensation received for

performing qualified services are reimbursements for (or reasonable allowances

for) reasonable expenses incurred in performing such services or reasonable benefits (including length of service awards)

and nominal fees for such services, customarily paid by eligible employers in connection with the performance of such

services by volunteers.

Section 457(e)(11)(B)(ii) provides that

a length of service award plan may not provide for an aggregate amount of length of

service awards exceeding $3,000 accruing with respect to any year of service by

any volunteer.

Section 3121(a)(5)(I) provides that any

payment made to, or on behalf of, an employee or his or her beneficiary under a plan

described in § 457(e)(11)(A)(ii) and maintained by an eligible employer, as defined

in § 457(e)(1), is not treated as “wages” for

purposes of Federal Insurance Contributions Act (FICA) taxes.

The Plan established by County C and

its fire department satisfies the requirements of § 457(e)(11)(A)(ii). The Plan applies only to volunteers who provide

qualified services, i.e., fire fighting and prevention services, emergency medical services, ambulance services, or other related

essential services in compliance with

§ 457(e)(11)(C). The Plan also satisfies

§ 457(e)(11)(B)(i) by limiting eligible volunteers to persons who receive reimbursements, reasonable expenses, nominal fees,

or reasonable benefits customarily paid by

eligible employers in connection with the

performance of qualified services by volunteers. Finally, the Plan satisfies

§ 457(e)(11)(B)(ii) by limiting the aggregate amount of awards for any year of service to $3,000.

Since the Plan qualifies as a length of

service award plan under § 457(e)(11)

(A)(ii), neither § 457(a) nor § 457(f) apply to benefits under the Plan. Instead,

867

amounts distributable under the Plan are includible in gross income under § 451 and

the regulations thereunder, when paid or

made available without substantial limitation or restriction.

In addition, since the Plan qualifies as

a length of service award plan under

§ 457(e)(11)(A)(ii) maintained by an eligible employer (as defined in § 457(e)(1)),

§ 3121(a)(5)(I) provides that any payment

made to, or on behalf of, a volunteer or his

or her beneficiary under the Plan is not

treated as “wages” for purposes of determining if FICA taxes apply to such payment.

HOLDINGS

(1) County C’s Plan is a length of service award plan described in § 457(e)(11)

(A)(ii). The Plan, therefore, is not subject

to § 457(a) or § 457(f).

(2) An award under the Plan is includible in a cash basis recipient’s gross income under § 451 and the regulations

thereunder, in the taxable year when paid

or made available without substantial limitation or restriction.

(3) Awards paid under the Plan are not

wages for purposes of FICA taxes.

DRAFTING INFORMATION

The principal author of this revenue ruling is John Tolleris of the Office of Division Counsel/Associate Chief Counsel (Tax

Exempt and Government Entities). For further information regarding this revenue ruling, contact John Tolleris at (202) 622–

6060 (not a toll-free call).

Section 467.—Certain

Payments for the Use of

Property or Services

The adjusted applicable federal short-term,

mid-term, and long-term rates are set forth for the

month of May 2003. See Rev. Rul. 2003–45, page

876.

Section 468.—Special Rules

for Mining and Solid Waste

Reclamation and Closing

Costs

The adjusted applicable federal short-term,

mid-term, and long-term rates are set forth for the

May 12, 2003

month of May 2003. See Rev. Rul. 2003–45, page

876.

Section 861.—Income From

Sources Within the United

States

Section 482.—Allocation of

Income and Deductions

Among Taxpayers

Ct. D. 2077

Federal short-term, mid-term, and long-term

rates are set forth for the month of May 2003. See

Rev. Rul. 2003–45, page 876.

Section 483.—Interest on

Certain Deferred Payments

The adjusted applicable federal short-term,

mid-term, and long-term rates are set forth for the

month of May 2003. See Rev. Rul. 2003–45, page

876.

Section 642.—Special Rules

for Credits and Deductions

Federal short-term, mid-term, and long-term

rates are set forth for the month of May 2003. See

Rev. Rul. 2003–45, page 876.

Section 807.—Rules for

Certain Reserves

The adjusted applicable federal short-term,

mid-term, and long-term rates are set forth for the

month of May 2003. See Rev. Rul. 2003–45, page

876.

Section 846.—Discounted

Unpaid Losses Defined

The adjusted applicable federal short-term,

mid-term, and long-term rates are set forth for the

month of May 2003. See Rev. Rul. 2003–45, page

876.

*

SUPREME COURT OF THE

UNITED STATES

No. 01–1209 (2003)

BOEING CO., ET AL.

v.

UNITED STATES

CERTIORARI TO THE

UNITED STATES COURT OF

APPEALS FOR

THE NINTH CIRCUIT

March 4, 2003*

Syllabus

Under a 1971 statute providing special

tax treatment for export sales made by an

American manufacturer through a subsidiary that qualified as a “domestic international sales corporation” (DISC), no tax is

payable on the DISC’s retained income until it is distributed. See 26 U.S.C. Secs. 991–

997. The statute thus provides an incentive

to maximize the DISC’s share — and to

minimize the parent’s share — of the parties’ aggregate income from export sales.

The statute provides three alternative ways

for a parent to divert a limited portion of

its income to the DISC. See Sec. 994(a)(1)–

(3). The alternative that The Boeing Company chose limited the DISC’s taxable

income to a little over half of the parties

“combined taxable income” (CTI). In 1984,

the “foreign sales corporation” (FSC) provisions replaced the DISC provisions. As

under the DISC regime, it is in the parent’s interest to maximize the FSC’s share

of the taxable income generated by export sales. Because most of the differences

between these regimes are immaterial to this

suit, the Court’s analysis focuses mainly on

the DISC provisions. The Treasury Regulation at issue, 26 CFR Sec. 1.861–8(e)(3)

(1979), governs the accounting for research

and development (R&D) expenses when a

taxpayer elects to take a current deduction, telling the taxpaying parent and its

DISC “what” must be treated as a cost

when calculating CTI, and “how” those

costs should be (a) allocated among dif-

ferent products and (b) apportioned between the DISC and its parent. With respect

to the “what” question, the regulation includes a list of Standard Industrial Classification (SIC) categories (e.g., transportation

equipment) and requires that R&D for any

product within the same category as the exported product be taken into account. The

regulations use gross receipts from sales as

the basis for both “how” questions. Boeing organized its internal operations along

product lines (e.g., aircraft model 767) for

management and accounting purposes, each

of which constituted a separate “program”

within the organization; and $3.6 billion of

its R&D expenses were spent on “Company Sponsored Product Development,” i.e.,

product-specific research. Boeing’s accountants treated all Company Sponsored costs

as directly related to a single program and

unrelated to any other program. Because

nearly half of the Company Sponsored

R&D at issue was allocated to programs

that had no sales in the year in which the

research was conducted, that amount was

deducted by Boeing currently in calculating its taxable income for the years at issue, but never affected the calculation of the

CTI derived by Boeing and its DISC from

export sales. The Internal Revenue Service reallocated Boeing’s Company Sponsored R&D costs for 1979 to 1987, thereby

decreasing the untaxed profits of its export subsidiaries and increasing its taxable profits on export sales. After paying

the additional taxes, Boeing filed this refund suit. In granting Boeing summary

judgment, the District Court found Sec.

1.861–8(e)(3) invalid, reasoning that its categorical treatment of R&D conflicted with

congressional intent that there be a direct

relationship between items of gross income and expenses related thereto, and with

a specific DISC regulation giving the taxpayer the right to group and allocate income and costs by product or product line.

The Ninth Circuit reversed.

Held: section 1.861–8(e)(3) is a proper

exercise of the Secretary of the Treasury’s

rulemaking authority. Pp. 8–19.

(a) The relevant statutory text does not

support Boeing’s argument that the statute and certain regulations give it an unqualified right to allocate its Company

Sponsored R&D expenses to the specific

products to which they are factually

Together with No. 01–1382, United States v. Boeing Sales Corp. et al., also on certiorari to the same court.

May 12, 2003

868

2003–19 I.R.B.

related and to exclude such R&D from

treatment as a cost of any other product.

The method that Boeing chose to determine an export sale’s transfer price allowed the DISC “to derive taxable income

attributable to [an export sale] in an amount

which does not exceed . . . 50 percent of

the combined taxable income of [the DISC

and the parent] which is attributable to the

qualified export receipts on such property

derived as the result of a sale by the DISC

plus 10 percent of the export promotion expenses of such DISC attributable to such

receipts. . . .” 26 U.S.C. Sec. 994(a)(2) (emphasis added).

The statute does not define “combined

taxable income” or specifically mention

R&D expenditures. The Secretary’s regulation must be treated with deference, see

Cottage Savings Assn. v. Commissioner, 499

U.S. 554, 560–561, but the statute places

some limits on the Secretary’s interpretive authority. First, “does not exceed”

places an upper limit on the share of the export profits that can be assigned to a DISC

and gives three methods of setting the transfer price. Second, “combined taxable income” makes it clear that the domestic

parent’s taxable income is a part of the CTI

equation. Third, “attributable” limits the portion of the domestic parent’s taxable income that can be treated as a part of the

CTI. The Secretary’s classification of all

R&D as an indirect cost of all export sales

of products in a broadly defined SIC category is not arbitrary. It provides consistent treatment for cost items used in

computing the taxpayer’s domestic taxable income and CTI, and its allocation of

R&D expenditures to all products in a category even when specifically intended to

improve only one or a few of those products is no more tenuous than the allocation of a chief executive officer’s salary to

every product that a company sells, even

when he devotes virtually all of his time to

1

the development of the Edsel. Reading Sec.

994 in light of Sec. 861, the more general provision dealing with the distinction

between domestic and foreign source income, does not support Boeing’s contrary

view. If the Secretary reasonably determines that Company Sponsored R&D can

be properly apportioned on a categorical basis, the portion of Sec. 861(b) that deducts from gross income “a ratable part of

any expenses . . . which cannot definitely

be allocated to some item or class of gross

income” is inapplicable. Pp. 8–13.

(b) Boeing’s arguments based on specific DISC regulations are also unavailing. Language in 26 CFR Sec. 1.994–

1(c)(6)(iii), part of the rule describing CTI

computation, does not prohibit a ratable allocation of R&D expenditures that can be

“definitely related” to particular export sales.

Whether such an expense can be “definitely related” is determined by the rules

set forth in the very rule that Boeing challenges, Sec. 1.861–8. Moreover, the Secretary could reasonably determine that

expenditures on model 767 research conducted in years before any 767’s were sold

were not “definitely related” to any sales,

but should be treated as an indirect cost of

producing the gross income derived from

the sale of all planes in the transportation

equipment category. Nor do Secs. 1.994–

1(c)(7)(i) and (ii)(a), which control grouping of transactions for determining the

transfer price of sales of export property,

and Sec. 1.994–1(c)(6)(iv), which governs the grouping of receipts when the CTI

method is used, speak to the questions

whether or how research costs should be allocated and apportioned. Pp. 13–17.

(c) What little relevant legislative history there is in this suit weighs in the Government’s favor. Pp. 18–19.

258 F.3d 958, affirmed.

STEVENS, J., delivered the opinion of

the Court, in which REHNQUIST, C.J., and

O’CONNOR, KENNEDY, SOUTER,

GINSBURG, and BREYER, JJ., joined.

THOMAS, J., filed a dissenting opinion, in

which SCALIA, J., joined.

SUPREME COURT OF THE

UNITED STATES

Nos. 01–1209 and 01–1382

THE BOEING COMPANY

AND CONSOLIDATED

SUBSIDIARIES PETITIONERS v.

UNITED STATES — 01–1209

UNITED STATES PETITIONER v.

BOEING SALES CORPORATION

ET AL. — 01–1382

ON WRITS OF CERTIORARI TO THE

UNITED STATES COURT OF

APPEALS

FOR THE NINTH CIRCUIT

March 4, 2003

JUSTICE STEVENS delivered the opinion of the Court.

This suit concerns tax provisions enacted by Congress in 1971 to provide incentives for domestic manufacturers to

increase their exports and in 1984 to limit

and modify those incentives. The specific

question presented involves the interpretation of a Treasury Regulation (26 CFR

Sec. 1.861–8(e)(3) (1979)) promulgated in

1977 that governs the accounting for research and development (R&D) expenses

under both statutory schemes.1 We shall explain the general outlines of the two statutes before we focus on that regulation.

The 1971 statute provided special tax

treatment for export sales made by an

American manufacturer through a subsidiary that qualified as a “domestic international sales corporation” (DISC).2 The DISC

itself is not a taxpayer; a portion of its income is deemed to have been distributed

In 1996, the provisions of 26 CFR Sec. 1.861–8 were amended, renumbered, and republished as 26 CFR Sec. 1.861–17. See 26 CFR Sec. 1.861–17 (2002); see also 60 Fed. Reg. 66503 (1995).

2

To qualify as a DISC, at least 95 percent of a corporation’s gross receipts must arise from qualified export receipts. See 26 U.S.C. Sec. 992(a)(1)(A). In addition, at least 95 percent of the corporation’s assets must be

export related. See Sec. 992(a)(1)(B).

2003–19 I.R.B.

869

May 12, 2003

to its shareholders, and the shareholders

must pay taxes on that portion, but no tax

is payable on the DISC’s retained income

until it is actually distributed. See 26 U.S.C.

Secs. 991–997. Typically, “a DISC is a

wholly owned subsidiary of a U.S. corporation.” 1 Senate Finance Committee, Deficit Reduction Act of 1984, 98th Cong., p.

630, n. 1 (Comm. Print 1984) (hereinafter Committee Print). The statute thus provides an incentive to maximize the DISC’s

share — and to minimize the parent’s share

— of the parties’ aggregate income from

export sales.

The DISC statute does not, however, allow the parent simply to assign all of the

profits on its export sales to the DISC.

Rather, “to avoid granting undue tax advantages,”3 the statute provides three alternative ways in which the parties may

divert a limited portion of taxable income

from the parent to the DISC. See 26 U.S.C.

Secs. 994(a)(1)–(3). Each of the alternatives assumes that the parent has sold the

product to the DISC at a hypothetical

“transfer price” that produced a profit for

both seller and buyer when the product was

resold to the foreign customer. The alternative used by Boeing in this suit limited

the DISC’s taxable income to a little over

half of the parties’ “combined taxable income” (CTI).4

Soon after its enactment, the DISC statute became “the subject of an ongoing dispute between the United States and certain

other signatories of the General Agreement on Tariffs and Trade (GATT)” regarding whether the DISC provisions were

impermissible subsidies that violated our

treaty obligations. Committee Print 634. “To

remove the DISC as a contentious issue and

to avoid further disputes over retaliation, the

United States made a commitment to the

GATT Council on October 1, 1982, to propose legislation that would address the concerns of other GATT members.” Id. at 634–

3

635. This ultimately resulted in the

replacement of the DISC provisions in 1984

with the “foreign sales corporation” (FSC)

provisions of the Code. See Deficit Reduction Act of 1984, Pub. L. 98–369, Secs.

801–805, 98 Stat. 985.5

Unlike a DISC, an FSC is a foreign corporation, and a portion of its income is taxable by the United States. See ibid.; see also

B. Bittker & J. Eustice, Federal Income

Taxation of Corporations and Shareholders ¶17.14 (5th ed. 1987). Whereas a portion of a DISC’s income was tax deferred,

a portion of an FSC’s income is exempted

from taxation. Compare 26 U.S.C. Secs.

991–997 with 26 U.S.C. Secs. 921, 923

(1988 ed.). Hence, under the FSC regime,

as under the DISC regime, it is in the parent’s interest to maximize the FSC’s share

of the taxable income generated by export sales. Because the differences between the DISC and FSC regimes for the

most part are immaterial to this suit, the

analysis in this opinion will focus mainly

on the DISC provisions.6

The Internal Revenue Code gives the

taxpayer an election either to capitalize and

amortize the costs of R&D over a period

of years or to deduct such expenses currently. See 26 U.S.C. Sec. 174. The regulation at issue here, 26 CFR Sec. 1.861–

8(e)(3) (1979), deals with R&D

expenditures for which the taxpayer has

taken a current deduction. It tells the taxpaying parent and its DISC “what” must be

treated as a cost when calculating CTI, and

“how” those costs should be (a) allocated

among different products and (b) apportioned between the DISC and its parent.7

With respect to the “what” question, the

Treasury might have adopted a broad approach defining the relevant R&D as including all of the parent’s products, or, a

narrow approach defining the relevant R&D

as all R&D directly related to a particular

product being exported. Instead, the regu-

lation includes a list of two-digit Standard Industrial Classification (SIC)

categories (examples are “chemicals and allied products” and “transportation equipment”), and it requires that R&D for any

product within the same category as the exported product be taken into account.8 See

ibid. The regulation explains that R&D on

any product “is an inherently speculative activity” that sometimes contributes unexpected benefits on other products, and “that

the gross income derived from successful

research and development must bear the

cost of unsuccessful research and development.” Ibid.

With respect to the two “how” questions, the regulations use gross receipts from

sales as the basis both for allocating the

costs among the products within the broad

R&D categories and also for apportioning those costs between the parent and the

DISC. Thus, if the exported product constitutes 20 percent of the parties’ total sales

of all products within an R&D category, 20

percent of the R&D cost is allocated to that

product. And if export sales represent 70

percent of the total sales of that product, 70

percent of that amount, or 14 percent of the

R&D, is apportioned to the DISC.

I

Petitioners (and cross-respondents) are

The Boeing Company and subsidiaries that

include a DISC and an FSC. For over 40

years, Boeing has been a world leader in

commercial aircraft development and a major exporter of commercial aircraft. During the period at issue in this litigation, the

dollar volume of its sales amounted to about

$64 billion, 67 percent of which were

DISC-eligible export sales. The amount that

Boeing spent on R&D during that period

amounted to approximately $4.6 billion.

During the tax years at issue here, Boeing organized its internal operations along

S. Rep. No. 92–437, p. 13 (1971) (hereinafter S. Rep.).

4

To be more precise, it allowed the DISC “to derive taxable income attributable to [an export sale] in an amount which does not exceed . . . 50 percent of the combined taxable income of [the DISC and the parent]

plus 10 percent of the export promotion expenses of such DISC attributable to such receipts. . . . 26 U.S.C. Sec. 994(a)(2).

A hypothetical example in both the House and Senate Committee Reports illustrated the computation of a transfer price of $816 based on a DISC’s selling price of $1,000 and the parent’s cost of goods sold of $650.

The gross margin of $350 was reduced by $180 (including the DISC’s promotion expenses of $90, the parent’s directly related selling and administrative expenses of $60, and the parent’s prorated indirect expenses of

$30), to produce a CTI of $170. Half of that amount ($85) plus 10 percent of the DISC’s promotion expenses ($9) gave the DISC its allowable taxable income of $94, leaving only $76 of income immediately taxable

to the parent. The $184 aggregate of the two amounts attributed to the DISC (promotion expenses of $90 plus its $94 share of CTI) subtracted from the $1,000 gross receipt produced the “transfer price” of $816. See

S. Rep. at 108, n. 7; H.R. Rep. No. 92–533, p. 74, n. 7 (1971) (hereinafter H.R. Rep.).

5

In 2000, Congress repealed and replaced the FSC provisions with the “extraterritorial income” exclusion of 26 U.S.C. Sec. 114.

6

Two aspects of the 1984 statute that do have special significance to this suit are discussed in Part IV, infra.

7

Treasury Regulation Sec. 1.861–8 (1979) also specifies how other specific items of expense should be treated. See, e.g., 26 CFR Sec. 1.861–8(e)(2) (1979) (interest fees); Sec. 1.861–8(e)(5) (legal and accounting fees);

Sec. 1.861–8(e)(6) (income taxes).

8

The original regulation used two-digit SIC categories. See Sec. 1.861–8(e)(3). The current regulation uses narrower three-digit SIC categories, See 26 CFR Sec. 1.861–17(a)(2)(ii) (2002), but the change is not relevant

to this suit.

May 12, 2003

870

2003–19 I.R.B.

product lines (e.g., aircraft models 727, 737,

747, 757, 767) for management and accounting purposes, each of which constituted a separate “program” within the

Boeing organization. For those purposes, it

divided its R&D expenses into two broad

categories: “Blue Sky” and “Company

Sponsored Product Development.” The

former includes the cost of broad-based research aimed at generally advancing the

state of aviation technology and developing alternative designs of new commercial planes. The latter includes productspecific research pertaining to a specific

program after the board of directors has

given its approval for the production of a

new model. With respect to its $1 billion

of “Blue Sky” R&D, Boeing’s accounting was essentially consistent with 26 CFR

Sec. 1.861–8(e)(3) (1979).9 Its method of

accounting for $3.6 billion of “Company

Sponsored” R&D gave rise to this litigation.

Boeing’s accountants treated all of the

Company Sponsored research costs as directly related to a single program, and as

totally unrelated to any other program. Thus,

for DISC purposes, the cost of Company

Sponsored R&D directly related to the 767

model, for example, had no effect on the

calculation of the “combined taxable income” produced by export sales of any

other models. Moreover, because immense

Company Sponsored research costs were

routinely incurred while a particular model

was being completed and before any sales

of that model occurred, those costs effectively “disappeared” in the calculation of

the CTI even for the model to which the

R&D was most directly related.10 Almost

half of the $3.6 billion of Company Sponsored R&D at issue in this suit was allocated to programs that had no sales in the

year in which the research was conducted.

That amount (approximately $1.75 billion) was deducted by Boeing currently in

the calculation of its taxable income for the

years at issue, but never affected the calculation of the CTI derived by Boeing and

its DISC from export sales.

Pursuant to an audit, the Internal Revenue Service reallocated Boeing’s Company Sponsored R&D costs for the years

1979 to 1987, thereby decreasing the untaxed profits of its export subsidiaries and

increasing the parent’s taxable profits from

export sales. Boeing paid the additional tax

obligation of $419 million and filed this suit

seeking a refund. Relying on the decision

of the Eighth Circuit in St. Jude Medical,

Inc. v. Commissioner, 34 F.3d 1394 (1994),

the District Court entered summary judgment in favor of Boeing. It held that 26

CFR Sec. 1.861–8(e)(3) (1979) is invalid

as applied to DISC and FSC transactions

because the regulation’s categorical treatment of R&D conflicted with congressional intent that there be a “direct”

relationship between items of gross income and expenses “related thereto,” and

with a specific DISC regulation giving the

taxpayer the right to group and allocate income and costs by product or product line.

The Court of Appeals for the Ninth Circuit reversed, 258 F.3d 958 (2001), and we

granted certiorari to resolve the conflict between the Circuits, 535 U.S. 1094 (2002).

We now affirm.

II

Section 861 of the Internal Revenue

Code distinguishes between United States

and foreign source income for several different purposes. See 26 U.S.C. Sec. 861.

The regulation at issue in this suit, 26 CFR

Sec. 1.861–8(e)(3) (1979), was promulgated pursuant to that general statute. Separate regulations promulgated under the

DISC statute, 26 U.S.C. Secs. 991–997, incorporate 26 CFR Sec. 1.861–8(e)(3) (1979)

by specific reference. See Sec. 1.994–

1(c)(6)(iii) (citing and incorporating the cost

allocation rules of Sec. 1.861–8). Boeing

does not claim that its method of accounting for Company Sponsored R&D complied with Sec. 1.861–8(e)(3). Rather, it

argues that Sec. 1.861–8(e)(3) is so plainly

inconsistent with congressional intent and

with other provisions of the DISC regulations that it cannot be validly applied to its

computation of CTI for DISC purposes.

Boeing argues, in essence, that the statute and certain specific regulations promulgated pursuant to 26 U.S.C. Sec. 994

give it an unqualified right to allocate its

Company Sponsored R&D expenses to the

specific products to which they are “factually related” and to exclude any allocated R&D from being treated as a cost of

any other product. The relevant statutory

text does not support its argument.

As we have already mentioned, the

DISC statute gives the taxpayer a choice of

three methods of determining the transfer

price for an exported good. Boeing elected

to use only the second method described in

the following text:

“Inter-company pricing rules”

(a) In general

“In the case of a sale of export property to a DISC by a person described in

section 482, the taxable income of such

DISC and such person shall be based

upon a transfer price which would allow such DISC to derive taxable income attributable to such sale (regardless

of the sales price actually charged) in an

amount which does not exceed the greatest of —

(1) 4 percent of the qualified export

receipts on the sale of such property by

the DISC plus 10 percent of the export promotion expenses of such DISC

attributable to such receipts,

(2) 50 percent of the combined taxable income of such DISC and such person which is attributable to the qualified

export receipts on such property derived as the result of a sale by the DISC

plus 10 percent of the export promotion expenses of such DISC attributable to such receipts, or

(3) taxable income based upon the sale

price actually charged (but subject to the

rules provided in section 482).”

(b) Rules for commissions, rentals, and

marginal costing

The Secretary shall prescribe regulations setting forth

****

“(2) rules for the allocation of expenditures in computing combined taxable income under subsection (a)(2) in

those cases where a DISC is seeking to

establish or maintain a market for export property.” 26 U.S.C. Secs.

994(a)(1)–(3), (b)(2) (emphasis added).

The statute does not define the term

“combined taxable income,” nor does it spe-

9

Because all of Boeing’s commercial aircraft were “transportation equipment” within the meaning of the Treasury Regulation, it properly allocated all of its Blue Sky research among all of its programs, and then apportioned those costs between the parent and the DISC. However, according to the Government, it erroneously did so on the basis of hours of direct labor rather than sales. See Brief for United States 10.

10

When Boeing charged R&D costs to programs that had no sales in the year the research was conducted, the R&D costs effectively “disappeared” in the sense that they were not accounted for by Boeing in computing

its CTI.

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871

May 12, 2003

cifically mention expenditures for R&D.

Congress did grant the Secretary express authority to prescribe regulations for determining the proper allocation of expenditures

in computing CTI in certain specific contexts. See, e.g., Secs. 994(b)(1)–(2). Yet in

promulgating 26 CFR Sec. 1.861–8 (1979),

the Secretary of the Treasury exercised his

rulemaking authority under 26 U.S.C. Sec.

7805(a), which gives the Secretary general authority to “prescribe all needful rules

and regulations for the enforcement” of the

Internal Revenue Code. See 41 Fed. Reg.

49160 (1976) (“The proposed regulations

are to be issued under the authority contained in section 7805 of the Internal Revenue Code”). Even if we regard the

challenged regulation as interpretive because it was promulgated under Sec.

7805(a)’s general rulemaking grant rather

than pursuant to a specific grant of authority, we must still treat the regulation with

deference. See Cottage Savings Assn. v.

Commissioner, 499 U.S. 554, 560–561

(1991).

The words that we have emphasized in

the statutory text do place some limits on

the Secretary’s interpretive authority. First,

the “does not exceed” phrase places an upper limit on the share of the export profits that can be assigned to a DISC and also

gives the taxpayer an unfettered right to select any of the three methods of setting a

“transfer price.” Second, the use of the term

“combined taxable income” in subsection

(a)(2) makes it clear that the taxable income of the domestic parent is a part of the

equation that should produce the CTI. As

Boeing recognizes, even a charitable contribution to the Seattle Symphony that reduces its domestic earnings from sales of

767’s must be treated as a cost that is not

definitely related to any particular category of income and thus must be apportioned among all categories of income,

including income from export sales. See

Brief for Petitioners 8, n. 7. Third, the word

“attributable” places a limit on the portion of the domestic parent’s taxable income that can be treated as a part of the

CTI. It is this word that provides the statutory basis for Boeing’s position.

Under Boeing’s reading of the statute,

a calculation of the domestic income “attributable” to the export sale of a 767 may

include both the direct and indirect costs of

manufacturing and selling 767’s, but it may

not include the direct costs of selling anything else. Moreover, if Boeing’s accountants classify a particular cost as directly

related to the 767, that classification is conclusive. Thus, while the Secretary asserts

that Boeing’s R&D expenses are definitely

related to all income in the relevant SIC category, Boeing claims the right to divide its

R&D in a way that effectively creates three

segments: (1) Blue Sky; (2) Company

Sponsored R&D on products that have no

sales in the current year; and (3) Company Sponsored R&D on products that are

being sold currently. Boeing, like the Secretary, essentially treats Blue Sky R&D as

an indirect cost in computing both its domestic taxable income and its CTI. With respect to the second segment, Boeing uses

the R&D to reduce its domestic taxable

earnings on every product it sells, but eliminates it entirely from the calculation of CTI

on any product by charging the R&D costs

to programs without any sales. The third

segment is used for both domestic and CTI

purposes, but with respect to CTI only for

the export sales to which it is “factually related.”

The Secretary’s classification of all R&D

as an indirect cost of all export sales of

products in a broadly defined SIC category — in other words, as “attributable”

to such sales is surely not arbitrary. It has

the virtue of providing consistent treatment for cost items used in computing the

taxpayer’s domestic taxable income and its

CTI. Moreover, its allocation of R&D expenditures to all products in a category even

when specifically intended to improve only

one or a few of those products is no more

tenuous than the allocation of a chief executive officer’s salary to every product that

a company sells even when he devotes virtually all of his time to the development of

an Edsel.

On the other hand, even if Boeing’s

method of accounting for R&D is fully justified for management purposes, it certainly produces anomalies for tax purposes.

Most obvious is the fact that it enabled Boeing to deduct some $1.75 billion of expenditures from its domestic taxable earnings

under 26 U.S.C. Sec. 174 and never deduct a penny of those expenditures from its

“combined taxable earnings” under the

DISC statute. See Brief for Petitioners 11.

Less obvious, but nevertheless significant,

is that Boeing’s method assumed that Blue

Sky research produces benefits for airplane models that are producing current income and — at the same time — assumed

that Company Sponsored research related

to a specific product, such as the 727, is not

likely to produce benefits for other airplane models, such as the 737 or 767.11

In all events, the mere use of the word

“attributable” in the text of Sec. 994 surely

does not qualify the Secretary’s authority

to decide whether a particular tax deductible expenditure made by the parent of a

DISC is sufficiently related to its export

sales to qualify as an indirect cost in the

computation of the parties’ CTI. Boeing argues, however, that the text of Sec. 994

should be read in light of Sec. 861, the

more general provision dealing with the distinction between domestic and foreign

source income.

Title 26 U.S.C. Sec. 861(b) contains the

following two sentences:

“Taxable income from sources within

United States”

“From the items of gross income specified in subsection (a) as being income

from sources within the United States

there shall be deducted the expenses,

losses, and other deductions properly apportioned or allocated thereto and a ratable part of any expenses, losses, or

other deductions which cannot definitely be allocated to some item or class

of gross income. The remainder, if any,

shall be included in full as taxable income from sources within the United

States”. (Emphasis added.)

Focusing on the emphasized words, Boeing interprets this section as having created a background rule dividing all expenses

into two categories: those that can be allocated to specific income and those that

cannot. “Ratable” allocation is permissible for the second category, but not for the

first, according to Boeing. Moreover, in

Boeing’s view, any expense in the first category cannot be ratably apportioned across

all classes of income.

There are at least two flaws in this argument. First, although the emphasized

words authorize ratable apportionment of

11

This assumption, of course, runs contrary to the Secretary’s determination that R&D “is an inherently speculative activity” that sometimes contributes unexpected benefits on other products. 26 CFR Sec. 1.861–

8(e)(3)(i)(A) (1979).

May 12, 2003

872

2003–19 I.R.B.

costs that cannot definitely be allocated to

some item or class of income, the sentence as a whole does not prohibit ratable

apportionment of expenses that could be,

but perhaps in fairness should not be, treated

as direct costs. Second, the Secretary has

the authority to prescribe regulations determining whether an expense can be properly apportioned to an item of gross income

in the calculation of CTI. See 26 U.S.C.

Sec. 7805(a). Thus, as in this suit, if the

Secretary reasonably determines that Company Sponsored R&D can be properly apportioned on a categorical basis, the

italicized portion of Sec. 861 is simply inapplicable.

In sum, Boeing’s arguments based on

statutory text are plainly insufficient to overcome the deference to which the Secretary’s interpretation is entitled.

III

Boeing also advances two arguments

based on the text of specific DISC regulations. The first resembles its argument

based on the text of Sec. 861 and the second relies on regulations providing that certain accounting decisions made by the

taxpayer shall be controlling.

The regulations included in 26 CFR Sec.

1.994–1 (1979) set forth intercompany pricing rules for DISCs. They generally describe the three methods of determining a

transfer price, noting that the taxpayer may

choose the most favorable method, and may

group transactions to use one method for

some export sales and another method for

others. See ibid. With respect to the CTI

method used by Boeing, there is a rule, Sec.

1.994–1(c)(6), that describes the computation of CTI. The rule broadly defines the

CTI of a DISC and its related supplier from

a sale of export property as the excess of

gross receipts over their total costs “which

relate to such gross receipts.”12 Subdivision (iii) of that rule, on which Boeing relies, provides:

12

“Costs (other than cost of goods sold)

which shall be treated as relating to gross

receipts from sales of export property are

(a) the expenses, losses, and other deductions definitely related, and therefore allocated and apportioned, thereto,

and (b) a ratable part of any other expenses, losses, or other deductions which

are not definitely related to a class of

gross income, determined in a manner

consistent with the rules set forth in Sec.

1.861–8.” Sec. 1.994–1(c)(6)(iii) (emphasis added).

Boeing interprets the emphasized words

as prohibiting a ratable allocation of R&D

expenditures that can be “definitely related” to particular export sales. The obvious response to this argument is provided

by the final words in the paragraph.

Whether such an expense can be “definitely related” is determined by the rules

set forth in the very regulation that Boeing challenges, Sec. 1.861–8. Moreover, it

seems quite clear that the Secretary could

reasonably determine that expenditures on

767 research conducted in years before any

767’s were sold were not “definitely related” to any sales, but should be treated

as an indirect cost of producing the gross

income derived from the sale of all planes

in the transportation equipment category.

Boeing also argues that the regulations

expressly allow it to allocate and apportion R&D expenses to groups of export

sales that are based on industry usage rather

than SIC categories. The regulations providing the strongest support for this argument are Secs. 1.994–1(c)(7)(i) and (ii)(a),

which control the grouping of transactions for the purpose of determining the

transfer price of sales of export property,

and Sec. 1.994–1(c)(6)(iv), which governs the grouping of receipts when the CTI

method of transfer pricing is used.13 Treasury Regulation Sec. 1.994–1(c)(7) reads,

in part, as follows:

“Grouping transactions. (i) Generally, the

determinations under this section are to

be made on a transaction-by-transaction

basis. However, at the annual choice of

the taxpayer some or all of these determinations may be made on the basis of

groups consisting of products or product lines.”

“(ii) A determination by a taxpayer as to

a product or a product line will be accepted by a district director if such determination conforms to any one of the

following standards: (a) A recognized industry or trade usage, or (b) the 2-digit

major groups . . . of the Standard Industrial Classification. . . .”

As we understand the statutory and regulatory scheme, it gives controlling effect to

three important choices by the taxpayer.

First, the taxpayer may elect to deduct R&D

expenses on an annual basis instead of capitalizing and amortizing those costs. See 26

U.S.C. Sec. 174(a)(1). Second, when engaging in export transactions with a DISC,

the taxpayer may choose any one of the

three methods of determining the transfer

price. See Sec. 994(a). Third, the taxpayer

may decide how best to group those transactions for purposes of applying the transfer pricing methods. See 26 CFR Sec.

1.994–1(c)(7) (1979). Conceivably the taxpayer could account for each sale separately, by product lines, or by grouping all

of its export sales together. These regulations confirm the finality of the third type

of choice (i.e., which groups of sales will

be evaluated under one of the three alternative transfer pricing methods), but do not

speak to the questions answered by the

regulation at issue in this suit — namely,

whether or how a particular research cost

should be allocated and apportioned.

Nor does Sec. 1.994–1(c)(6)(iv) support Boeing’s argument. It provides that a

“taxpayer’s choice in accordance with subparagraph (7) of this paragraph as to the

grouping of transactions shall be control-

Treasury Regulation Sec. 1.994–1(c)(6), 26 CFR Sec. 1.994–1(c)(6) (1979), provides in part:

“Combined taxable income.” For purposes of this section, the combined taxable income of a DISC and its related supplier from a sale of export property is the excess of the gross receipts (as defined in section 993(f))

of the DISC from such sale over the total costs of the DISC and related supplier which relate to such gross receipts. Gross receipts from a sale do not include interest with respect to the sale. Combined taxable income

under this paragraph shall be determined after taking into account under paragraph (e)(2) of this section all adjustments required by section 482 with respect to transactions to which such section is applicable. In determining the gross receipts of the DISC and the total costs of the DISC and related supplier which relate to such gross receipts, the following rules shall be applied:

“(i) Subject to subdivisions (ii) through (v) of this subparagraph, the taxpayer’s method of accounting used in computing taxable income will be accepted for purposes of determining amounts and the taxable year for

which items of income and expense (including depreciation) are taken into account. See Sec. 1.991–1(b)(2) with respect to the method of accounting which may be used by a DISC.”

13

In support of its argument that Secs. 1.994–1(c) and 1.861–8(e)(3) conflict, Boeing also points to various proposed regulations, including example 1 of proposed regulation Sec. 1.861–8(g). See Brief for Petitioners

22–26. Unlike Boeing and the dissent, See post at 2–3, we find these proposed regulations to be of little consequence given that they were nothing more than mere proposals. In 1972 — when regulations governing

DISCs were first proposed — the Secretary made clear that the proposed regulations were suggestions only and that whatever final regulations were ultimately adopted would govern. See Technical Memorandum accompanying Notice of Proposed Rulemaking, 1972 T. M. Lexis 14, pp. *8–*9 (June 29, 1972) (providing that in determining deductible expenses, “the rules of section 861(b) and Sec. 1.861–8 are to be applied in whatever form they ultimately take in a new notice to be prepared”).

2003–19 I.R.B.

873

May 12, 2003

ling, and costs deductible in a taxable year

shall be allocated and apportioned to the

items or classes of gross income of such

taxable year resulting from such grouping.” The regulation makes clear that if the

taxpayer selects the CTI method of transfer pricing (as Boeing did), then the taxpayer may choose to group export receipts

according to product lines, two-digit SIC

codes, or on a transaction-by-transaction basis. Ibid. The regulation also establishes that

there shall be an allocation and apportionment of all relevant costs deducted in the

taxable year. Ibid. Notably, however, the

regulation simply does not speak to how

costs should be allocated among different

items or classes of gross income and apportioned between the DISC and its parent once the taxpayer (pursuant to Sec.

1.994–1(c)(6)) groups its gross receipts.

Treasury Regulation Sec. 1.861–8(e)(3) fills

this gap by providing that R&D expenditures that are related to all income reasonably connected with the taxpayer’s relevant

two-digit SIC category or categories are “allocable to all items of gross income as a

class . . . related to such product category

(or categories).” 26 CFR Sec. 1.861–8(e)(3)

(1979) (emphasis added).

IV

Boeing also relies heavily on legislative history, particularly on statements in

Reports prepared by the tax-writing committees of the House and the Senate on the

DISC statute. Those Reports are virtually

identical in terms of their discussion of the

DISC provisions. See H.R. Rep. at 58–

95; S. Rep. at 90–129. Neither says anything about R&D costs. They both contain

statements supporting the proposition that

in determining how to calculate income that

qualifies for a tax benefit, the expenses to

be deducted from gross income are those

expenses that are “directly related” to the

income. See H.R. Rep., at 74, S. Rep., at

107. Those statements are not, however, inconsistent with the proposition that particular R&D expenses may be factually

related to more than one item of income,

or with the proposition that the Secretary

has broad authority to promulgate regula-

tions determining which expenses are directly or indirectly related to particular items

of income.

If anything, what little relevant legislative history there is in this suit weighs in

favor of the Government’s position in two

important respects. First, whereas the DISC

transfer price could be set at a level that attributed over half of the CTI to the DISC,

when Congress enacted the FSC provisions in 1984, it lowered the maximum allowable share of CTI attributable to an FSC

to 23 percent. Compare 26 U.S.C. Sec.

994(a)(2) with 26 U.S.C. Sec. 925(a)(2)

(1988 ed.). This dramatizes the point that

even though the purpose of the DISC and

FSC statutes was to provide American firms

with a tax incentive to increase their exports, Congress did not intend to grant “undue tax advantages” to firms. S. Rep., at 13.

Rather, the statutory formulas were designed to place ceilings on the amount of

those special tax benefits. See Committee

Print 636 (“[T]he income of the foreign

sales corporation must be determined according to transfer prices specified in the

bill: either actual prices for sales between

unrelated, independent parties or, if the sales

are between related parties, formula prices

which are intended to comply with GATT’s

requirement of arm’s-length prices”).

Second, the 1977 R&D regulation at issue in this suit had been in effect for seven

years when Congress enacted the FSC provisions. Yet Congress did not legislatively

override 26 CFR Sec. 1.861–8(e)(3) (1979)

in enacting the FSC provisions. In fact, although a moratorium was placed on the application of Sec. 1.861–8(e)(3) for purposes

of the sourcing of income in 1981,14 a 1984

conference agreement specified that the

moratorium would “not apply for other purposes, such as the computation of combined taxable income of a DISC (or FSC)

and its related supplier.” H.R. Conf. Rep.

No. 98–861, p. 1263 (1984). The fact that

Congress did not legislatively override 26

CFR Sec. 1.861–8(e)(3) (1979) in enacting the FSC provisions in 1984 serves as

persuasive evidence that Congress regarded

that regulation as a correct implementation of its intent. See Lorillard v. Pons, 434

U.S. 575, 580–581 (1978).

The judgment of the Court of Appeals

is affirmed.

It is so ordered.

SUPREME COURT OF THE

UNITED STATES

Nos. 01–1209 and 01–1382

THE BOEING COMPANY AND

CONSOLIDATED

SUBSIDIARIES PETITIONERS v.

UNITED STATES — 01–1209

UNITED STATES PETITIONER v.

BOEING SALES CORPORATION

ET AL. — 01–1382

ON WRITS OF CERTIORARI

TO THE UNITED STATES

COURT OF APPEALS

FOR THE NINTH CIRCUIT

JUSTICE THOMAS, with whom JUSTICE SCALIA joins, dissenting.

Before placing its hand in the taxpayer’s pocket, the Government must place its

finger on the law authorizing its action.

United Dominion Industries, Inc. v.

United States, 532 U.S. 822, 839 (2001)

(THOMAS, J., concurring) (citing

Leavell v. Blades, 237 Mo. 695, 700–701,

141 S.W. 893, 894 (1911)). Despite the

Government’s failure to do so here, the

Court holds in its favor; I respectfully dissent.

To read the majority opinion, one would

think that the Court has before it a perfectly clear statutory and regulatory scheme

and that the position of petitioners/crossrespondents (hereinafter Boeing) is utterly without support. Nothing could be

further from the facts of this suit. Indeed,

the Internal Revenue Service (IRS) itself initially read the statutory and regulatory provisions at issue here to permit precisely

what Boeing asserts it is allowed to do.1

When regulations governing DISCs were

first proposed in 1972, the IRS received

public comments recommending that the

regulations be amplified to include rules and

examples on how expenses should be

treated for purposes of determining the combined taxable income of the DISC and a related supplier. The IRS, however, declined

to incorporate the recommendations in the

14

In 1981, Congress imposed a temporary moratorium on the application of the cost allocation rules of 26 CFR Sec. 1.861–8(e)(3) (1979) solely for the geographic sourcing of income. See Economic Recovery Tax Act

of 1981, Pub. L. 97–34, Sec. 223, 95 Stat. 249. As a result, research expenditures made for research conducted in the United States were allocated against United States source gross income only — not between United

States source income and foreign source income. See H.R. Conf. Rep. No. 98–861, p. 1262 (1984).

1

Because, as the Court notes, ante at 4, differences in the rules governing domestic international sales corporations (DISCs) and foreign sales corporations do not affect the outcome of this suit, I too focus only on the

relevant DISC provisions.

May 12, 2003

874

2003–19 I.R.B.

final regulations, explaining that proposed

regulation Sec. 1.861–8, which had been

published in 1973, provided ample guidance on the subject. Technical Memorandum accompanying T.D. 7364, 1974, T. M.

Lexis 30, pp. *20–21 (Oct. 29, 1974).

Proposed regulation Sec. 1.861–8(e)(3),

in turn, explained that where “research and

development . . . is intended or is reasonably expected to result in the improvement of specific properties or processes,

deductions in connection with such research and development shall be considered definitely related and therefore

allocable to the class of gross income to

which the properties or processes give rise

or are reasonably expected to give rise.” 38

Fed. Reg. 15843 (1973). The regulations

went on to note that in “other cases, as in

the case of most basic research, research and

development shall generally be considered definitely related and therefore allocable to all gross income of the current

taxable year which is likely to benefit from

the research and development.”

Ibid. Example 1 in Sec. 1.8618(g) illustrated this principle by considering the

research and development (R&D) expenditures of a corporation manufacturing four-,

six-, and eight-cylinder gasoline engines.

The corporation conducted both general and

engine-specific research. The example made

clear that, while general R&D expenses

were “definitely related” to gross income

resulting from sales of all three types of engines, R&D expenses in connection with a

specific type of engine were to be allocated only to gross income arising from

sales of that type of engine. Id., at 15846

(“X’s deductions for its research and development expenses in connection with the

4 cylinder engine are definitely related to

the gross income to which the 4 cylinder

engine gives rise, i.e., gross income from

the sales of 4 cylinder engines . . . ”).

Indeed, the IRS’ 1974 position on the

proper allocation of R&D expenses incurred in connection with separate lines of

products is the only one that makes sense

under the relevant DISC regulations. See,

e.g., 26 CFR Secs. 1.994–1(c)(6), (7)

(1979). As the Court explains, ante, at 2,

26 U.S.C. Sec. 994 was designed to pro-

vide special tax treatment for American

companies engaged in export activities. To

that end, Sec. 994 permits a DISC and its

related supplier to compute their relevant

transfer price (and, relatedly, their income

tax liability) based on one of three methods. See Sec. 994 (providing that the transfer price for sales between a DISC and a

related supplier can be computed based on

(1) the gross income method, (2) the combined taxable income method, and (3) the

usual transfer-pricing rules set forth in Sec.

482).

The Treasury Department has promulgated regulations explaining how the statutory framework must be applied. Section

1.994–1(c)(7) of those regulations explains

that, as a general rule, a determination of

the transfer price under Sec. 994 is to be

made on a transaction-by-transaction basis. Section 1.994–1(c)(7), however, provides that, instead of following the

transaction-by-transaction rule, taxpayers

may make Sec. 994 transfer price determinations based on groups consisting of

products or product lines. Sec. 1.994–

1(c)(7)(i). Specifically, the regulation states

that

“A determination by a taxpayer as to a

product or a product line will be accepted by a district director if such determination conforms to any one of the

following standards: (a) A recognized industry or trade usage, or (b) the 2-digit

major groups (or any inferior classifications or combinations thereof, within

a major group) of the Standard Industrial Classification [SIC] as prepared by

the [Office of Management and Budget].” Sec. 1.994–1(c)(7)(ii).

Section 1.994–1(c)(6)(iv), in turn, provides that, in connection with the computation of combined taxable income, “[t]he

taxpayer’s choice in accordance with [Sec.

1.994–1(c)(7)] as to the grouping of transactions shall be controlling, and costs deductible in a taxable year shall be allocated

and apportioned to the items or classes of

gross income of such taxable year resulting from such grouping.” (Emphasis added.)

Thus, in tandem, Secs. 1.994–1(c)(6)(iv) and

1.994–1(c)(7) give a taxpayer the choice of

allocating and apportioning costs to items

or classes of gross income resulting from

(1) case-by-case transactions, (2) products or product lines grouped together based

on industry or trade usage, and (3) products or product lines grouped together based

on 2-digit SIC codes or lesser included subgroups.

Although under Sec. 1.991–1(c)(7) taxpayers are given three choices with respect to the proper grouping of export

income (and the related allocation of expenses), and although Sec. 1.994–1(c)(6)(iv)

provides that the taxpayer’s selection under Sec. 1.991–1(c)(7) shall be “controlling,” Sec. 1.861–8(e)(3) takes away the

very choices Sec. 1.991–1 provides. Under Sec. 1.861–8(e)(3), the taxpayer is told

that R&D expenses may be allocated solely

to items or classes of gross income resulting from products that are within the same

2-digit SIC group — which happens to be

only one of the three options given under

Sec. 1.991–1(c)(7). In my view, the rule set

forth in Sec. 1.861–8(e)(3) entirely eviscerates the options given in Sec. 1.991–1.

Thus, despite the Court’s efforts to show

that the two regulations complement, rather

than contradict, each other, ante, at 15–

17, the conflict is irreconcilable.2 On these

facts, a taxpayer should be permitted to

compute its tax liability under Sec. 1.991–1,

rather than under Sec. 1.861–8(e)(3), based

on the principle that a specific rule governs a general one.3 See Morales v. Trans

World Airlines, Inc., 504 U.S. 374, 384

(1992); Crawford Fitting Co. v. J. T.

Gibbons, Inc., 482 U.S. 437, 445 (1987);

see also St. Jude Medical, Inc. v. Commissioner, 34 F.3d 1394 (CA8 1994).

The Court disapproves of Boeing’s

method of allocating R&D because, as the

Court sees it, Boeing’s approach results in

the “disappear[ance]” of relevant costs, ante,

at 6, in “the sense that [R&D costs] were

not accounted for by Boeing in computing its [combined taxable income],” ante,

at 7, n. 10. The Court is troubled by the fact

that this computation method has enabled

Boeing “to deduct some $1.75 billion of expenditures from its domestic taxable earnings under 26 U.S.C. Sec. 174 and never

deduct a penny of those expenditures from

its ‘combined taxable earnings’ under the

2

A taxpayer wishing to (1) group its sales based on an accepted industry practice, for example based on different models, and (2) allocate its R&D expenses with respect to a specific model to the items or classes of

gross income resulting from that model is not, on the Government’s view, permitted to do so. Rather, the taxpayer must first allocate R&D expenses incurred in connection with the relevant model to items or classes of

gross income resulting from all models falling within the same 2-digit SIC group and only after doing so can the taxpayer deduct a portion of that model’s R&D expenses from the income earned by sales of that model.

3

With respect to a DISC, Sec. 1.991–1 provides the more specific rules because it applies only to DISCs, while Sec. 1.861–8(e)(3) sets forth more general rules because it applies to all taxpayers that have foreign source

income.

2003–19 I.R.B.

875

May 12, 2003

DISC statute.” Ante, at 11–12. But the “disappearance” of Boeing’s R&D expenses is

the direct result of Congress’ decision to encourage such expenditures by making them

immediately deductible under 26 U.S.C.

Sec. 174(a)(1). Moreover, the approach

adopted in the regulations, and approved by

the Court, does not remedy the alleged

problem of disappearing R&D expenses. A

company that decides to enter the export

market with a product unrelated to its existing business remains free to deduct in the

current tax period all R&D expenses incurred in connection with the new product, even though those expenses would not

be used to offset DISC income resulting

from the sale of existing products.4 Finally, neither the Court nor the Government provide a satisfactory explanation for

why Sec. 861 can be read to permit the

“disappearance” of most expenses, see, e.g.,

26 CFR Sec. 1.861–8(d)(1) (1979) (“Each

deduction which bears a definite relationship to a class of gross income shall be allocated to that class . . . even though, for

the taxable year, no gross income in such

class is received or accrued. . . . In apportioning deductions, it may be that, for the

taxable year, there is no gross income in the

statutory grouping (or residual grouping),

or that deductions exceed the amount of

gross income in the statutory grouping

(or residual grouping)”); see also 1 J.

Isenbergh, International Taxation: U.S. Taxation of Foreign Persons and Foreign Income ¶21.10 (3d ed. 2003) (“[I]f an expense

incurred in one year is properly allocable

to income arising in another, the expense

will be allocated to the class to which the

income belongs and may therefore produce a loss in that class for the year”), but

to disallow the “disappearance” of R&D expenses.

Because I believe that Sec. 1.861–8(e)(3)

does not apply to a DISC, I need not decide here whether Sec. 1.861–8(e)(3) is consistent with the text of Sec. 861(b) and may

be properly applied in other contexts. I am

puzzled, however, by the Court’s assertion that the Secretary is free to determine that certain expenses “can be properly

apportioned on a categorical basis,” ante,

at 13, and the implication that the Secretary has authority to require “ratable apportionment of expenses that could be, but

perhaps in fairness should not be, treated

as direct costs.” Ibid. By its terms, Sec.

861(b) appears to contemplate two types of

expenses: (1) those that can definitely be

allocated to some item or class of gross income and (2) those that cannot. 26 U.S.C.

Sec. 861(b) (providing for the deduction of

“the expenses, losses, and other deductions properly apportioned or allocated

thereto and a ratable part of any expenses,

losses, or other deductions which cannot

definitely be allocated to some item or class

of gross income” (emphasis added)). Moreover, on its face, the statute does not appear to permit expenses to be “deemed”

related to an item or class of gross income, even though in actual fact they are

not so related. Yet, Sec. 1.861–8(e)(3) relies on the notion of “deemed relationships.” The regulation states that the

methods of allocation and apportionment established there “recognize that research and

development is an inherently speculative activity, that findings may contribute unexpected benefits, and that the gross income

derived from successful research and development must bear the cost of unsuccessful research and development. 26 CFR

Sec. 1.861–8(e)(3)(i)(A) (1979). The regulation then proceeds to require the allocation of R&D expenses based on 2-digit SIC

groups. But neither the regulation nor the

Court attempt to reconcile the statutory text

with the regulation’s determination to allocate certain R&D expenses to items or

classes of gross income that admittedly did

not benefit from that research.

****

In short, I conclude that Boeing properly computed its tax liability for the years

at issue here. I would therefore reverse the

judgment of the Court of Appeals. Because the Court concludes otherwise, I respectfully dissent.

Section 1274.—

Determination of Issue Price

in the Case of Certain Debt

Instruments Issued for

Property

(Also Sections 42, 280G, 382, 412, 467, 468, 482,

483, 642, 807, 846, 1288, 7520, 7872.)

Federal rates; adjusted federal rates;

adjusted federal long-term rate and the

long-term exempt rate. For purposes of

sections 382, 1274, 1288, and other sections of the Code, tables set forth the rates

for May 2003.

Rev. Rul. 2003–45

This revenue ruling provides various prescribed rates for federal income tax purposes for May 2003 (the current month).

Table 1 contains the short-term, mid-term,

and long-term applicable federal rates

(AFR) for the current month for purposes

of section 1274(d) of the Internal Revenue Code. Table 2 contains the shortterm, mid-term, and long-term adjusted

applicable federal rates (adjusted AFR) for

the current month for purposes of section

1288(b). Table 3 sets forth the adjusted federal long-term rate and the long-term taxexempt rate described in section 382(f).

Table 4 contains the appropriate percentages for determining the low-income housing credit described in section 42(b)(2) for

buildings placed in service during the current month. Finally, Table 5 contains the

federal rate for determining the present

value of annuity, an interest for life or for

a term of years, or a remainder or a reversionary interest for purposes of section

7520.

4

Boeing illustrates this point with the following example: Suppose a company that produces and exports athletic clothing (SIC Code 23) decides to invest the proceeds of its clothing sales in research to develop a line

of athletic equipment (SIC Code 39). The company has current DISC sales of $1 million from the athletic clothing, no current sales of athletic equipment, and $500,000 in athletic equipment R&D expenses. Under the

regulations, the $500,000 of equipment-related R&D will be allocated to the athletic equipment SIC Code, which has no income. It will not be allocated to the athletic clothing SIC Code to reduce the income eligible

for the DISC benefit related to the clothing. Thus, in the words of the Court, the expense will simply “disappear.” Brief for Petitioners 37, n. 17.

May 12, 2003

876

2003–19 I.R.B.

REV. RUL. 2003–45 TABLE 1

Applicable Federal Rates (AFR) for May 2003

Period for Compounding

Annual

Semiannual

Quarterly

Monthly

Short-Term

AFR

110% AFR

120% AFR

130% AFR

1.53%

1.68%

1.83%

1.99%

1.52%

1.67%

1.82%

1.98%

1.52%

1.67%

1.82%

1.98%

1.52%

1.66%

1.81%

1.97%

Mid-Term

AFR

110% AFR

120% AFR

130% AFR

150% AFR

175% AFR

3.17%

3.50%

3.82%

4.14%

4.79%

5.59%

3.15%

3.47%

3.78%

4.10%

4.73%

5.51%

3.14%

3.46%

3.76%

4.08%

4.70%

5.47%

3.13%

3.45%

3.75%

4.07%

4.68%

5.45%

Long-Term

AFR

110% AFR

120% AFR

130% AFR

4.79%

5.27%

5.76%

6.24%

4.73%

5.20%

5.68%

6.15%

4.70%

5.17%

5.64%

6.10%

4.68%

5.14%

5.61%

6.07%

REV. RUL. 2003–45 TABLE 2

Adjusted AFR for May 2003

Period for Compounding

Annual

Semiannual

Quarterly

Monthly

Short-term

adjusted AFR

1.34%

1.34%

1.34%

1.34%

Mid-term

adjusted AFR

2.72%

2.70%

2.69%

2.68%

Long-term

adjusted AFR

4.45%

4.40%

4.38%

4.36%

REV. RUL. 2003–45 TABLE 3

Rates Under Section 382 for May 2003

Adjusted federal long-term rate for the current month

4.45%

Long-term tax-exempt rate for ownership changes during the current month (the highest

of the adjusted federal long-term rates for the current month and the prior two months.)

4.58%

2003–19 I.R.B.

May 12, 2003

877

REV. RUL. 2003–45 TABLE 4

Appropriate Percentages Under Section 42(b)(2) for May 2003

Appropriate percentage for the 70% present value low-income housing credit

7.92%

Appropriate percentage for the 30% present value low-income housing credit

3.40%

REV. RUL. 2003–45 TABLE 5

Rate Under Section 7520 for May 2003

Applicable federal rate for determining the present value of an annuity, an interest for life or a term

of years, or a remainder or reversionary interest

Section 1288.—Treatment of

Original Issue Discounts on

Tax-Exempt Obligations

The adjusted applicable federal short-term,

mid-term, and long-term rates are set forth for the

month of May 2003. See Rev. Rul. 2003–45, page

876.

Section 3121.—Definitions

Federal Insurance Contributions Act

(FICA); Medicare. This ruling provides

that for the continuing employment exception to the Medicare portion of the Federal Insurance Contributions Act tax to

apply to service performed by an employee

of a state, political subdivision, or instrumentality thereof, such employee must be

a member of a retirement system pursuant to Internal Revenue Code section

3121(b)(7)(F). Rev. Ruls. 86–88 and 88–36

supplemented.

Rev. Rul. 2003–46

The Federal Insurance Contributions Act

(FICA) tax consists of an old age, survivors, and disability insurance (“OASDI”)

portion and a hospital insurance (“Medicare”) portion. This revenue ruling provides guidance concerning the applicability

of the Medicare portion of FICA tax under Internal Revenue Code § 3121(u)(2) to

employees of state and local governments.

Specifically, this revenue ruling considers

the interaction between §§ 3121(u)(2)(C)

and 3121(b)(7)(F) in the context of the continuing employment exception. Section

3121(u)(2) generally extends the Medi-

May 12, 2003

care portion of FICA tax to wages for service performed by employees of states,

political subdivisions, and wholly owned instrumentalities thereof hired after March 31,

1986. Section 3121(b)(7)(F), enacted by section 11332(b) of the Omnibus Budget Reconciliation Act of 1990 (OBRA ’90), Pub.

L. 101–508, 104 Stat. 1388, expands the

definition of employment for FICA tax purposes to include service performed after July

1, 1991, by state or local government employees who are not members of a retirement system.

This revenue ruling supplements Rev.

Rul. 86–88, 1986–2 C.B. 172, and Rev. Rul.

88–36, 1988–1 C.B. 343, both of which

provide guidelines concerning the application of § 3121(u)(2) in a question and answer format. This revenue ruling also

provides guidelines in a question and answer format. In this revenue ruling, the

terms “state,” “political subdivision,” “state

employer,” “political subdivision employer,”

and “continuing employment exception”

have the same meanings as in Rev. Rul. 86–

88.

SERVICE ELIGIBLE FOR THE

CONTINUING EMPLOYMENT

EXCEPTION

Q1. Is the continuing employment exception to the Medicare portion of FICA tax

available for service performed by an employee for a state employer or political subdivision employer who is not a member of

a retirement system within the meaning of

§ 3121(b)(7)(F)?

A1. No. Under § 3121(u)(2)(C)(i), the

continuing employment exception applies

only to service that is otherwise excluded

878

3.8%

from employment under § 3121(b)(7). Section 3121(b)(7) excepts from employment

service in the employ of a state employer

or political subdivision employer for FICA

tax purposes. However, § 3121(b)(7)(F) expands the definition of employment for

FICA tax purposes to include service by an

employee who is not a member of a retirement system. See § 31.3121(b)(7)–2 of

the Employment Tax Regulations. The

House-Senate Conference Report to OBRA

’90 provides that “[t]he conference agreement extends Medicare coverage to, and applies the HI [(Medicare)] tax with respect

to wages of, those employees (otherwise not

already subject to the HI tax) who become

subject to OASDI by reason of this provision.” H.R. Rep. No. 101–964, at 1105

(1990). Consequently, wages paid for service performed by an employee who is not

a member of a retirement system for the

state employer or political subdivision employer are subject to the OASDI and Medicare portions of FICA tax regardless of

when the employee became employed.

Q2. Is the continuing employment exception available for service performed by

an employee for a state employer or political subdivision employer who is subject to the Medicare portion of FICA tax

solely because the employee is not a member of a retirement system (i.e., the employee meets all the requirements of

§ 3121(u)(2)(C), and the employee’s service is not covered by a voluntary agreement with the Secretary of Health and

Human Services pursuant to § 218 of the

Social Security Act, 42 U.S.C. § 418), but

who becomes a member of a retirement system after July 1, 1991?

2003–19 I.R.B.

A2. Yes. If an employee’s wages are

subject to FICA tax solely because the employee is not a member of a retirement system within the meaning of § 3121(b)(7)(F),

and the employee subsequently becomes a

member of a retirement system, then the

employee’s wages will cease to be subject to the OASDI and Medicare portions

of FICA tax.

EFFECT ON OTHER REVENUE

RULINGS:

This revenue ruling supplements Rev.

Rul. 86–88, 1986–2 C.B. 172, and Rev. Rul.

88–36, 1988–1 C.B. 343.

DRAFTING INFORMATION

The principal author of this revenue ruling is Patricia P. Holdsworth of the Office of the Division Counsel/Associate Chief

Counsel (Tax Exempt and Government Entities). For further information regarding this

revenue ruling, contact Ms. Holdsworth at

(202) 622–6040 (not a toll-free call).

(ERISA). Under these final regulations, a

plan administrator must give notice of a

plan amendment to certain plan participants and beneficiaries when the plan

amendment provides for a significant reduction in the rate of future benefit accrual or the elimination or significant

reduction in an early retirement benefit or

retirement-type subsidy. These final regulations affect retirement plan sponsors and

administrators, participants in and beneficiaries of retirement plans, and employee

organizations representing retirement plan

participants.

DATES: Effective date: These regulations

are effective on April 9, 2003.

Applicability date: For dates of applicability of these regulations, see

§54.4980F–1, Q&A–18, of these regulations.

FOR FURTHER INFORMATION CONTACT: Pamela R. Kinard at (202) 622–

6060 or Diane S. Bloom at (202) 283–

9888 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Section 4980F.—Failure of

Applicable Plans Reducing

Benefit Accruals to Satisfy

Notice Requirements

26 CFR 54.4980F–1: Notice requirements for

certain pension plan amendments significantly

reducing the rate of future benefit accrual.

T.D. 9052

DEPARTMENT OF THE

TREASURY

Internal Revenue Service

26 CFR Part 1, 54, and 602

Notice of Significant

Reduction in the Rate of

Future Benefit Accrual

AGENCY: Internal Revenue Service (IRS),

Treasury.

ACTION: Final regulations.

SUMMARY:This document contains final regulations providing guidance on the

notification requirements under section

4980F of the Internal Revenue Code (Code)

and section 204(h) of the Employee Retirement Income Security Act of 1974

2003–19 I.R.B.

Paperwork Reduction Act

The collection of information contained

in these final regulations has been reviewed

and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act (44 U.S.C. 3507)

under control number 1545–1780. Responses to this collection of information are

required to obtain a benefit for a taxpayer

who wants to amend a plan with an amendment that significantly reduces the rate of

future benefit accrual or eliminates or significantly reduces an early retirement benefit or retirement-type subsidy.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless

the collection of information displays a valid

control number assigned by the Office of

Management and Budget.

The estimated annual burden per respondent varies from 1 hour to 80 hours,

depending on individual circumstances, with

an estimated average of 10 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, W:CAR:MP:T:T:SP,

Washington, DC 20224, and to the Of-

879

fice of Management and Budget, Attn:

Desk Officer for the Department of the

Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503.

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

as their contents may become material in

the administration of any internal revenue

law. Generally, tax returns and tax return

information are confidential, as required by

26 U.S.C. 6103.

Background

This document contains amendments to

26 CFR parts 1, 54, and 602 under section 4980F of the Code and section 204(h)

of ERISA. Prior to 2001, section 204(h) of

ERISA had no analogous section in the

Code, but pursuant to section 101(a) of the

Reorganization Plan No. 4 of 1978, 29

U.S.C. 1001nt, the Secretary of the Treasury has authority to issue regulations under parts 2 and 3 of subtitle B of title I of

ERISA, including section 204(h) of ERISA.

Under section 104 of the Reorganization

Plan No. 4, the Secretary of Labor retains

enforcement authority with respect to parts

2 and 3 of subtitle B of title 1 of ERISA,

but, in exercising that authority, is bound

by the regulations issued by the Secretary

of Treasury. On December 15, 1995, temporary regulations (T.D. 8631, 1996–1 C.B.

54 [60 FR 64320]), under section 411(d)(6)

of the Code were published in the Federal Register, providing guidance on section 204(h) of ERISA. A notice of proposed

rulemaking (EE–34–95, 1996–1 C.B. 761

[60 FR 64401]), cross-referencing the temporary regulations was published in the

Federal Register on the same day. On December 14, 1998, final regulations (T.D.

8795, 1999–1 C.B. 459 [63 FR 68678]) addressing the notice requirements under section 204(h) of ERISA were published in the

Federal Register and were codified in

§1.411(d)–6. The final regulations in this

Treasury decision remove Treasury regulation §1.411(d)–6.

Section 659 of the Economic Growth

and Tax Relief Reconciliation Act of 2001,

Public Law 107–16 (115 Stat. 38)

(EGTRRA) added section 4980F of the

Code. Section 4980F imposes an excise tax

when a plan administrator fails to provide timely notice of plan amendments that

provide for a significant reduction in the rate

of future benefit accrual. A reduction of an

early retirement benefit or a retirementtype subsidy is also treated, for purposes of

May 12, 2003

section 4980F of the Code, as a reduction

in the rate of future benefit accrual. Section 659(b) of EGTRRA also amended section 204(h) of ERISA to treat the

elimination of an early retirement benefit

or a retirement-type subsidy as a reduction in the rate of future benefit accrual. The

Job Creation and Worker Assistance Act of

2002, Public Law 107–147 (116 Stat. 21)

included certain technical corrections to section 659 of EGTRRA.

On April 23, 2002, proposed regulations (REG–136193–01, 2002–1 C.B. 995

[67 FR 19713]) under section 4980F of the

Code and section 204(h) of ERISA were

published in the Federal Register. On August 15, 2002, the IRS held a public hearing on the proposed regulations. Written

comments responding to the notice of proposed rulemaking were also received. After consideration of all the comments, the

proposed regulations are adopted, as

amended by this Treasury decision, and the

regulations under §1.411(d)–6 are removed.

The revisions are discussed below.

The regulations retain the overall structure of the proposed regulations and, like

the proposed regulations, include a number of examples illustrating applicable rules.

Some of the examples show the information required to be furnished in a section

204(h) notice, both as to amendments that

result in a simple reduction in the future rate

of benefit accrual and as to those that result in more complex reductions. The most

complex are examples in which a defined

benefit plan is amended to change prospectively the plan’s benefit accrual formula

from a traditional formula to a formula that

bases future benefits on an account balance — commonly called a conversion to

a cash balance pension plan — with the result that, for purposes of the notice requirements of section 4980F and section 204(h),

the future rate of benefit accrual may be reduced for some participants and increased

for others, including a separate but similarly complex effect on future early retirement benefits.

None of the examples illustrates rules in

any other regulation or positions of Treasury or the IRS regarding provisions of the

Internal Revenue Code other than the notice requirements of section 4980F and section 204(h). Thus, the examples do not

indicate any possible outcome regarding

proposed regulations that were published in

the Federal Register (67 FR 76123) on De-

May 12, 2003

cember 11, 2002, relating to sections

411(b)(1)(H) and 411(b)(2) of the Internal Revenue Code, which require that accruals or allocations under certain retirement

plans not cease or be reduced because of

the attainment of any age. Specifically, Treasury and the IRS are still considering comments received in connection with those

proposed regulations, including comments

relating to cash balance pension plans, and

will only address the application of section 411(b)(1)(H) to cash balance plans as

part of the process to issue regulations under sections 411(b)(1)(H).

Explanation of Revisions and Summary of Comments

A. Overview

Section 4980F of the Code and section 204(h) of ERISA require notice of an

amendment to an applicable pension plan

that either provides for a significant reduction in the rate of future benefit accrual or

eliminates or significantly reduces an early

retirement benefit or retirement-type subsidy. An applicable pension plan is a defined benefit plan and any individual

account plan that is subject to the funding requirements of section 412 of the Code.

The notice is required to be provided to participants and alternate payees for whom the

amendment is reasonably expected to reduce significantly the rate of future benefit accrual and to employee organizations

representing those participants. The statute generally requires the plan administrator to provide the notice within a reasonable

time before the effective date of the plan

amendment.

A plan amendment that is subject to the

notice requirements of section 4980F of the

Code and section 204(h) of ERISA (section 204(h) amendment) may be subject to

additional reporting and disclosure requirements under title I of ERISA, such as the

requirement to provide a summary of material modifications (SMM) describing the

amendment. Notice under section 4980F of

the Code and section 204(h) of ERISA (section 204(h) notice) must be provided in accordance with the provisions of these

regulations even though sections 102(a) and

104(b) of ERISA also may require that an

SMM describing the plan amendment be

furnished to participants covered under the

plan and beneficiaries receiving benefits under the plan. The Department of Labor has

advised the IRS that a plan administrator

880

who provides a section 204(h) notice to applicable individuals in accordance with this

final rule will be treated as having furnished those individuals with an SMM regarding the section 204(h) amendment. The

Department of Labor has also advised the

IRS that furnishing the notice to the last

known address of an individual would be

sufficient for this purpose where the plan

utilizes a method of delivery described in

29 CFR 2520.104b–1 and the fiduciaries of

the plan have taken reasonable steps to keep

plan records up-to-date and to locate lost

or missing participants. Finally, the Department of Labor noted that the plan administrator is required to satisfy any other

requirements regarding the furnishing of

SMMs or updated summary plan descriptions, including, for example, satisfaction

of the requirement to furnish an SMM to

any other participants covered under the

plan, and to beneficiaries receiving benefits under the plan, who are entitled to an

SMM regarding the amendment.

B. Conversion of a Money Purchase

Pension Plan into an Individual Account

Plan That is Not Subject to Section 412

Rev. Rul. 2002–42, 2002–28 I.R.B. 76,

provides that a conversion of a money purchase pension plan into a profit-sharing plan

is considered a significant reduction in the

rate of future benefit accrual under the

money purchase pension plan, thus requiring notice under section 4980F of the Code

and section 204(h) of ERISA. As stated in

the revenue ruling, allocations under the

profit-sharing plan are not benefit accruals under the money purchase pension plan

for purposes of determining whether there

is a reduction in the rate of future benefit

accrual. Accordingly, the final regulations

clarify that a plan amendment to convert a

money purchase pension plan into a profitsharing or any other individual account plan

that is not subject to section 412 of the

Code (including a merger, consolidation, or

transfer) is deemed to be a plan amendment that provides for a significant reduction in the rate of future benefit accrual for

purposes of section 4980F of the Code and

section 204(h) of ERISA.

C. Rate of Future Benefit Accrual

Determined Annually

A commentator questioned the provisions of the proposed regulations under

which the determination of whether there

2003–19 I.R.B.

is a reduction in the rate of future benefit

accrual would be based on whether the

amendment is reasonably expected to reduce “the benefits accruing for a year.” The

commentator objected on the grounds that

this could require section 204(h) notice for

an amendment that increases benefits in one

year and then reduces them in the next,

even though the aggregate benefit over the

two years might not be reduced or might

even be increased in the aggregate. The final regulations retain this rule, but clarify

in an example that where a reduction occurs at the same time as an immediate increase in accrued benefits such that the

participant’s aggregate benefit can never be

less than what it would have been had the

amendment not been adopted, the reduction is not significant.

D. Reduction in the Rate of Future

Benefit Accrual for Individual Account

Plans

A commentator suggested that the regulations be revised to clarify that only contributions or forfeitures that are allocated

to a participant’s account be considered in

determining whether a plan amendment to

an individual account plan reduces the rate

of future benefit accrual. The commentator recommended this revision to clarify that

an amendment reducing a contribution formula is not considered insignificant solely

because expected future investment returns might offset a portion of the reduction in the contribution formula. A

clarification that reflects this suggestion has

been adopted in the final regulations.

F. Definition of Early Retirement

Benefits and Retirement-Type Subsidies

A commentator stated that Treasury and

IRS should issue regulations defining the

terms early retirement benefits and

retirement-type subsidies. The commentator noted that there are numerous references to the terms early retirement benefit

or retirement-type subsidy in both the Code

(section 4980F(f)(3) and section

411(d)(6)(B)(i)),

ERISA (sections

204(g)(2)(A) and 204(h)(9)) and the regulations (§1.411(d)–4 and Proposed

§54.4980F–1), but the terms are not defined. The commentator expressed concern that adverse consequences might result

from an egregious failure to identify a significant reduction in early retirement benefit or a retirement-type subsidy and

guidance has not been issued to clarify the

meaning of those terms. The definitions of

early retirement benefits and retirementtype subsidies affect more than determining whether an amendment requires a

section 204(h) notice and, therefore, are beyond the scope of these final regulations.

Treasury and IRS anticipate issuing proposed regulations under section 411(d)(6),

including general guidance concerning early

retirement benefits and retirement-type subsidies. Comments regarding the anticipated proposed regulations were requested,

including comments on the guidance that

should be provided regarding early retirement benefits and retirement-type subsidies, in Notice 2002–46, 2002–28 I.R.B. 96,

and Notice 2003–10, 2003–5 I.R.B. 369.

E. Determination of Applicable

Individuals

G. Timing of Notice

A commentator suggested that the regulations be revised to clarify the date as of

which applicable individuals should be identified. The commentator argued that the lack

of a clear determination date would make

it difficult, from an administrative standpoint, for plans to identify applicable individuals due to turnover among

participants. The final regulations provide that whether a plan participant or an

alternate payee is an applicable individual

is determined on a typical business day that

is reasonably proximate to the time the section 204(h) notice is provided (or at the latest date for providing section 204(h) notice,

if earlier), based on all relevant facts and

circumstances. An example to this effect has

been added to the final regulations.

A number of comments addressed what

constitutes a reasonable period for providing a section 204(h) notice. The proposed

regulations included a generally applicable 45-day advance notice rule with exceptions for amendments in connection with

certain business transactions and small

plans. Some comments recommended that

notice generally be required to be provided more than 45 days in advance of the

effective date of the section 204(h) amendment and others recommended that notice generally be allowed to be provided less

than 45 days in advance of the effective

date of the section 204(h) amendment. The

approach in the proposed regulations was

designed to strike a balance between providing participants with sufficient time to

2003–19 I.R.B.

881

understand and consider the information in

the notice and allowing employers to effect changes in their plans for business reasons within a reasonable time, and has been

retained in the final regulations.

A commentator requested clarification

that section 204(h) notice may be provided before the adoption date of the

amendment. The commentator noted that

neither section 4980F of the Code nor section 204(h) of ERISA prevents a plan administrator from providing section 204(h)

notice before the adoption date of the

amendment. The regulations have not been

revised to reflect this suggestion because the

statute is already sufficiently clear that section 204(h) notice may be provided before the adoption of the amendment.

H. Certification of Accuracy by Senior

Officer

A commentator suggested that the regulations be revised to require that a senior

officer of the plan sponsor or the plan administrator certify to employees of the plan

sponsor and the IRS that the disclosures in

the section 204(h) notice accurately describe the effects of the amendment and that

the notice is presented in a manner that is

understandable to the average applicable individual. The commentator also suggested

that the senior officer should certify that the

section 204(h) notice provided to applicable individuals does not contain any false

or misleading information. The commentator argued that this certification would not

be burdensome to plan sponsors if they have

exercised due diligence concerning the content of the section 204(h) notice. Because

of concerns about the usefulness of such a

rule as well as whether there is statutory authority for such a rule, this suggestion has

not been adopted.

I. Determination and Effects of

Egregious Failures

A commentator suggested that the regulations revise the definition of an egregious violation to distinguish between

intentional and negligent acts of failure. The

commentator stated that it is possible that

a trustee or plan sponsor may make a decision not to provide section 204(h) notice that the trustee or plan sponsor thought

was prudent at the time but later determined was a mistake. The commentator argued that these types of decisions, which

may be negligent but not intentional, should

May 12, 2003

not be considered egregious failures. The

commentator suggested that the final regulations be revised to provide that an egregious failure is an action resulting from a

deliberate choice by the plan sponsor, in

which the plan sponsor knew or reasonably should have known that a section

204(h) notice would be required. The commentator also suggested that the final regulations be revised to provide that only

applicable individuals who were adversely

affected by the egregious failure be entitled to the greater of the old or new benefit formulas.

Section 204(h)(6)(B) of ERISA generally defines an egregious failure as a failure within the control of the plan sponsor

that is either an intentional failure or a failure to provide most of the individuals with

most of the information they are entitled to

receive. Further, section 204(h)(6)(A) of

ERISA provides that, in the case of any

egregious failure to meet any requirement

of section 204(h) with respect to any plan

amendment, the provisions are applied so

that all applicable individuals are entitled

to the greater of the benefits to which they

would have been entitled without regard to

the amendment, or the benefits under the

plan with regard to the amendment. Accordingly, these suggestions were not

adopted in the final regulations because they

would conflict with the plain language of

section 204(h) of ERISA.

J. Content of Section 204(h) Notice

Section 4980F of the Code and section 204(h) of ERISA require that section

204(h) notice be written in a manner calculated to be understood by the average

plan participant and that it provide sufficient information to allow applicable individuals to understand the effect of the

amendment. Q&A–11 of these final regulations sets forth the content requirements

for section 204(h) notice. The final regulations retain the basic structure of Q&A–11

in the proposed regulations, but include a

number of clarifications, including clarifying that the content must permit the applicable individual to determine the

approximate magnitude of the reduction applicable to that individual. The regulations provide that this requirement is

deemed to be satisfied if the notice includes illustrative examples satisfying certain conditions. At the request of a

commentator, the final regulations clarify

that individualized benefit statements may

May 12, 2003

be used in lieu of illustrative examples if

the statements include the same information as illustrative examples, such as showing the approximate range of the reductions

for the individual if the reductions vary over

time and identification of the assumptions

used in the projections.

final regulations provide that, for a multiemployer plan, section 204(h) notice must

be provided at least 15 days before the effective date of any section 204(h) amendment.

K. Benefit Changes Made by Collective

Bargaining Agreements

Except with respect to Q&A–7(a)(2),

these regulations are applicable to amendments with an effective date that is on or

after September 1, 2003.

The provisions of Q&A–7(a)(2) of these

regulations are applicable to amendments

with an effective date that is on or after

January 1, 2004.

A commentator suggested that the final regulations be revised to distinguish between a reduction in the rate of future

benefit accrual by collective bargaining

agreements and a reduction in the rate of

future benefit accrual by plan amendments.

Multiemployer plans often incorporate the

provisions of related collective bargaining agreements by reference. The commentator argued that when the rate of future

benefit accrual is being reduced by a change

to a collective bargaining agreement, section 204(h) notice is not required because

there is no plan amendment relating to the

reduction. The commentator suggested that

the final regulations include an example

clarifying that in situations where there is

an automatic benefit change that is linked

to a collective bargaining agreement, section 204(h) notice is not required, or at a

minimum that some relief be provided to

allow the amendment to go into effect

quickly. The IRS and Treasury believe that

when a benefit formula in a plan document incorporates provisions of the collective bargaining agreement by reference,

those provisions are part of the plan. Accordingly, the final regulations provide a

rule in Q&A–7(a)(2) that if all or a part of

a plan’s rate of future benefit accrual, or an

early retirement benefit or retirement-type

subsidy provided under the plan, depends

on provisions in another document that are

referenced in the plan document, a change

in the provisions of the other document is

an amendment of the plan. An example illustrating this rule has been added to the final regulations.

The IRS and Treasury recognize that

multiemployer plans may need additional

time to comply with the requirements of

Q&A–7(a)(2) of these final regulations,

therefore the effective date of this rule has

been delayed until January 1, 2004. In addition, because of the special characteristics of multiemployer plans (e.g.,

participating employers are often small businesses with fewer than 100 employees), the

882

Effective Date

Special Analyses

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

12866. Therefore, a regulatory assessment

is not required. It has also been determined

that section 553(b) of the Administrative

Procedure Act (5 U.S.C. chapter 5) does not

apply to these regulations.

It is hereby certified that the collection of information in these final regulations will not have a significant economic

impact on a substantial number of small entities. This certification is based upon the

fact that small entities generally do not have

very complex benefit structures in their

plans, or many different classes of participants who will be differently affected by an

amendment reducing the rate of future benefit accrual. Small entities also have fewer

employees, and thus they are required to

provide section 204(h) notice to fewer individuals. Accordingly, the time required for

them to prepare and provide section 204(h)

notice will usually be modest. Furthermore, because most small entities will only

be affected when they amend the retirement plans they sponsor to reduce or eliminate benefits, and most small entities will

not so amend their retirement plans frequently, it is generally expected that most

small entities would be required to provide section 204(h) notice only once over

the course of several years. 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 Code,

the notice of proposed rulemaking preceding these final regulations was submitted to

the Chief Counsel for Advocacy of the

2003–19 I.R.B.

Small Business Administration for comment on its impact on small business.

Drafting Information

The principal author of these regulations is Pamela R. Kinard, Office of Division Counsel/Associate Chief Counsel (Tax

Exempt and Government Entities), Internal Revenue Service. However, personnel

from other offices of the Internal Revenue Service and Treasury Department participated in their development.

*****

Adoption of

Regulations

Amendments

to

the

Accordingly, 26 CFR parts 1, 54, 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 ***

§1.411(d)–6 [Removed]

Par. 2. Section 1.411(d)–6 is removed.

PART 54—PENSION EXCISE TAXES

Par. 3. The authority citation for part 54

is amended by adding the following citation in numerical order to read as follows:

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

Section 54.4980F–1 also issued under 26

U.S.C. 4980F.* * *

Par. 4. Section 54.4980F–1 is added to

read as follows:

§54.4980F–1 Notice requirements for

certain pension plan amendments

significantly reducing the rate of future

benefit accrual.

The following questions and answers

concern the notification requirements imposed by 4980F of the Internal Revenue

Code and section 204(h) of ERISA relating to a plan amendment of an applicable

pension plan that significantly reduces the

rate of future benefit accrual or that eliminates or significantly reduces an early retirement benefit or retirement-type subsidy.

List of Questions

Q–1. What are the notice requirements

of section 4980F(e) of the Internal Revenue Code and section 204(h) of ERISA?

2003–19 I.R.B.

Q–2. What are the differences between

section 4980F and section 204(h)?

Q–3. What is an “applicable pension

plan” to which section 4980F and section

204(h) apply?

Q–4. What is “section 204(h) notice” and

what is a “section 204(h) amendment”?

Q–5. For which amendments is section 204(h) notice required?

Q–6. What is an amendment that reduces the rate of future benefit accrual or

reduces an early retirement benefit or

retirement-type subsidy for purposes of determining whether section 204(h) notice is

required?

Q–7. What plan provisions are taken into

account in determining whether an amendment is a section 204(h) amendment?

Q–8. What is the basic principle used in

determining whether a reduction in the rate

of future benefit accrual or a reduction in

an early retirement benefit or retirementtype subsidy is significant for purposes of

section 4980F and section 204(h)?

Q–9. When must section 204(h) notice

be provided?

Q–10. To whom must section 204(h) notice be provided?

Q–11. What information is required to

be provided in a section 204(h) notice?

Q–12. What special rules apply if participants can choose between the old and

new benefit formulas?

Q–13. How may section 204(h) notice

be provided?

Q–14. What are the consequences if a

plan administrator fails to provide section

204(h) notice?

Q–15. What are some of the rules that

apply with respect to the excise tax under

section 4980F?

Q–16. How do section 4980F and section 204(h) apply when a business is sold?

Q–17. How are amendments to cease accruals and terminate a plan treated under

section 4980F and section 204(h)?

Q–18. What are the effective dates of

section 4980F, section 204(h), as amended

by EGTRRA, and these regulations?

Questions and Answers

Q–1. What are the notice requirements

of section 4980F(e) of the Internal Revenue Code and section 204(h) of ERISA?

A–1. (a) Requirements of Internal Revenue Code section 4980F(e) and ERISA section 204(h). Section 4980F of the Internal

Revenue Code (section 4980F) and sec-

883

tion 204(h) of the Employee Retirement Income Security Act of 1974, as amended

(ERISA), 29 U.S.C. 1054(h) (section

204(h)) each generally requires notice of an

amendment to an applicable pension plan

that either provides for a significant reduction in the rate of future benefit accrual or

that eliminates or significantly reduces an

early retirement benefit or retirement-type

subsidy. The notice is required to be provided to plan participants and alternate payees who are applicable individuals (as

defined in Q&A–10 of this section) and to

certain employee organizations. The plan

administrator must generally provide the notice before the effective date of the plan

amendment. Q&A–9 of this section sets

forth the time frames for providing notice, Q&A–11 of this section sets forth the

content requirements for the notice, and

Q&A–12 of this section contains special

rules for cases in which participants can

choose between the old and new benefit formulas.

(b) Other notice requirements. Other provisions of law may require that certain parties be notified of a plan amendment. See,

for example, sections 102 and 104 of

ERISA, and the regulations thereunder, for

requirements relating to summary plan descriptions and summaries of material modifications.

Q–2. What are the differences between

section 4980F and section 204(h)?

A–2. The notice requirements of section 4980F generally are parallel to the notice requirements of section 204(h), as

amended by the Economic Growth and Tax

Relief Reconciliation Act of 2001, Public

Law 107–16 (115 Stat. 38) (2001)

(EGTRRA). However, the consequences of

the failure to satisfy the requirements of the

two provisions differ: section 4980F imposes an excise tax on a failure to satisfy

the notice requirements, while section

204(h)(6), as amended by EGTRRA, contains a special rule with respect to an egregious failure to satisfy the notice

requirements. See Q&A–14 and Q&A–15

of this section. Except to the extent specifically indicated, these regulations apply both to section 4980F and to section

204(h).

Q–3. What is an “applicable pension

plan” to which section 4980F and section

204(h) apply?

A–3. (a) In general. Section 4980F and

section 204(h) apply to an applicable pen-

May 12, 2003

sion plan. For purposes of section 4980F,

an applicable pension plan means a defined benefit plan qualifying under section 401(a) or 403(a) of the Internal

Revenue Code, or an individual account

plan that is subject to the funding standards of section 412 of the Internal Revenue Code. For purposes of section 204(h),

an applicable pension plan means a defined benefit plan that is subject to part 2

of subtitle B of title I of ERISA, or an individual account plan that is subject to such

part 2 and to the funding standards of section 412 of the Internal Revenue Code. Accordingly, individual account plans that are

not subject to the funding standards of section 412 of the Internal Revenue Code, such

as profit-sharing and stock bonus plans and

contracts under section 403(b) of the Internal Revenue Code, are not applicable

pension plans to which section 4980F or

section 204(h) apply. Similarly, a defined

benefit plan that neither qualifies under section 401(a) or 403(a) of the Internal Revenue Code nor is subject to part 2 of subtitle

B of title I of ERISA is not an applicable

pension plan. Further, neither a governmental plan (within the meaning of section 414(d) of the Internal Revenue Code),

nor a church plan (within the meaning of

section 414(e) of the Internal Revenue

Code) with respect to which no election has

been made under section 410(d) of the Internal Revenue Code is an applicable pension plan.

(b) Section 204(h) notice not required for

small plans covering no employees. Section 204(h) notice is not required for a plan

under which no employees are participants covered under the plan, as described

in §2510.3–3(b) of the Department of Labor regulations, and which has fewer than

100 participants.

Q–4. What is “section 204(h) notice” and

what is a “section 204(h) amendment”?

A–4. (a) Section 204(h) notice is notice that complies with section 4980F(e) of

the Internal Revenue Code, section

204(h)(1) of ERISA, and this section.

(b) A section 204(h) amendment is an

amendment for which section 204(h) notice is required under this section.

Q–5. For which amendments is section 204(h) notice required?

A–5. (a) Significant reduction in the rate

of future benefit accrual. Section 204(h) notice is required for an amendment to an ap-

May 12, 2003

plicable pension plan that provides for a

significant reduction in the rate of future

benefit accrual.

(b) Early retirement benefits and

retirement-type subsidies. Section 204(h) notice is also required for an amendment to

an applicable pension plan that provides for

the significant reduction of an early retirement benefit or retirement-type subsidy. For

purposes of this section, early retirement

benefit and retirement-type subsidy mean

early retirement benefits and retirementtype subsidies within the meaning of section 411(d)(6)(B)(i).

(c) Elimination or cessation of benefits. For purposes of this section, the terms

reduce or reduction include eliminate or

cease or elimination or cessation.

(d) Delegation of authority to Commissioner. The Commissioner may provide in

revenue rulings, notices, or other guidance published in the Internal Revenue Bulletin (see §601.601(d)(2) of this chapter) that

section 204(h) notice need not be provided

for plan amendments otherwise described

in paragraph (a) or (b) of this Q&A–5 that

the Commissioner determines to be necessary or appropriate, as a result of changes

in the law, to maintain compliance with the

requirements of the Internal Revenue Code

(including requirements for tax qualification), ERISA, or other applicable federal

law.

Q–6. What is an amendment that reduces the rate of future benefit accrual or

reduces an early retirement benefit or

retirement-type subsidy for purposes of determining whether section 204(h) notice is

required?

A–6. (a) In general. For purposes of determining whether section 204(h) notice is

required, an amendment reduces the rate of

future benefit accrual or reduces an early

retirement benefit or retirement-type subsidy only as provided in paragraph (b) or

(c) of this Q&A–6.

(b) Reduction in rate of future benefit

accrual—(1) Defined benefit plans. For purposes of section 4980F and section 204(h),

an amendment to a defined benefit plan reduces the rate of future benefit accrual only

if it is reasonably expected that the amendment will reduce the amount of the future annual benefit commencing at normal

retirement age (or at actual retirement age,

if later) for benefits accruing for a year. For

this purpose, the annual benefit commencing at normal retirement age is the ben-

884

efit payable in the form in which the terms

of the plan express the accrued benefit (or,

in the case of a plan in which the accrued

benefit is not expressed in the form of an

annual benefit commencing at normal retirement age, the benefit payable in the form

of a single life annuity commencing at normal retirement age that is the actuarial

equivalent of the accrued benefit expressed

under the terms of the plan, as determined

in accordance with section 411(c)(3) of the

Internal Revenue Code).

(2) Individual account plans. For purposes of section 4980F and section 204(h),

an amendment to an individual account plan

reduces the rate of future benefit accrual

only if it is reasonably expected that the

amendment will reduce the amount of contributions or forfeitures allocated for any future year. Changes in the investments or

investment options under an individual account plan are not taken into account for

this purpose.

(3) Determination of rate of future benefit accrual. The rate of future benefit accrual for purposes of this paragraph (b) is

determined without regard to optional forms

of benefit within the meaning of

§1.411(d)–4, Q&A–1(b) of this chapter

(other than the annual benefit described in

paragraph (b)(1) of this Q&A–6). The rate

of future benefit accrual is also determined

without regard to ancillary benefits and

other rights or features as defined in

§1.401(a)(4)–4(e) of this chapter.

(c) Reduction of early retirement benefits or retirement-type subsidies. For purposes of section 4980F and section 204(h),

an amendment reduces an early retirement

benefit or retirement-type subsidy only if

it is reasonably expected that the amendment will eliminate or reduce an early retirement benefit or retirement-type subsidy.

Q–7. What plan provisions are taken into

account in determining whether an amendment is a section 204(h) amendment?

A–7. (a) Plan provisions taken into

account—(1) In general. All plan provisions that may affect the rate of future benefit accrual, early retirement benefits, or

retirement-type subsidies of participants or

alternate payees must be taken into account in determining whether an amendment is a section 204(h) amendment. For

example, plan provisions that may affect the

rate of future benefit accrual include the dollar amount or percentage of compensation on which benefit accruals are based;

2003–19 I.R.B.

the definition of service or compensation

taken into account in determining an employee’s benefit accrual; the method of determining average compensation for

calculating benefit accruals; the definition of normal retirement age in a defined

benefit plan; the exclusion of current participants from future participation; benefit offset provisions; minimum benefit

provisions; the formula for determining the

amount of contributions and forfeitures allocated to participants’ accounts in an individual account plan; in the case of a plan

using permitted disparity under section

401(l) of the Internal Revenue Code, the

amount of disparity between the excess benefit percentage or excess contribution percentage and the base benefit percentage or

base contribution percentage (all as defined in section 401(l) of the Internal Revenue Code); and the actuarial assumptions

used to determine contributions under a target benefit plan (as defined in §1.401(a)(4)–

8(b)(3)(i) of this chapter). Plan provisions

that may affect early retirement benefits or

retirement-type subsidies include the right

to receive payment of benefits after severance from employment and before normal retirement age and actuarial factors used

in determining optional forms for distribution of retirement benefits.

(2) Provisions incorporated by reference in plan. If all or a part of a plan’s rate

of future benefit accrual, or an early retirement benefit or retirement-type subsidy provided under the plan, depends on

provisions in another document that are referenced in the plan document, a change in

the provisions of the other document is an

amendment of the plan.

(b) Plan provisions not taken into account. Plan provisions that do not affect the

rate of future benefit accrual of participants or alternate payees are not taken into

account in determining whether there has

been a reduction in the rate of future benefit accrual. Further, any benefit that is not

a section 411(d)(6) protected benefit as described in §1.411(d)–4, Q&A–1(d) of this

chapter, or that is a section 411(d)(6) protected benefit that may be eliminated or reduced as permitted under §1.411(d)–4,

Q&A–2(a) or (b) of this chapter, is not

taken into account in determining whether

an amendment is a section 204(h) amendment. Thus, for example, provisions relating to vesting schedules or the right to make

2003–19 I.R.B.

after-tax contributions or elective deferrals are not taken into account.

(c) Examples. The following examples

illustrate the rules in this Q&A–7:

Example 1. (i) Facts. A defined benefit plan provides a normal retirement benefit equal to 50% of highest 5-year average pay multiplied by a fraction (not

in excess of one), the numerator of which equals the

number of years of participation in the plan and the

denominator of which is 20. A plan amendment is

adopted that changes the numerator or denominator

of that fraction.

(ii) Conclusion. The plan amendment must be

taken into account in determining whether there has

been a reduction in the rate of future benefit accrual.

Example 2. (i) Facts. Plan C is a multiemployer

defined benefit plan subject to several collective bargaining agreements. The specific benefit formula under Plan C that applies to an employee depends on

the hourly rate of contribution of the employee’s employer, which is set forth in the provisions of the collective bargaining agreements that are referenced in

the Plan C document. Collective Bargaining Agreement A between Employer B and the union representing employees of Employer B is renegotiated to

provide that the hourly contribution rate for an employee of B who is subject to the Collective Bargaining Agreement A will decrease. That decrease will

result in a decrease in the rate of future benefit accrual for employees of B.

(ii) Conclusion. Under paragraph (a)(2) of this

Q&A–7, the change to Collective Bargaining Agreement A is a plan amendment that is a section 204(h)

amendment if the reduction in the rate of future benefit accrual is significant.

Q–8. What is the basic principle used in

determining whether a reduction in the rate

of future benefit accrual or a reduction in

an early retirement benefit or retirementtype subsidy is significant for purposes of

section 4980F and section 204(h)?

A–8. (a) General rule. Whether an

amendment reducing the rate of future benefit accrual or reducing an early retirement benefit or retirement-type subsidy

provides for a reduction that is significant for purposes of section 4980F and section 204(h) is determined based on

reasonable expectations taking into account the relevant facts and circumstances

at the time the amendment is adopted.

(b) Application for determining significant reduction in the rate of future benefit accrual. For a defined benefit plan, the

determination of whether an amendment

provides for a significant reduction in the

rate of future benefit accrual is made by

comparing the amount of the annual benefit commencing at normal retirement age

(or at actual retirement age, if later), as determined under Q&A–6(b)(1) of this section, under the terms of the plan as amended

with the amount of the annual benefit com-

885

mencing at normal retirement age (or at actual retirement age, if later), as determined

under Q&A–6(b)(1) of this section, under

the terms of the plan prior to amendment.

For an individual account plan, the determination of whether an amendment provides for a significant reduction in the rate

of future benefit accrual is made in accordance with Q&A–6(b)(2) of this section by

comparing the amounts to be allocated in

the future to participants’ accounts under

the terms of the plan as amended with the

amounts to be allocated in the future to participants’ accounts under the terms of the

plan prior to amendment. An amendment

to convert a money purchase pension plan

to a profit-sharing or other individual account plan that is not subject to section 412

of the Internal Revenue Code is, in all cases,

deemed to be an amendment that provides

for a significant reduction in the rate of future benefit accrual.

(c) Application to certain amendments

reducing early retirement benefits or

retirement-type subsidies. Because section 204(h) notice is required only for reductions that are significant, section 204(h)

notice is not required for an amendment that

reduces an early retirement benefit or

retirement-type subsidy if the amendment

is permitted under the third sentence of section 411(d)(6)(B) of the Internal Revenue

Code and regulations thereunder (relating

to the elimination or reduction of benefits

or subsidies which create significant burdens or complexities for the plan and plan

participants unless the amendment adversely

affects the rights of any participant in a

more than de minimis manner).

(d) Example. The following example illustrates the rules in this Q&A–8:

Example. (i) Facts. Pension Plan A is a defined

benefit plan that provides a rate of benefit accrual of

1% of highest-five years’ pay multiplied by years of

service, payable annually for life commencing at normal retirement age (or at actual retirement age, if later).

Plan A is amended, effective January 1, 2008, to provide that any participant who separates from service

after December 31, 2007, and before January 1, 2013,

will have the same number of years of service he or

she would have had if his or her service continued to

December 31, 2012.

(ii) Conclusion. While the amendment will result in a reduction in the annual rate of future benefit accrual from 2009 through 2012 (because under

the amendment, benefits based upon an additional five

years of service accrue on January 1, 2008, and no

additional service is credited after January 1, 2008,

until January 1, 2013), the amendment does not result in a reduction that is significant because the

amount of the annual benefit commencing at normal retirement age (or at actual retirement age, if later)

May 12, 2003

under the terms of the plan as amended is not under

any conditions less than the amount of the annual benefit commencing at normal retirement age (or at actual retirement age, if later) to which any participant

would have been entitled under the terms of the plan

had the amendment not been made.

Q–9. When must section 204(h) notice

be provided?

A–9. (a) 45-day general rule. Except as

described in paragraphs (b), (c), and (d) of

this Q&A–9, section 204(h) notice must be

provided at least 45 days before the effective date of any section 204(h) amendment. See paragraph (e) of this Q&A–9 for

special rules for amendments permitting participant choice.

(b) 15-day rule for small plans. Except for amendments described in paragraph (d)(2) of this Q&A–9, section 204(h)

notice must be provided at least 15 days before the effective date of any section 204(h)

amendment in the case of a small plan. For

purposes of this section, a small plan is a

plan that the plan administrator reasonably expects to have, on the effective date

of the section 204(h) amendment, fewer

than 100 participants who have an accrued

benefit under the plan.

(c) 15-day rule for multiemployer plans.

Except for amendments described in paragraph (d)(2) of this Q&A–9, section 204(h)

notice must be provided at least 15 days before the effective date of any section 204(h)

amendment in the case of a multiemployer

plan. For purposes of this section, a multiemployer plan means a multiemployer plan

as defined in section 414(f) of the Internal Revenue Code.

(d) Special timing rule for business

transactions—(1) 15-day rule for section

204(h) amendment in connection with an

acquisition or disposition. Except for

amendments described in paragraph (d)(2)

of this Q&A–9, if a section 204(h) amendment is adopted in connection with an acquisition or disposition, section 204(h)

notice must be provided at least 15 days before the effective date of the section 204(h)

amendment.

(2) Later notice permitted for a section 204(h) amendment significantly reducing early retirement benefit or retirementtype subsidies in connection with certain

plan transfers, mergers, or consolidations.

If a section 204(h) amendment is adopted

with respect to liabilities that are transferred to another plan in connection with

a transfer, merger, or consolidation of assets or liabilities as described in section

May 12, 2003

414(l) of the Internal Revenue Code and

§1.414(l)–1 of this chapter, the amendment is adopted in connection with an acquisition or disposition, and the amendment

significantly reduces an early retirement

benefit or retirement-type subsidy, but does

not significantly reduce the rate of future

benefit accrual, then section 204(h) notice must be provided no later than 30 days

after the effective date of the section 204(h)

amendment.

(3) Definition of acquisition or disposition. For purposes of this paragraph (d),

see §1.410(b)–2(f) of this chapter for the

definition of acquisition or disposition.

(e) Timing rule for amendments permitting participant choice. In general, section 204(h) notice of a section 204(h)

amendment that provides applicable individuals with a choice between the old and

the new benefit formulas (as described in

Q&A–12 of this section) must be provided

in accordance with the time period applicable under paragraphs (a) through (d) of

this Q&A–9. See Q&A–12 of this section for additional guidance regarding section 204(h) notice in connection with

participant choice.

Q–10. To whom must section 204(h) notice be provided?

A–10. (a) In general. Section 204(h) notice must be provided to each applicable individual and to each employee organization

representing participants who are applicable individuals. A special rule is provided in paragraph (d) of this Q&A–10.

(b) Applicable individual. Applicable individual means each participant in the plan,

and any alternate payee, whose rate of future benefit accrual under the plan is reasonably expected to be significantly

reduced, or for whom an early retirement

benefit or retirement-type subsidy under the

plan may reasonably be expected to be significantly reduced, by the section 204(h)

amendment. The determination is made with

respect to individuals who are reasonably

expected to be participants or alternate payees in the plan at the effective date of the

section 204(h) amendment.

(c) Alternate payee. Alternate payee

means a beneficiary who is an alternate

payee (within the meaning of section

414(p)(8) of the Internal Revenue Code) under an applicable qualified domestic relations order (within the meaning of section

414(p)(1)(A) of the Internal Revenue Code).

886

(d) Designees. Section 204(h) notice may

be provided to a person designated in writing by an applicable individual or by an employee organization representing participants

who are applicable individuals, instead of

being provided to that applicable individual or employee organization. Any designation of a representative made through

an electronic method that satisfies standards similar to those of Q&A–13(c)(1) of

this section satisfies the requirement that a

designation be in writing.

(e) Facts and circumstances test.

Whether a participant or alternate payee is

an applicable individual is determined on

a typical business day that is reasonably

proximate to the time the section 204(h) notice is provided (or at the latest date for providing section 204(h) notice, if earlier),

based on all relevant facts and circumstances.

(f) Examples. The following examples

illustrate the rules in this Q&A–10:

Example 1. (i) Facts. A defined benefit plan requires an individual to complete 1 year of service to

become a participant who can accrue benefits, and participants cease to accrue benefits under the plan at severance from employment with the employer. There are

no alternate payees and employees are not represented by an employee organization. On November

18, 2004, the plan is amended effective as of January 1, 2005, to reduce significantly the rate of future benefit accrual. Section 204(h) notice is provided

on November 1, 2004.

(ii) Conclusion. Section 204(h) notice is only required to be provided to individuals who, based on

the facts and circumstances on November 1, 2004, are

reasonably expected to have completed at least 1 year

of service and to be employed by the employer on

January 1, 2005.

Example 2. (i) Facts. The facts are the same as

in Example 1, except that the sole effect of the plan

amendment is to alter the pre-amendment plan provisions under which benefits payable to an employee

who retires after 20 or more years of service are unreduced for commencement before normal retirement age. The amendme

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