These synopses are intended only as aids to the reader in

Agency decision

Ask Donna

What actually matters in this document.

Text

Bulletin No. 1997–8

February 24, 1997

HIGHLIGHTS

OF THIS ISSUE

These synopses are intended only as aids to the reader in

identifying the subject matter covered. They may not be relied

upon as authoritative interpretations.

INCOME TAX

T.D. 8702, page 4.

Final regulations relate to certain transfers of stock or

securities of domestic corporations by U.S. persons to

foreign corporations pursuant to the corporate organization, reorganization, or liquidation provisions of section

367 of the Code.

T.D. 8703, page 18.

Final regulations under section 6081 of the Code

provide new and simpler procedures for an individual to

obtain an automatic extension of time to file an individual income tax return.

T.D. 8704, page 12.

Final regulations under sections 952, 954, and 960 of

the Code relate to the definitions of subpart F income

and foreign personal holding company income of a

controlled foreign corporation and the allocation of

deficits to compute the deemed-paid foreign tax credit.

premiums. A public hearing will be held on April 30,

1997.

REG–246018–96, page 30.

Proposed regulations under section 801 of the Code

relate to the definition of life insurance reserves. A

public hearing will be held on April 17, 1997.

REG–248770–96, page 33.

Proposed regulations under section 6601 of the Code

relate to joint returns, property exempt from levy,

interest, penalties, offers in compromise, and the awarding of costs and certain fees.

Notice 97–14, page 23.

Low-income housing tax credit. Resident populations

of the various states, for determining the 1997 calendar

year (1) state housing credit ceiling under section 42(h)

of the Code, and (2) private activity bond volume cap

under section 146, are reproduced.

T.D. 8705, page 16.

REG–247862–96, page 32.

Final and temporary regulations under section 6071 of

the Code provide that disqualified persons and organization managers liable for Code section 4958 excise taxes

are required to file Form 4720.

EXEMPT ORGANIZATIONS

REG–209494–90, page 24.

Proposed regulations under section 41 of the Code

describe when computer software that is developed by

(or for the benefit of) a taxpayer, primarily for the

taxpayer’s internal use, can qualify for the credit for

increasing research activities. A public hearing will be

held on May 13, 1997.

Announcement 97–14, page 38.

A list is given of organizations now classified as private

foundations.

REG–209839–96, page 26.

Proposed regulations under section 832 of the Code

relate to the requirement that insurance companies

other than life insurance companies reduce, by 20

percent, their deductions for increases in unearned

Finding Lists begin on page 41.

Announcement of Disbarments and Suspensions begins on page 40.

Announcement 97–13, page 38.

A Taste of Orange County, Inc., Irvine, CA, no longer

qualifies as an organization to which contributions are

deductible under section 170 of the Code.

EXCISE TAX

Notice 97–15, page 23.

The Service intends to modify section 40.6302(c)–

1(c)(2) of the Excise Tax Procedural Regulations to

provide that the availability of the safe harbor deposit

rule based on look-back quarter liability is limited in

cases where a new excise tax is enacted or an expired

excise tax is reinstated.

Mission of the Service

The purpose of the Internal Revenue Service is to

collect the proper amount of tax revenue at the least

cost; serve the public by continually improving the

quality of our products and services; and perform in a

manner warranting the highest degree of public

confidence in our integrity, efficiency and fairness.

Statement of Principles

of Internal Revenue

Tax Administration

The Service also has the responsibility of applying

and administering the law in a reasonable,

practical manner. Issues should only be raised by

examining of ficers when they have merit, never

arbitrarily or for trading purposes. At the same

time, the examining officer should never hesitate

to raise a meritorious issue. It is also important

that care be exercised not to raise an issue or to

ask a court to adopt a position inconsistent with

an established Service position.

The function of the Internal Revenue Service is to

administer the Internal Revenue Code. Tax policy

for raising revenue is determined by Congress.

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

carry out that policy by correctly applying the laws

enacted by Congress; to determine the reasonable

meaning of various Code provisions in light of the

Congressional purpose in enacting them; and to

perform this work in a fair and impartial manner,

with neither a government nor a taxpayer point of view.

Administration should be both reasonable and

vigorous. It should be conducted with as little

delay as possible and with great cour tesy and

considerateness. It should never try to overreach,

and should be reasonable within the bounds of law

and sound administration. It should, however, be

vigorous in requiring compliance with law and it

should be relentless in its attack on unreal tax

devices and fraud.

At the heart of administration is interpretation of the

Code. It is the responsibility of each person in the

Service, charged with the duty of interpreting the

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

provision and not to adopt a strained construction in

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

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

Introduction

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

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

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

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

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

single-copy basis.

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

cautioned against reaching the same conclusions in

other cases unless the facts and circumstances are

substantially the same.

The Bulletin is divided into four parts as follows:

Part I.—1986 Code.

This part includes rulings and decisions based on

provisions of the Internal Revenue Code of 1986.

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

substantive rulings necessary to promote a uniform

application of the tax laws, including all rulings that

supersede, revoke, modify, or amend any of those

previously published in the Bulletin. All published rulings

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

are not published; however, statements of internal

practices and procedures that affect the rights and

duties of taxpayers are published.

Part II.—Treaties and Tax Legislation.

This part is divided into two subparts as follows:

Subpart A, Tax Conventions, and Subpart B, Legislation

and Related Committee Reports.

Part III.—Administrative, Procedural, and Miscellaneous.

To the extent practicable, pertinent cross references to

these subjects are contained in the other Parts and

Subparts. Also included in this part are Bank Secrecy

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

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

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

stated in the revenue ruling. In those based on positions

taken in rulings to taxpayers or technical advice to

Service field offices, identifying details and information

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

requirements.

Part IV.—Items of General Interest.

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

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

Rulings and procedures reported in the Bulletin do not

have the force and effect of Treasury Department

Regulations, but they may be used as precedents.

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

as precedents by Service personnel in the disposition of

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

The first Bulletin for each month includes an index for

the matters published during the preceding month.

These monthly indexes are cumulated on a quarterly and

semiannual basis, and are published in the first Bulletin

of the succeeding quarterly and semi-annual period,

respectively.

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

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

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

Section 367.—Foreign

Corporations

26 CFR 1.367(a)–3: Treatment of transfers of

stock or securities to foreign corporations.

T.D. 8702

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

Certain Transfers of Domestic

Stock or Securities by U.S. Persons

to Foreign Corporations

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains

final regulations relating to certain transfers of stock or securities of domestic

corporations by United States persons to

foreign corporations pursuant to the corporate organization, reorganization, or

liquidation provisions of the Internal

Revenue Code. These final regulations

modify the rules contained in the temporary regulations to reflect certain taxpayer comments received in response to

those temporary regulations. This action

is necessary to provide the public with

guidance to comply with the Tax Reform Act of 1984.

DATES: These regulations are effective

January 29, 1997. For dates of applicability of these regulations, see

§ 1.367(a)–3(c)(11).

FOR FURTHER INFORMATION CONTACT: Philip L. Tretiak at (202) 622–

3860 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in these final regulations has been

reviewed and approved by the Office of

Management and Budget in accordance

with the Paperwork Reduction Act (44

U.S.C. 3507) under control number

1545–1478. Responses to these collections of information are required in

order for U.S. shareholders that transfer

stock or securities in section 367(a)

exchanges to qualify for an exception to

the general rule of taxation under section 367(a)(1).

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

respond to, a collection of information

unless the collection of information displays a valid control number.

The estimated one-time burden per

respondent: 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, T:FP,

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

Desk Officer for the Department of the

Treasury, Office of Information and

Regulatory Affairs, Washington, DC

20503.

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

long as their contents may become material in the administration of any internal revenue law. Generally, tax returns

and tax return information are confidential, as required by 26 U.S.C. 6103.

Background

On May 16, 1986, temporary and

proposed regulations under sections

367(a) and (d) and section 6038B were

published in the Federal Register (51

FR 17936 [LR–3–86, 1986–1 C.B.

902]). These regulations were published

to provide the public with guidance

necessary to comply with changes made

to the Internal Revenue Code by the Tax

Reform Act of 1984. The IRS and the

Treasury Department later issued Notice

87–85 (1987–2 C.B. 395), which set

forth substantial changes to the 1986

regulations, effective with respect to

transfers occurring after December 16,

1987. A further notice of proposed

rulemaking, containing rules under section 367(a), as well as under section

367(b), was published in the Federal

41993 [INTL–54–91; INTL–178–86,

1991–2 C.B. 1070]). The 1991 proposed

section 367(a) regulations were generally based upon the positions announced

in Notice 87–85, but the regulations

made certain modifications to Notice

87–85, particularly with respect to transfers of stock or securities of foreign

corporations. Subsequently, the IRS and

the Treasury Department issued Notice

94–46 (1994–1 C.B. 356), announcing

modifications to the positions set forth

in Notice 87–85 (and the 1991 proposed

regulations) with respect to transfers of

stock or securities of domestic corporations occurring after April 17, 1994.

Most recently, temporary and proposed regulations were published in the

Federal Register on December 26,

1995 (60 FR 66739 and 66771). The

temporary regulations, which are generally effective for transfers occurring after April 17, 1994, but cease to be

effective when the final regulations take

effect, generally incorporated the positions announced in Notice 94–46, with

certain modifications. These final regulations generally follow the rules set

forth in the temporary regulations, with

changes as described below. Explanation

of provisions

Section 367(a)(1) generally treats a

transfer of property (including stock or

securities) by a U.S. person to a foreign

corporation in connection with an exchange described in section 332, 351,

354, 356 or 361 as a taxable exchange

unless the transfer qualifies for an exception to this general rule.

Rules that address transfers of stock

or securities of domestic corporations

are contained in the final regulations

described herein. Rules that address

transfers of stock or securities of foreign

corporations under section 367(a) are

contained in Notice 87–85.

The final regulations retain the general rules set forth in the temporary

regulations, which provide that a U.S.

person that exchanges stock or securities

in a U.S. target company (UST) for

stock of a foreign corporation (the transferee foreign corporation (or TFC)) in

an exchange described in section 367(a)

will qualify for nonrecognition treatment

if certain reporting requirements are satisfied and each of the following conditions is met:

(i) U.S. transferors must receive no

more than 50 percent of the voting

power and value of the stock of the

TFC in the transfer (i.e., the 50-percent

ownership threshold is not exceeded);

(ii) U.S. officers, directors and

5-percent or greater shareholders of the

U.S. target must not own, in the aggregate, more than 50 percent of the voting

power and value of the TFC immediately after the transfer (i.e., the control

group case does not apply);

(iii) The U.S. person (exchanging

U.S. shareholder) either must not be a

5-percent transferee shareholder immediately after the transfer or, if the U.S.

person is a 5-percent transferee shareholder, must enter into a 5-year gain

recognition agreement (GRA) with respect to the UST stock or securities it

exchanged. (Without such GRA, the

transfer by the 5-percent transferee

shareholder will not qualify for nonrecognition treatment; however, transfers

by other U.S. transferors not subject to

the GRA requirement may qualify if all

other requirements are met.); and

(iv) The active trade or business requirement must be satisfied.

If one or more of the foregoing

requirements is not satisfied, the transfer

by the U.S. person of stock or securities

of a domestic corporation in exchange

for stock of a TFC is taxable under

section 367(a).

In response to suggestions from commentators, however, the final regulations

make a number of modifications to the

temporary regulations, principally in two

areas: (i) the treatment of transfers of

‘‘other property’’ in the context of the

50-percent ownership threshold requirement, and (ii) the active trade or business requirement.

Location:

Transfers of ‘‘Other Property’’

Under the temporary regulations, if

U.S. transferors receive more than 50

percent of the stock (by vote or value)

of the TFC, the 50-percent ownership

threshold is exceeded and the transfer is

taxable under section 367(a)(1). The

temporary regulations define a ‘‘U.S.

transferor’’ as a U.S. person who transfers (directly, indirectly or constructively) stock or securities of the U.S.

target company or ‘‘other property’’ for

stock of the TFC in an exchange described in section 367. Persons who

transfer U.S. target company stock or

other property are presumed to be U.S.

persons.

The inclusion of ‘‘other property’’ in

the class of tainted transferred property

was designed to prevent the avoidance

of the 50-percent ownership threshold

through ‘‘stuffing’’ transactions. For example, assume that FC, a foreign corporation, and UST, an unrelated U.S. corporation, seek to combine their

operations in a new foreign joint venture

company (JV). The shareholders of each

company will transfer their respective

stock interests in UST and FC to JV in

a transaction that would qualify as a

section 351 exchange unless the transaction was taxable under section 367(a)(1).

Assume that FC has all foreign shareholders. The value of the stock of UST

is 550x; the value of the stock of FC is

450x. Because UST is more valuable

than FC, UST’s shareholders would receive more than 50 percent of JV’s

stock. Consequently, even if the transaction would otherwise qualify for an

exception to the general rule of taxation

under section 367(a)(1), the transaction

would be taxable because the 50-percent

ownership threshold would be exceeded.

If, however, a U.S. person (X) contributed at least 100x in cash (or property)

to JV, JV would not issue more than 50

percent of its stock to the UST shareholders, and, therefore, the 50-percent

ownership threshold would not be exceeded. The temporary regulations, however, treat X as a U.S. transferor, so that

the 50-percent ownership threshold

would be exceeded in this case.

Commentators have pointed out that

the term ‘‘other property’’ raises issues

in the joint venture context that are

broader than the ‘‘stuffing’’ example

described above. Because the term

‘‘other property’’ is broad enough to

include stock of a foreign company, the

transfer of UST stock could be taxable

under section 367(a)(1) even if UST

were less valuable than the foreign

‘‘target’’ company (i.e., in cases where

U.S. transferors would receive less than

50 percent of the stock of the joint

venture company/TFC). Assume similar

facts as in the earlier example, except

that FC is widely- held and the shareholders of UST receive 40 percent of

the stock of JV, while the shareholders

of FC receive the remaining 60 percent.

No cash or any other property is transferred to the JV. In such case, if the

stock of FC constitutes ‘‘other property,’’ UST shareholders would not

qualify for an exception to section

367(a)(1) if they were unable to prove

that the U.S. shareholders of FC, if any,

received no more than 10 percent of the

stock of JV in the exchange.

Although the IRS and the Treasury

Department remain concerned with

‘‘stuffing’’ transactions, the final regulations consider the active trade or business test to be the primary safeguard for

preventing tax-motivated transactions

from qualifying for an exception under

these section 367(a) regulations. In particular, because the active trade or business test addresses ‘‘stuffing’’ transactions that occur within the 36-month

period prior to the acquisition, the final

regulations eliminate consideration of

transfers of other property with regard

to the 50-percent ownership threshold.

Thus, any TFC stock received by U.S.

persons in exchange for transfers of

other property will not be taken into

account in determining whether the 50percent ownership threshold is exceeded.

Active trade or business test: in general

The final regulations modify the ‘‘active trade or business’’ requirement that

must be satisfied for a U.S. transferor to

qualify for an exception to the general

rule of taxability under section

367(a)(1).

Under the requirement contained in

the temporary regulations, no exception

under section 367(a)(1) is available unless (i) the TFC or an affiliate was

engaged in an active trade or business

for the entire 36-month period prior to

the exchange (the 36-month test), and

(ii) such business was substantial in

relation to the business of the U.S.

target company (the substantiality test).

For this purpose, an affiliate is generally

defined by reference to the rules in

section 1504(a) (without the exclusion

of foreign corporations).

The active trade or business test under the final regulations includes (i) a

modified 36-month test, (ii) a new antiavoidance rule requiring that the transaction not be undertaken with an intention that the TFC cease its active trade

or business, and (iii) a modified substantiality test. The final regulations make a

number of other modifications and clarifications to the active trade or business

test. For example, the final regulations

permit the TFC to consider only an

80-percent owned foreign subsidiary (referred to as a ‘‘qualified subsidiary’’),

and not an affiliate, to satisfy the active

trade or business test on its behalf.

Active trade or business test: 36-month

test and intent test

Under the 36-month test contained in

the temporary regulations, the TFC or

an affiliate is required to be engaged in

an active trade or business for the entire

36 months immediately preceding the

date of the transfer. Under the final

regulations, this test can be satisfied by

acquired businesses that have a 36month operating history, unless they are

acquired with the principal purpose of

satisfying the active trade or business

test.

In addition to the 36-month test, the

active trade or business test in the final

regulations contains a requirement that

the transaction not be undertaken with

an intention that the TFC cease its

active business. The IRS and the Treasury Department believe that if a TFC

with a 36- month active business history

does not intend to maintain such business, but is only used as a vehicle to

acquire the UST, an ‘‘inversion’’ transaction rather than a synergy of two

businesses has been effected.

Under the temporary regulations,

there is uncertainty as to whether an

affiliate of a newly-formed TFC can

satisfy the active trade or business test

on behalf of the TFC for the (36-month)

period prior to the exchange. Subject to

a stuffing rule, the final regulations

clarify that, for purposes of determining

whether a TFC satisfies the 36-month

test, the TFC may take into account an

active business of a company that is a

qualified subsidiary immediately after

the transaction, even if such company

was not a qualified subsidiary for all or

part of the 36 months prior to the

transaction. Thus, for example, if the

TFC is a new foreign joint venture

company, it will not be disqualified

from satisfying the active trade or business test solely because its qualifying

active trade or business was engaged in

by a qualified subsidiary whose stock is

received in the exchange.

Under the temporary regulations, it is

unclear whether a newly-formed joint

venture TFC could satisfy the active

trade or business test if, in the transaction, it received both stock of a UST

(from U.S. transferors) and an active

trade or business (i.e., a foreign branch)

that had been operating for at least 36

months prior to the exchange (from

foreign transferors). This uncertainty

arose because the active trade or business test in the temporary regulations

required that either the TFC or an

affiliate satisfy the 36-month requirement. Although the temporary regulations did not intend to establish a

preference for transfers of stock (i.e.,

affiliates) vis-a-vis assets, the temporary

regulations did not expressly provide

that a TFC could utilize a newlytransferred foreign branch to satisfy the

TFC’s active trade or business requirement.

The final regulations clarify that, subject to a stuffing rule, the TFC may

satisfy the active trade or business test if

it receives in the exchange foreign assets that constituted an active trade or

business during such 36-month period.

Active trade or business test: qualified

subsidiaries

The final regulations permit a TFC to

take into account only qualified subsidiaries, rather than affiliates, to satisfy

the active trade or business test. This

aspect of the active trade or business

test has been narrowed because the IRS

and the Treasury Department do not

believe that a TFC should satisfy the

active trade or business exception

merely because its parent company (or

an affiliate of the parent company) is

engaged in an active trade or business.

For example, assume that foreign parent (FP), which is engaged in an active

business outside the United States (either directly or through a subsidiary),

forms a foreign subsidiary (FS) and

contributes cash to FS. Shareholders of

a U.S. target company (UST) then transfer all of the stock of UST in exchange

for 20 percent of the stock of FS in a

transaction described in sections

368(a)(1)(B) and 367(a). If FS is permitted to satisfy the active trade or business

test by taking into account FP’s business, UST has effectively ‘‘gone offshore’’ in an inversion transaction. Because the shareholders of UST receive

stock of FS (which is the TFC), and not

FP, such shareholders will have no interest in FP’s active business. In contrast,

if the shareholders received stock of FP

in an exchange described in section

367(a), such persons would participate

in FP’s active business, and the active

trade or business test under the final

regulations would be satisfied.

Active Trade or Business Test:

Partnership Interests

The temporary regulations did not

address whether the TFC could satisfy

the active trade or business requirement

by taking into account an interest in a

partnership engaged in an active trade or

business.

The final regulations permit a TFC

(or a qualified subsidiary) to take into

account the active trade or business

engaged in outside the United States by

any qualified partnership as there defined. Active trade or business test:

substantiality test

Under the temporary regulations, the

second prong of the active trade or

business requirement is the substantiality

test. The active trade or business of the

TFC is required to be ‘‘substantial’’

vis-a-vis the active trade or business of

the UST, but the temporary regulations

do not define substantiality.

The final regulations modify the substantiality requirement. Under the final

regulations, the substantiality test no

longer compares the active trade or

business of the TFC vis-a-vis the UST.

Instead, it requires that the entire value

of the TFC be at least equal to the

entire value of the UST at the time of

the transaction. However, for this purpose, the value of the TFC may include

the value of assets (including stock)

acquired within the 36-month period

prior to the transaction only if (i) such

assets were acquired in the ordinary

course of business, or (ii) such assets (or

their proceeds) do not produce and are

not held for the production of passive

income (as defined under section

1296(b)), and were not acquired with

the principal purpose of satisfying the

active trade or business test. A special

rule applies if the asset acquired by the

TFC in the 36-month period prior to the

exchange is stock of a qualified subsidiary or qualified partnership engaged in

an active trade or business. In such case,

the value of the stock or partnership

interest may be taken into account, but

must be reduced in accordance with the

principles described above.

When formulating the substantiality

test under the final regulations, the IRS

and the Treasury Department considered

and rejected other alternatives considered to be more complex and burdensome for taxpayers. For example, a

comparison of the active business of the

TFC vis-a-vis the active business of the

UST for the 36-month period prior to

the acquisition, taking into account the

property, payroll and sales of the two

companies, was considered and rejected.

Indirect and constructive transfers

One commentator suggested that the

IRS clarify the definition of ‘‘U.S.

Transferor’’ contained in the temporary

regulations, which refers to a U.S. person who transfers ‘‘directly, indirectly or

constructively’’ UST stock or other

property. The IRS and the Treasury

Department believe that the reference to

‘‘direct, indirect and constructive’’ transfers may have been unclear and, thus,

the final regulations delete such reference. Such technical modification does

not modify the substantive law in which

indirect and constructive transfers may

be treated as transfers subject to section

367(a)(1) (see § 1.367(a)–1T(c)(2) with

respect to the ‘‘indirect’’ stock transfer

rules; constructive transfers include, but

are not limited to, section 367(a) transfers that result from section 304 transactions and section 367(a) transfers that

result from a change in classification of

an entity from a foreign partnership to a

foreign corporation). GRA term

Under the temporary regulations, a

5-percent transferee shareholder is required to file a GRA. The duration is 5

years if all U.S. transferors own less

than 50 percent of the total voting

power and total value of the TFC stock

immediately after the transfer. The duration of the GRA is 10 years if the U.S.

transferors own 50 percent or more of

the TFC stock immediately after the

transaction, or if the 5-percent transferee

shareholder is unable to prove that all

U.S. transferors own less than 50 percent of the total voting power and total

value of the TFC immediately after the

transfer. Thus, in determining whether a

5- or 10-year GRA is appropriate, the

temporary regulations take into account

cross-ownership (i.e., consideration of

stock owned independently of the transaction) by all U.S. transferors, and contain a presumption that a 10-year GRA

is required.

For example, assume that UST shareholders receive 30 percent of the stock

of the TFC in a nonrecognition transaction that qualifies for an exception under

section 367(a). Assume further that one

UST shareholder, X, a U.S. person,

transfers stock of UST in the section

367(a) exchange and owns 5 percent of

the TFC after the transaction. Under the

temporary regulations, X is required to

file a 10-year GRA unless X can prove

that all U.S. transferors in the aggregate

own less than 50 percent of the voting

power and value of the TFC immediately after the transfer (taking into account the 30 percent received in the

transaction by U.S. target shareholders

plus any other stock that such persons

may own independently of the transaction). If the companies are publicly

traded or widely-held, it is burdensome

and may be impractical for X to rebut

the presumption that U.S. transferors

own 50 percent or more of the TFC

stock.

In response to comments received and

in the interest of simplification, the final

regulations provide that any 5-percent

transferee shareholder that is required to

file a GRA upon the transfer of domestic stock or securities is required to file

a 5-year GRA; 10-year GRAs will no

longer be required in the case of

5-percent transferee shareholders who

transfer domestic stock or securities.

Other Areas in Which Comments Were

Received

After careful consideration by the IRS

and the Treasury Department, the positions set forth in the temporary regulations were generally not modified in

response to certain comments other than

those described above. For example, the

final regulations did not modify: (i) the

amount of stock U.S. transferors could

receive without exceeding the ownership

threshold (i.e., not more than 50 percent), (ii) testing the 50-percent ownership threshold at the time of the exchange, and (iii) the presumption that all

shareholders of the U.S. target company

are U.S. persons.

PLR Option in Limited Instances

The final regulations provide that, in

limited instances, the IRS may consider

issuing private letter rulings to taxpayers

that (i) satisfy all of the requirements

contained in these regulations, with the

exception of the active trade or business

test, or (ii) make a good faith effort, but

are unable to establish non-adverse applicability of the ownership attribution

rules. The IRS and the Treasury Department are aware that the active trade or

business test is mechanical in nature

and, thus, in limited instances, a taxpayer may demonstrate an ongoing and

substantial active trade or business even

though it fails to meet the test set forth

in the final regulations. However, in no

event will the IRS rule on the issue of

whether a TFC acquired an active business with the principal purpose of satisfying the 36-month test and/or the substantiality test.

Other Matters

The IRS and the Treasury Department

expect to issue additional final regulations under section 367(a) to address the

transfer of stock or securities of foreign

corporations and other matters contained

in the 1991 proposed regulations not

addressed herein. Until the 1991 proposed regulations are finalized, the positions originally announced in Notice

87–85 will continue to govern the availability of section 367(a) exceptions for

transfers of stock or securities of foreign

corporations. See § 1.367(a)–3(d).

Special Analyses

It has been determined that this regulation is not a significant regulatory

action as defined in EO 12866. Therefore, a regulatory assessment is not

required. It is hereby certified that this

regulation does not have a significant

economic impact on a substantial number of small entities. This certification is

based on the fact that the number of

U.S. target companies that are acquired

by foreign corporations in nonrecognition transactions subject to section

367(a), and thus are subject to collection

of information, is estimated to be only

100 per year. Moreover, because these

regulations will primarily affect large

shareholders and U.S. multinational corporations with foreign operations, it is

estimated that very few of the 100

transactions will involve small entities.

Thus, a Regulatory Flexibility Analysis

under the Regulatory Flexibility Act (5

U.S.C. chapter 6) is not required. Pursu-

ant to section 7805(f) of the Code, the

notice of proposed rulemaking preceding

these regulations was submitted to the

Small Business Administration for comment on its impact on small business.

Drafting Information

The principal author of these regulations is Philip L. Tretiak of the Office of

Associate Chief Counsel (International),

within the Office of Chief Counsel, IRS.

However, other personnel from the IRS

and Treasury Department participated in

their development.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 602

are amended as follows:

Part 1—INCOME TAXES

Paragraph 1. The authority citation for

part 1 continues to read in part as

follows:

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

Par. 2. Section 1.367(a)–3 is added to

read as follows:

§ 1.367(a)–3 Treatment of transfers of

stock or securities to foreign corporations.

(a) In general. This section provides

rules concerning the transfer of stock or

securities by a U.S. person to a foreign

corporation in an exchange described in

section 367(a). In general, a transfer of

stock or securities by a U.S. person to a

foreign corporation that is described in

section 351, 354 (pursuant to a reorganization described in section 368(a)(1)(B))

or section 361(a) or (b) is subject to

section 367(a)(1) and, therefore, is

treated as a taxable exchange, unless

one of the exceptions set forth in paragraph (c) or (d) of this section or

§ 1.367(a)–3T(b) applies. For additional

rules relating to an exchange involving a

foreign corporation in connection with

which there is a transfer of stock, see

section 367(b) and the regulations under

that section. For additional rules regarding a transfer of stock or securities in an

exchange described in section 361(a) or

(b), see section 367(a)(5) and any regulations under that section.

(b) [Reserved] For further guidance,

see § 1.367(a)– 3T(b).

or securities of domestic corporations to

foreign corporations—(1) In general.

Except as provided in section 367(a)(5),

a transfer of stock or securities of a

domestic corporation by a U.S. person

to a foreign corporation that would

otherwise be subject to section 367(a)(1)

under paragraph (a) of this section shall

not be subject to section 367(a)(1) if the

domestic corporation the stock or securities of which are transferred (referred to

as the U.S. target company) complies

with the reporting requirements in paragraph (c)(6) of this section and if each

of the following four conditions is met:

(i) Fifty percent or less of both the

total voting power and the total value of

the stock of the transferee foreign corporation is received in the transaction, in

the aggregate, by U.S. transferors (i.e.,

the amount of stock received does not

exceed the 50-percent ownership threshold).

(ii) Fifty percent or less of each of

the total voting power and the total

value of the stock of the transferee

foreign corporation is owned, in the

aggregate, immediately after the transfer

by U.S. persons that are either officers

or directors of the U.S. target company

or that are five-percent target shareholders (as defined in paragraph (c)(5)(iii) of

this section) (i.e., there is no control

group). For purposes of this paragraph

(c)(1)(ii), any stock of the transferee

foreign corporation owned by U.S. persons immediately after the transfer will

be taken into account, whether or not it

was received in the exchange for stock

or securities of the U.S. target company.

(iii) Either—

(A) The U.S. person is not a fivepercent transferee shareholder (as defined in paragraph (c)(5)(ii) of this section); or

(B) The U.S. person is a five-percent

transferee shareholder and enters into a

five-year agreement to recognize gain

with respect to the U.S. target company

stock or securities it exchanged in the

form provided in § 1.367(a)–3T(g); and

(iv) The active trade or business test

(as defined in paragraph (c)(3) of this

section) is satisfied.

(2) Ownership presumption. For purposes of paragraph (c)(1) of this section,

persons who transfer stock or securities

of the U.S. target company in exchange

for stock of the transferee foreign corporation are presumed to be U.S. persons.

This presumption may be rebutted in

accordance with paragraph (c)(7) of this

section.

(3) Active trade or business test—(i)

In general. The tests of this paragraph

(c)(3), collectively referred to as the

active trade or business test, are satisfied

if:

(A) The transferee foreign corporation or any qualified subsidiary (as

defined in paragraph (c)(5)(vii) of this

section) or any qualified partnership (as

defined in paragraph (c)(5)(viii) of this

section) is engaged in an active trade or

business outside the United States,

within the meaning of § 1.367(a)–

2T(b)(2) and (3), for the entire 36month period immediately before the

transfer;

(B) At the time of the transfer, neither the transferors nor the transferee

foreign corporation (and, if applicable,

the qualified subsidiary or qualified

partnership engaged in the active trade

or business) have an intention to substantially dispose of or discontinue such

trade or business; and

in paragraph (c)(3)(iii) of this section) is

satisfied.

(ii) Special rules. For purposes of

paragraphs (c)(3)(i)(A) and (B) of this

section, the following special rules apply:

(A) The transferee foreign corporation, a qualified subsidiary, or a qualified partnership will be considered to be

engaged in an active trade or business

for the entire 36-month period preceding

the exchange if it acquires at the time

of, or any time prior to, the exchange a

trade or business that has been active

throughout the entire 36-month period

preceding the exchange. This special

rule shall not apply, however, if the

acquired active trade or business assets

were owned by the U.S. target company

or any affiliate (within the meaning of

section 1504(a) but excluding the exceptions contained in section 1504(b) and

substituting ‘‘50 percent’’ for ‘‘80 percent’’ where it appears therein) at any

time during the 36-month period prior to

the acquisition. Nor will this special rule

apply if the principal purpose of such

acquisition is to satisfy the active trade

or business test.

(B) An active trade or business does

not include the making or managing of

investments for the account of the transferee foreign corporation or any affiliate

(within the meaning of section 1504(a)

but excluding the exceptions contained

in section 1504(b) and substituting ‘‘50

percent’’ for ‘‘80 percent’’ where it

appears therein). (This paragraph

(c)(3)(ii)(B) shall not create any inference as to the scope of § 1.367(a)–

2T(b)(2) and (3) for other purposes.)

(iii) Substantiality test—(A) General

rule. A transferee foreign corporation

will be deemed to satisfy the substanti-

ality test if, at the time of the transfer,

the fair market value of the transferee

foreign corporation is at least equal to

the fair market value of the U.S. target

company.

(B) Special rules. (1) For purposes of

paragraph (c)(3)(iii)(A) of this section,

the value of the transferee foreign corporation shall include assets acquired

outside the ordinary course of business

by the transferee foreign corporation

within the 36-month period preceding

the exchange only if either—

(i) Both—

(A) At the time of the exchange, such

assets or, as applicable, the proceeds

thereof, do not produce, and are not

held for the production of, passive income as defined in section 1296(b); and

(B) Such assets are not acquired for

the principal purpose of satisfying the

substantiality test; or

(ii) Such assets consist of the stock

of a qualified subsidiary or an interest in

a qualified partnership. See paragraph

(c)(3)(iii)(B)(2) of this section.

(2) For purposes of paragraph

(c)(3)(iii)(A) of this section, the value of

the transferee foreign corporation shall

not include the value of the stock of any

qualified subsidiary or the value of any

interest in a qualified partnership, held

directly or indirectly, to the extent that

such value is attributable to assets acquired by such qualified subsidiary or

partnership outside the ordinary course

of business and within the 36-month

period preceding the exchange unless

those assets satisfy the requirements in

paragraph (c)(3)(iii)(B)(1) of this section.

(3) For purposes of paragraph

(c)(3)(iii)(A) of this section, the value of

the transferee foreign corporation shall

not include the value of assets received

within the 36-month period prior to the

acquisition, notwithstanding the special

rule in paragraph (c)(3)(iii)(B)(1) of this

section, if such assets were owned by

the U.S. target company or an affiliate

(within the meaning of section 1504(a)

but without the exceptions under section

1504(b) and substituting ‘‘50 percent’’

for ‘‘80 percent’’ where it appears

therein) at any time during the 36-month

period prior to the transaction.

(4) Special rules—(i) Treatment of

partnerships. For purposes of this paragraph (c), if a partnership (whether

domestic or foreign) owns stock or

securities in the U.S. target company or

the transferee foreign corporation, or

transfers stock or securities in an ex-

change described in section 367(a), each

partner in the partnership, and not the

partnership itself, is treated as owning

and as having transferred, or as owning,

a proportionate share of the stock or

securities. See § 1.367(a)–1T(c)(3).

(ii) Treatment of options. For purposes of this paragraph (c), one or more

options (or an interest similar to an

option) will be treated as exercised and

thus will be counted as stock for purposes of determining whether the 50percent threshold is exceeded or whether

a control group exists if a principal

purpose of the issuance or the acquisition of the option (or other interest) was

the avoidance of the general rule contained in section 367(a)(1).

(iii) U.S. target has a vestigial ownership interest in transferee foreign corporation. In cases where, immediately

after the transfer, the U.S. target company owns, directly or indirectly (applying the attribution rules of sections

267(c)(1) and (5)), stock of the transferee foreign corporation, that stock will

not in any way be taken into account

(and, thus, will not be treated as outstanding) in determining whether the

50-percent threshold under paragraph

(c)(1)(i) of this section is exceeded or

whether a control group under paragraph

(c)(1)(ii) of this section exists.

(iv) Attribution rule. Except as otherwise provided in this section, the rules

of section 318, as modified by the rules

of section 958(b), shall apply for purposes of determining the ownership or

receipt of stock, securities or other property under this paragraph (c).

(5) Definitions—(i) Ownership statement. An ownership statement is a statement, signed under penalties of perjury,

stating—

(A) The identity and taxpayer identification number, if any, of the person

making the statement;

(B) That the person making the statement is not a U.S. person (as defined in

paragraph (c)(5)(iv) of this section);

(1) Owns less than 1 percent of the

total voting power and total value of a

U.S. target company the stock of which

is described in Rule 13d–1(d) of Regulation 13D (17 CFR 240.13d–1(d)) (or

any rule or regulation to generally the

same effect) promulgated by the Securities and Exchange Commission under

the Securities and Exchange Act of 1934

(15 USC 78m), and such person did not

acquire the stock with a principal purpose to enable the U.S. transferors to

satisfy the requirement contained in

paragraph (c)(1)(i) of this section; or

(2) Is not related to any U.S. person

to whom the stock or securities owned

by the person making the statement are

attributable under the rules of section

958(b), and did not acquire the stock

with a principal purpose to enable the

U.S. transferors to satisfy the requirement contained in paragraph (c)(1)(i) of

this section;

(D) The citizenship, permanent residence, home address, and U.S. address,

if any, of the person making the statement; and

(E) The ownership such person has

(by voting power and by value) in the

U.S. target company prior to the exchange and the amount of stock of the

transferee foreign corporation (by voting

power and value) received by such

person in the exchange.

(ii) Five-percent transferee shareholder. A five-percent transferee shareholder is a person that owns at least five

percent of either the total voting power

or the total value of the stock of the

transferee foreign corporation immediately after the transfer described in

section 367(a)(1). For special rules involving cases in which stock is held by

a partnership, see paragraph (c)(4)(i) of

this section.

(iii) Five-percent target shareholder

and certain other 5-percent shareholders. A five-percent target shareholder is

a person that owns at least five percent

of either the total voting power or the

total value of the stock of the U.S.

target company immediately prior to the

transfer described in section 367(a)(1).

If the stock of the U.S. target company

(or any company through which stock of

the U.S. target company is owned indirectly or constructively) is described in

Rule 13d–1(d) of Regulation 13D (17

CFR 240.13d–1(d)) (or any rule or regulation to generally the same effect),

promulgated by the Securities and Exchange Commission under the Securities

Exchange Act of 1934 (15 USC 78m),

then, in the absence of actual knowledge

to the contrary, the existence or absence

of filings of Schedule 13–D or 13–G (or

any similar schedules) may be relied

upon for purposes of identifying fivepercent target shareholders (or a fivepercent shareholder of a corporation

which itself is a five-percent shareholder

of the U.S. target company). For special

rules involving cases in which U.S.

target company stock is held by a

partnership, see paragraph (c)(4)(i) of

this section.

(iv) U.S. Person. For purposes of this

section, a U.S. person is defined by

reference to § 1.367(a)–1T(d)(1). For

application of the rules of this section to

stock or securities owned or transferred

by a partnership that is a U.S. person,

however, see paragraph (c)(4)(i) of this

section.

(v) U.S. Transferor. A U.S. transferor

is a U.S. person (as defined in paragraph (c)(5)(iv) of this section) that

transfers stock or securities of one or

more U.S. target companies in exchange

for stock of the transferee foreign corporation in an exchange described in section 367.

(vi) Transferee foreign corporation. A

transferee foreign corporation is the foreign corporation whose stock is received

in the exchange by U.S. persons.

(vii) Qualified Subsidiary. A qualified

subsidiary is a foreign corporation

whose stock is at least 80-percent

owned (by total voting power and total

value), directly or indirectly, by the

transferee foreign corporation. However,

a corporation will not be treated as a

qualified subsidiary if it was affiliated

with the U.S. target company (within

the meaning of section 1504(a) but

without the exceptions under section

1504(b) and substituting ‘‘50 percent’’

for ‘‘80 percent’’ where it appears

therein) at any time during the 36-month

period prior to the transfer. Nor will a

corporation be treated as a qualified

subsidiary if it was acquired by the

transferee foreign corporation at any

time during the 36-month period prior to

the transfer for the principal purpose of

satisfying the active trade or business

test, including the substantiality test.

(viii) Qualified partnership. (A) Except as provided in paragraph (c)(5)(viii)(B) or (C) of this section, a qualified partnership is a partnership in

which the transferee foreign corporation—

(1) Has active and substantial management functions as a partner with

regard to the partnership business; or

(2) Has an interest representing a 25

percent or greater interest in the partnership’s capital and profits.

(B) A partnership is not a qualified

partnership if the U.S. target company

or any affiliate of the U.S. target company (within the meaning of section

1504(a) but without the exceptions under section 1504(b) and substituting ‘‘50

percent’’ for ‘‘80 percent’’ where it

appears therein) held a 5 percent or

greater interest in the partnership’s capi-

tal and profits at any time during the

36-month period prior to the transfer.

partnership if the transferee foreign corporation’s interest was acquired by that

corporation at any time during the 36month period prior to the transfer for

the principal purpose of satisfying the

active trade or business test, including

the substantiality test.

(6) Reporting requirements of U.S.

target company. (i) In order for a U.S.

person that transfers stock or securities

of a domestic corporation to qualify for

the exception provided by this paragraph

367(a)(1), in cases where 10 percent or

more of the total voting power or the

total value of the stock of the U.S.

target company is transferred by U.S.

persons in the transaction, the U.S.

target company must comply with the

reporting requirements contained in this

paragraph (c)(6). The U.S. target company must attach to its timely filed U.S.

income tax return for the taxable year in

which the transfer occurs a statement

titled ‘‘Section 367(a)—Reporting of

Cross-Border Transfer Under Reg.

§ 1.367(a)–3(c)(6),’’ signed under penalties of perjury by an officer of the

corporation to the best of the officer’s

knowledge and belief, disclosing the

following information—

(A) A description of the transaction

in which a U.S. person or persons

transferred stock or securities in the

U.S. target company to the transferee

foreign corporation in a transfer otherwise subject to section 367(a)(1);

(B) The amount (specified as to the

percentage of the total voting power and

the total value) of stock of the transferee

foreign corporation received in the

transaction, in the aggregate, by persons

who transferred stock or securities of

the U.S. target company. For additional

information that may be required to

rebut the ownership presumption of

paragraph (c)(2) of this section in cases

where more than 50 percent of either

the total voting power or the total value

of the stock of the transferee foreign

corporation is received in the transaction, in the aggregate, by persons who

transferred stock or securities of the

U.S. target company, see paragraph

(c)(7) of this section;

foreign corporation stock owned directly

or indirectly (applying the attribution

rules of sections 267(c)(1) and (5))

immediately after the exchange by the

U.S. target company;

(D) A statement that there is no control group within the meaning of paragraph (c)(1)(ii) of this section;

(E) A list of U.S. persons who are

officers, directors or five-percent target

shareholders and the percentage of the

total voting power and the total value of

the stock of the transferee foreign corporation owned by such persons both

immediately before and immediately after the transaction; and

(F) A statement that includes the following—

(1) A statement that the active trade

or business test described in paragraph

(c)(3) of this section is satisfied by the

transferee foreign corporation and a description of such business;

(2) A statement that on the day of the

transaction, there was no intent on the

part of the transferors or the transferee

foreign corporation (or any qualified

subsidiary or any qualified partnership,

if relevant) to substantially dispose of or

discontinue its active trade or business;

and

(3) A statement that the substantiality

test described in paragraph (c)(3)(iii) of

this section is satisfied, and documentation that such test is satisfied, including

the value of the transferee foreign corporation and the value of the U.S. target

company on the day of the transfer, and

either one of the following—

(i) A statement demonstrating that the

value of the transferee foreign corporation 36 months prior to the acquisition,

plus the value of any assets described in

paragraph (c)(3)(iii)(B) of this section

(including stock) acquired by the transferee foreign corporation within the 36month period, less the amount of any

liabilities acquired during that period,

exceeds the value of the U.S. target

company on the acquisition date; or

(ii) A statement demonstrating that

the value of the transferee foreign corporation on the date of the acquisition,

reduced by the value of any assets not

described in paragraph (c)(3)(iii)(B) of

this section (including stock) acquired

by the transferee foreign corporation

within the 36-month period, exceeds the

value of the U.S. target company on the

date of the acquisition.

(ii) For purposes of this paragraph

(c)(6), an income tax return will be

considered timely filed if such return is

filed, together with the statement required by this paragraph (c)(6), on or

before the last date for filing a Federal

income tax return (taking into account

any extensions of time therefor) for the

taxable year in which the transfer oc-

curs. If a return is not timely filed

within the meaning of this paragraph

(c)(6), the District Director may make a

determination, based on all facts and

circumstances, that the taxpayer had

reasonable cause for its failure to file a

timely filed return and, if such a determination is made, the requirement contained in this paragraph (c)(6) shall be

waived.

(7) Ownership statements. To rebut

the ownership presumption of paragraph

(c)(2) of this section, the U.S. target

company must obtain ownership statements (described in paragraph (c)(5)(i)

of this section) from a sufficient number

of persons that transfer U.S. target company stock or securities in the transaction that are not U.S. persons to demonstrate that the 50-percent threshold of

paragraph (c)(1)(i) of this section is not

exceeded. In addition, the U.S. target

company must attach to its timely filed

U.S. income tax return (as described in

paragraph (c)(6)(ii) of this section) for

the taxable year in which the transfer

occurs a statement, titled ‘‘Section

367(a)–Compilation of Ownership Statements under Reg. § 1.367(a)–3(c),’’

signed under penalties of perjury by an

officer of the corporation, disclosing the

following information:

(i) The amount (specified as to the

percentage of the total voting power and

the total value) of stock of the transferee

foreign corporation received, in the aggregate, by U.S. transferors;

(ii) The amount (specified as to the

percentage of total voting power and

total value) of stock of the transferee

foreign corporation received, in the aggregate, by foreign persons that filed

ownership statements;

(iii) A summary of the information

tabulated from the ownership statements,

including—

(A) The names of the persons that

filed ownership statements stating that

they are not U.S. persons;

(B) The countries of residence and

citizenship of such persons; and

(by voting power and by value) in the

U.S. target company prior to the exchange and the amount of stock of the

transferee foreign corporation (by voting

power and value) received by such

persons in the exchange.

(8) Certain transfers in connection

with performance of services. Section

367(a)(1) shall not apply to a domestic

corporation’s transfer of its own stock or

securities in connection with the performance of services, if the transfer is

considered to be to a foreign corporation

solely by reason of § 1.83–6(d)(1).

(9) Private letter ruling option. The

Internal Revenue Service may, in limited

circumstances, issue a private letter ruling to permit the taxpayer to qualify for

an exception to the general rule under

section 367(a)(1) if—

(i) A taxpayer is unable to satisfy all

of the requirements of paragraph (c)(3)

of this section relating to the active

trade or business test of paragraph

(c)(1)(iv) of this section, but such taxpayer meets all of the other requirements contained in paragraphs (c)(1)(i)

through (c)(1)(iii) of this section, and

such taxpayer is substantially in compliance with the rules set forth in paragraph (c)(3) of this section; or

(ii) A taxpayer is unable to satisfy

any requirement of paragraph (c)(1) of

this section due to the application of

paragraph (c)(4)(iv) of this section. Notwithstanding the preceding sentence, in

no event will the Internal Revenue Service rule on the issue of whether the

principal purpose of an acquisition was

to satisfy the active trade or business

test, including the substantiality test.

(10) Examples. This paragraph (c)

may be illustrated by the following

examples:

Example 1. Ownership presumption. (i) FC, a

foreign corporation, issues 51 percent of its stock

to the shareholders of S, a domestic corporation,

in exchange for their S stock, in a transaction

described in section 367(a)(1).

(ii) Under paragraph (c)(2) of this section, all

shareholders of S who receive stock of FC in the

exchange are presumed to be U.S. persons. Unless

this ownership presumption is rebutted, the condition set forth in paragraph (c)(1)(i) of this section

will not be satisfied, and the exception in paragraph (c)(1) of this section will not be available.

As a result, all U.S. persons that transferred S

stock will recognize gain on the exchange. To

rebut the ownership presumption, S must comply

with the reporting requirements contained in paragraph (c)(7) of this section, obtaining ownership

statements (described in paragraph (c)(5)(i) of this

section) from a sufficient number of non-U.S.

persons who received FC stock in the exchange to

demonstrate that the amount of FC stock received

by U.S. persons in the exchange does not exceed

50 percent.

Example 2. Filing of Gain Recognition Agreement. (i) The facts are the same as in Example 1,

except that FC issues only 40 percent of its stock

to the shareholders of S in the exchange. FC

satisfies the active trade or business test of

paragraph (c)(1)(iv) of this section. A, a U.S.

person, owns 10 percent of S’s stock immediately

before the transfer. All other shareholders of S

own less than five percent of its stock. None of

S’s officers or directors owns any stock in FC

immediately after the transfer. A will own 15

percent of the stock of FC immediately after the

transfer, 4 percent received in the exchange, and

the balance being stock in FC that A owned prior

to and independent of the transaction. No S

shareholder besides A owns five percent or more

of FC immediately after the transfer. The reporting

requirements under paragraph (c)(6) of this section

are satisfied.

(ii) The condition set forth in paragraph

(c)(1)(i) of this section is satisfied because, even

after application of the presumption in paragraph

(c)(2) of this section, U.S. transferors could not

receive more than 50 percent of FC’s stock in the

transaction. There is no control group because

five-percent target shareholders and officers and

directors of S do not, in the aggregate, own more

than 50 percent of the stock of FC immediately

after the transfer (A, the sole five-percent target

shareholder, owns 15 percent of the stock of FC

immediately after the transfer, and no officers or

directors of S own any stock of FC immediately

after the transfer). Therefore, the condition set

forth in paragraph (c)(1)(ii) of this section is

satisfied. The facts assume that the condition set

forth in paragraph (c)(1)(iv) of this section is

satisfied. Thus, U.S. persons that are not fivepercent transferee shareholders will not recognize

gain on the exchange of S shares for FC shares. A,

a five-percent transferee shareholder, will not be

required to include in income any gain realized on

the exchange in the year of the transfer if he files

a 5-year gain recognition agreement (GRA) and

complies with section 6038B.

Example 3. Control Group. (i) The facts are the

same as in Example 2, except that B, another U.S.

person, is a 5-percent target shareholder, owning

25 percent of S’s stock immediately before the

transfer. B owns 40 percent of the stock of FC

immediately after the transfer, 10 percent received

in the exchange, and the balance being stock in

FC that B owned prior to and independent of the

transaction.

(ii) A control group exists because A and B,

each a five-percent target shareholder within the

meaning of paragraph (c)(5)(iii) of this section,

together own more than 50 percent of FC immediately after the transfer (counting both stock received in the exchange and stock owned prior to

and independent of the exchange). As a result, the

condition set forth in paragraph (c)(1)(ii) of this

section is not satisfied, and all U.S. persons (not

merely A and B) who transferred S stock will

recognize gain on the exchange.

Example 4. Partnerships. (i) The facts are the

same as in Example 3, except that B is a

partnership (domestic or foreign) that has five

equal partners, only two of whom, X and Y, are

U.S. persons. Under paragraph (c)(4)(i) of this

section, X and Y are treated as the owners and

transferors of 5 percent each of the S stock owned

and transferred by B and as owners of 8 percent

each of the FC stock owned by B immediately

after the transfer. U.S. persons that are fivepercent target shareholders thus own a total of 31

percent of the stock of FC immediately after the

transfer (A’s 15 percent, plus X’s 8 percent, plus

Y’s 8 percent).

(ii) Because no control group exists, the condition in paragraph (c)(1)(ii) of this section is

satisfied. The conditions in paragraphs (c)(1)(i)

and (iv) of this section also are satisfied. Thus,

U.S. persons that are not five-percent transferee

shareholders will not recognize gain on the exchange of S shares for FC shares. A, X, and Y,

each a five-percent transferee shareholder, will not

be required to include in income in the year of the

transfer any gain realized on the exchange if they

file 5-year GRAs and comply with section 6038B.

(11) Effective date. This paragraph (c)

applies to transfers occurring after January 29, 1997. However, taxpayers may

elect to apply this section in its entirety

to all transfers occurring after April 17,

1994, provided that the statute of limitations of the affected tax year or years is

open.

(d) Transfers of stock or securities of

foreign corporations. For guidance, see

Notice 87–85 (1987–2 C.B. 395). See

§ 601.601(d)(2) of this chapter.

(e) through (h) [Reserved] For further

guidance, see § 1.367(a)–3T(e) through

(h).

Par. 3. In § 1.367(a)–3T, paragraphs

(a), (c) and (d) are revised to read as

follows:

§ 1.367(a)–3T Treatment of transfers of

stock or securities to foreign corporations (temporary).

(a) [Reserved] For further information, see § 1.367(a)–3(a).

information, see § 1.367(a)–3(c) and

(d).

PART 602—OMB CONTROL NUMBERS UNDER THE PAPERWORK

REDUCTION ACT

Par. 4. The authority for citation for

part 602 continues to read as follows:

Authority: 26 U.S.C. 7805

Par. 5. Section 602.101, paragraph (c)

is amended by revising the entry for

1.367(a)–3T and adding an entry to the

table in numerical order to read as

follows:

§ 602.101 OMB Control numbers.

CFR part or section

where identified and

described

Current OMB

control No.

1.367(a)–3 . . . . . . . . . . . . 1545–0026

1545–1478

1.367(a)–3T. . . . . . . . . . . 1545–0026

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved December 11, 1996.

Donald C. Lubick,

Assistant Secretary of the Treasury.

(Filed by the Office of the Federal Register on

December 27, 1996, 8:45 a.m., and published in

the issue of the Federal Register for December 30,

1996, 61 F.R. 68633)

Section 952.—Subpart F Income

Defined

26 CFR 1.952–1: Subpart F income defined.

T.D. 8704

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

Definition of Foreign Base

Company Income and Foreign

Personal Holding Company Income

of a Controlled Foreign Corporation

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains

final regulations relating to the definitions of subpart F income and foreign

personal holding company income of a

controlled foreign corporation and the

allocation of deficits for purposes of

computing the deemed-paid foreign tax

credit. These regulations are necessary

to provide guidance that coordinates

with previously published guidance under section 954. These regulations will

affect United States shareholders of controlled foreign corporations.

DATES: These regulations are effective

January 2, 1997.

For specific dates of applicability, see

§§ 1.952–1(f)(5), 1.952–2(c)(1), 1.954–

2(b)(3) and 1.960–1(i)(6).

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

(not a toll-free call).

SUPPLEMENTARY INFORMATION:

Background

On September 7, 1995, proposed

regulations (IL–75–92 [1995–2 C.B.

480]) amending the Income Tax Regulations (26 CFR Part 1) under sections

952, 954(c) and 960 of the Internal

Revenue Code (Code) were published in

the Federal Register (60 FR 46548). In

final regulations under section 954 (T.D.

8618 [1995–2 C.B. 89]), also published

on that date (60 FR 46500), a provision

relating to the treatment of tax-exempt

interest under the foreign personal holding company income rules was reserved.

The proposed regulations provided rules

for the treatment of tax-exempt interest

and also provided guidance under sections 952 and 960 to coordinate with the

final regulations. No public hearing was

requested or held. One written comment

was received on the proposed regulations. After consideration of this comment, the proposed regulations are

adopted as final regulations without

amendment.

§ 1.954–2(g)(2)

Explanation of Provisions

§ 1.957–1(c)

§ 1.952–1(e) and (f) and 1.960–1(i)

Technical corrections are made to

§ 1.957–1(c) Examples 8 and 9.

Sections 1.952–1(e) and (f) and

1.960–1(i) are unchanged from the proposed regulations.

§§ 1.952–2(c)(1) and 1.954–2(b)(3)

Under § 1.954–2T(b)(6), interest income that was exempt from tax under

section 103 was included in the foreign

personal holding company income of the

controlled foreign corporation. However,

the net foreign base company income

that was attributable to tax-exempt interest was treated as tax-exempt interest in

the hands of the United States shareholder upon a deemed distribution under

subpart F and therefore excluded for

regular tax purposes but potentially subject to the alternative minimum tax.

Section 1.954–2(b)(3), as proposed and

finalized, amends the rule in the temporary regulations to provide that foreign

personal holding company income includes interest income that is exempt

from tax under section 103. The taxexempt interest would not retain its

character as such in the hands of the

United States shareholder upon a

deemed distribution under subpart F. As

a result of the treatment of tax-exempt

interest in these final regulations, Rev.

Rul. 72–527 (1972–2 C.B. 456) is obsoleted.

A commentator argued that treatment

of tax-exempt interest in the proposed

regulations was contrary to section 103.

This comment was rejected. The Code

does not specifically address how section 103 applies in the context of subpart F. Although § 1.952–2 provides

that, in general, U.S. tax principles

apply in computing subpart F income,

this regulation makes certain Code provisions inapplicable when necessary to

serve the purposes of subpart F. See

§ 1.952–2(c)(1).

§ 1.954–1(d)(4)(iii)

The example in § 1.954–1(d)(4)(iii) is

amended to correct a mathematical error.

The regulations are amended to

clarify that income derived in the trade

or business of trading foreign currency

is not excluded from foreign personal

holding company income under the

business needs exception. A technical

correction is made to § 1.954–2(g)(2)(ii)(B)(2).

Special Analyses

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

Therefore, a regulatory assessment is not

required. It 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, and because these regulations do not impose a

collection of information on small entities, the Regulatory Flexibility Act (5

U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Internal

Revenue Code, the notice of proposed

rulemaking preceding these regulations

was submitted to the Chief Counsel for

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

small business.

Drafting Information

The principal authors of these regulations are Barbara Felker and Valerie

Mark of the Office of the Associate

Chief Counsel (International), IRS.

However, other personnel from the IRS

and Treasury Department participated in

their development.

Adoption of Amendments to the

Regulations

Accordingly, 26 CFR part 1 is

amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for

part 1 is amended by adding an entry in

numerical order to read as follows:

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

Section 1.960–1 also issued under 26

U.S.C. 960(a). * * *

Par. 2. Section 1.952–1 is amended by

adding paragraphs (e) and (f) to read as

follows:

§ 1.952–1 Subpart F income defined.

(e) Application of current earnings

and profits limitation—(1) In general. If

the subpart F income (as defined in

section 952(a)) of a controlled foreign

corporation exceeds the foreign corporation’s earnings and profits for the taxable year, the subpart F income includible in the income of the corporation’s

United States shareholders is reduced

under section 952(c)(1)(A) in accordance with the following rules. The

excess of subpart F income over current

year earnings and profits shall—

(i) First, proportionately reduce subpart F income in each separate category

of the controlled foreign corporation, as

defined in § 1.904–5(a)(1), in which

current earnings and profits are zero or

less than zero;

(ii) Second, proportionately reduce

subpart F income in each separate category in which subpart F income exceeds current earnings and profits; and

(iii) Third, proportionately reduce

subpart F income in other separate categories.

(2) Allocation to a category of subpart F income. An excess amount that is

allocated under paragraph (e)(1) of this

section to a separate category must be

further allocated to a category of subpart

F income if the separate category contains more than one category of subpart

F income described in section 952(a) or,

in the case of foreign base company

income, described in § 1.954–1(c)(1)(iii)(A)(1) or (2). In such case, the

excess amount that is allocated to the

separate category must be allocated to

the various categories of subpart F income within that separate category on a

proportionate basis.

(3) Recapture of subpart F income

reduced by operation of earnings and

profits limitation. Any amount in a category of subpart F income described in

section 952(a) or, in the case of foreign

base company income, described in

§ 1.954–1(c)(1)(iii)(A)(1) or (2) that is

reduced by operation of the current year

earnings and profits limitation of section

952(c)(1)(A) and this paragraph (e) shall

be subject to recapture in a subsequent

year under the rules of section 952(c)(2)

and paragraph (f) of this section.

(4) Coordination with sections 953

and 954. The rules of this paragraph (e)

shall be applied after the application of

sections 953 and 954 and the regulations

under those sections, except as provided

in § 1.954–1(d)(4)(ii).

(5) Earnings and deficits retain separate limitation character. The income

reduction rules of paragraph (e)(1) of

this section shall apply only for purposes of determining the amount of an

inclusion under section 951(a)(1)(A)

from each separate category as defined

in § 1.904–5(a)(1) and the separate categories in which recapture accounts are

established under section 952(c)(2) and

paragraph (f) of this section. For rules

applicable in computing post-1986 undistributed earnings, see generally section 902 and the regulations under that

section. For rules relating to the allocation of deficits for purposes of

computing foreign taxes deemed paid

under section 960 with respect to an

inclusion under section 951(a)(1)(A), see

§ 1.960–1(i).

(f) Recapture of subpart F income in

subsequent taxable year—(1) In general. If a controlled foreign corporation’s subpart F income for a taxable

year is reduced under the current year

earnings and profits limitation of section

952(c)(1)(A) and paragraph (e) of this

section, recapture accounts will be established and subject to recharacterization in any subsequent taxable year to

the extent the recapture accounts were

not previously recharacterized or distributed, as provided in paragraphs (f)(2)

and (3) of this section.

(2) Rules of recapture—(i) Recapture

account. If a category of subpart F

income described in section 952(a) or,

in the case of foreign base company

income, described in § 1.954–1(c)(1)(iii)(A)(1) or (2) is reduced under the

current year earnings and profits limitation of section 952(c)(1)(A) and paragraph (e) of this section for a taxable

year, the amount of such reduction shall

constitute a recapture account.

(ii) Recapture. Each recapture account of the controlled foreign corporation will be recharacterized, on a proportionate basis, as subpart F income in

the same separate category (as defined

in § 1.904–5(a)(1)) as the recapture account to the extent that current year

earnings and profits exceed subpart F

income in a taxable year. The United

States shareholder must include his pro

rata share (determined under the rules of

§ 1.951–1(e)) of each recharacterized

amount in income as subpart F income

in such separate category for the taxable

year.

(iii) Reduction of recapture account

and corresponding earnings. Each recapture account, and post-1986 undistributed earnings in the separate cat-

egory containing the recapture account,

will be reduced in any taxable year by

the amount which is recharacterized under paragraph (f)(2)(ii) of this section.

In addition, each recapture account, and

post-1986 undistributed earnings in the

separate category containing the recapture account, will be reduced in the

amount of any distribution out of that

account (as determined under the ordering rules of section 959(c) and paragraph (f)(3)(ii) of this section).

(3) Distribution ordering rules—

(i) Coordination of recapture and distribution rules. If a controlled foreign

corporation distributes an amount out of

earnings and profits described in section

959(c)(3) in a year in which current

year earnings and profits exceed subpart

F income and there is an amount in a

recapture account for such year, the

recapture rules will apply first.

(ii) Distributions reduce recapture accounts first. Any distribution made by a

controlled foreign corporation out of

earnings and profits described in section

959(c)(3) shall be treated as made first

on a proportionate basis out of the

recapture accounts in each separate category to the extent thereof (even if the

amount in the recapture account exceeds

post-1986 undistributed earnings in the

separate category containing the recapture account). Any remaining distribution shall be treated as made on a

proportionate basis out of the remaining

earnings and profits of the controlled

foreign corporation in each separate category. See section 904(d)(3)(D).

(4) Examples. The application of

paragraphs (e) and (f) of this section

may be illustrated by the following

examples:

Example 1. (i) A, a U.S. person, is the sole

shareholder of CFC, a controlled foreign corporation formed on January 1, 1998, whose functional

currency is the u. In 1998, CFC earns 100u of

foreign base company sales income that is general

limitation income described in section 904(d)(1)(I)

and incurs a (200u) loss attributable to activities

that would have produced general limitation income that is not subpart F income. In 1998 CFC

also earns 100u of foreign personal holding company income that is passive income described in

section 904(d)(1)(A), and 100u of foreign personal

holding company income that is dividend income

subject to a separate limitation described in section

904(d)(1)(E) for dividends from a noncontrolled

section 902 corporation. CFC’s subpart F income

for 1998, 300u, exceeds CFC’s current earnings

and profits, 100u, by 200u. Under section

952(c)(1)(A) and paragraph (e) of this section,

subpart F income is limited to CFC’s current

earnings and profits of 100u, all of which is

included in A’s gross income under section

951(a)(1)(A). The 200u of CFC’s 1998 subpart F

income that is not included in A’s income in 1998

by reason of section 952(c)(1)(A) is subject to

recapture under section 952(c)(2) and paragraph

(f) of this section.

(ii) For purposes of determining the amount and

type of income included in A’s gross income and

the amount and type of income in CFC’s recapture

account, the rules of paragraphs (e)(1) and (2) of

this section apply. Under paragraph (e)(1)(i) of

this section, the amount by which CFC’s subpart F

income exceeds its earnings and profits for 1998,

200u, first reduces from 100u to 0 CFC’s subpart

F income in the general limitation category, which

has a current year deficit of (100u) in earnings and

profits. Next, under paragraph (e)(1)(iii) of this

section, the remaining 100u by which CFC’s 1998

subpart F income exceeds earnings and profits is

applied proportionately to reduce CFC’s subpart F

income in the separate categories for passive

income (100u) and dividends from the

noncontrolled section 902 corporation (100u).

Thus, A includes 50u of passive limitation/foreign

personal holding company income and 50u of

dividends from the noncontrolled section 902

corporation/foreign personal holding company income in gross income in 1998. CFC has 100u in

its general limitation/foreign base company sales

income recapture account attributable to the 100u

of foreign base company sales income that is not

included in A’s income by reason of the earnings

and profits limitation of section 952(c)(1)(A). CFC

also has 50u in its passive limitation recapture

account, all of which is attributable to foreign

personal holding company income, and 50u in its

recapture account for dividends from the

noncontrolled section 902 corporation, all of

which is attributable to foreign personal holding

company income.

(iii) For purposes of computing post-1986 undistributed earnings, the rules of sections 902 and

960, including the rules of § 1.960–1(i), apply.

Under § 1.960–1(i), the general limitation deficit

of (100u) is allocated proportionately to reduce

passive limitation earnings of 100u and

noncontrolled section 902 dividend earnings of

100u. Thus, passive limitation earnings are reduced by 50u to 50u (100u passive limitation

earnings/200u total earnings in positive separate

categories x (100u) general limitation deficit = 50u

reduction), and the noncontrolled section 902

corporation earnings are reduced by 50u to 50u

(100u noncontrolled section 902 corporation

earnings/200u total earnings in positive separate

categories x (100u) general limitation deficit = 50u

reduction). All of CFC’s post-1986 foreign income

taxes with respect to passive limitation income and

dividends from the noncontrolled section 902

corporation are deemed paid by A under section

960 with respect to the subpart F inclusions (50u

inclusion/50u earnings in each separate category).

After the inclusion and deemed-paid taxes are

computed, at the close of 1998 CFC has a (100u)

deficit in general limitation earnings (100u subpart

F earnings + (200u) nonsubpart F loss), 50u of

passive limitation earnings (100u of earnings attributable to foreign personal holding company

income - 50u inclusion) with a corresponding

passive limitation/foreign personal holding company income recapture account of 50u, and 50u of

earnings subject to a separate limitation for dividends from the noncontrolled section 902 corporation (100u earnings - 50u inclusion) with a

corresponding noncontrolled section 902

corporation/foreign personal holding company income recapture account of 50u.

Example 2. (i) The facts are the same as in

Example 1 with the addition of the following

facts. In 1999, CFC earns 100u of foreign base

company sales income that is general limitation

income and 100u of foreign personal holding

company income that is passive limitation income.

In addition, CFC incurs (10u) of expenses that are

allocable to its separate limitation for dividends

from the noncontrolled section 902 corporation.

Thus, CFC’s subpart F income for 1999, 200u,

exceeds CFC’s current earnings and profits, 190u,

by 10u. Under section 952(c)(1)(A) and paragraph

(e) of this section, subpart F income is limited to

CFC’s current earnings and profits of 190u, all of

which is included in A’s gross income under

section 951(a)(1)(A).

(ii) For purposes of determining the amount and

type of income included in A’s gross income and

the amount and type of income in CFC’s recapture

accounts, the rules of paragraphs (e)(1) and (2) of

this section apply. While CFC’s general limitation

post-1986 undistributed earnings for 1999 are 0

((100u) opening balance + 100u subpart F income), CFC’s general limitation subpart F income

(100u) does not exceed its general limitation

current earnings and profits (100u) for 1999.

Accordingly, under paragraph (e)(1)(iii) of this

section, the amount by which CFC’s subpart F

income exceeds its earnings and profits for 1999,

10u, is applied proportionately to reduce CFC’s

subpart F income in the separate categories for

general limitation income, 100u, and passive income, 100u. Thus, A includes 95u of general

limitation foreign base company sales income and

95u of passive limitation foreign personal holding

company income in gross income in 1999. At the

close of 1999 CFC has 105u in its general

limitation/foreign base company sales income recapture account (100u from 1998 + 5u from

1999), 55u in its passive limitation/foreign personal holding company income recapture account

(50u from 1998 + 5u from 1999), and 50u in its

dividends from the noncontrolled section 902

corporation/foreign personal holding company income recapture account (all from 1998).

(iii) For purposes of computing post-1986 undistributed earnings in each separate category, the

rules of sections 902 and 960, including the rules

of § 1.960–1(i), apply. Thus, post-1986 undistributed earnings (or an accumulated deficit) in each

separate category are increased (or reduced) by

current earnings and profits or current deficits in

each separate category. The accumulated deficit in

CFC’s general limitation earnings and profits

(100u) is reduced to 0 by the addition of 100u of

1999 earnings and profits. CFC’s passive limitation earnings of 50u are increased by 100u to

150u, and CFC’s noncontrolled section 902 corporation earnings of 50u are decreased by (10u) to

40u. After the addition of current year earnings

and profits and deficits to the separate categories

there are no deficits remaining in any separate

category. Thus, the allocation rules of § 1.960–

1(i)(4) do not apply in 1999. Accordingly, in

determining the post-1986 foreign income taxes

deemed paid by A, post-1986 undistributed earnings in each separate category are unaffected by

earnings in the other categories. Foreign taxes

deemed paid under section 960 for 1999 would be

determined as follows for each separate category:

with respect to the inclusion of 95u of foreign

base company sales income out of general limitation earnings, the section 960 fraction is 95u

inclusion/0 total earnings; with respect to the

inclusion of 95u of passive limitation income the

section 960 fraction is 95u inclusion/150u passive

earnings. Thus, no general limitation taxes would

be associated with the inclusion of the general

limitation earnings because there are no accumulated earnings in the general limitation category.

After the deemed-paid taxes are computed, at the

close of 1999 CFC has a (95u) deficit in general

limitation earnings and profits ((100u) opening

balance + 100u current earnings - 95u inclusion),

55u of passive limitation earnings and profits (50u

opening balance + 100u current foreign personal

holding company income - 95u inclusion), and

40u of earnings and profits subject to the separate

limitation for dividends from the noncontrolled

section 902 corporation (50u opening balance +

(10u) expense).

Example 3. (i) A, a U.S. person, is the sole

shareholder of CFC, a controlled foreign corporation whose functional currency is the u. At the

beginning of 1998, CFC has post-1986 undistributed earnings of 275u, all of which are general

limitation earnings described in section

904(d)(1)(I). CFC has no previously-taxed earnings and profits described in section 959(c)(1) or

(c)(2). In 1998, CFC has a (200u) loss in the

shipping category described in section

904(d)(1)(D), 100u of foreign personal holding

company income that is passive income described

in section 904(d)(1)(A), and 125u of general

limitation manufacturing earnings that are not

subpart F income. CFC’s subpart F income for

1998, 100u, exceeds CFC’s current earnings and

profits, 25u, by 75u. Under section 952(c)(1)(A)

and paragraph (e) of this section, subpart F

income is limited to CFC’s current earnings and

profits of 25u, all of which is included in A’s

gross income under section 951(a)(1)(A). The 75u

of CFC’s 1998 subpart F income that is not

included in A’s income in 1998 by reason of

section 952(c)(1)(A) is subject to recapture under

section 952(c)(2) and paragraph (f) of this section.

(ii) For purposes of determining the amount and

type of income included in A’s gross income and

the amount and type of income in CFC’s recapture

account, the rules of paragraphs (e)(1) and (2) of

this section apply. Under paragraph (e)(1) of this

section, the amount of CFC’s subpart F income in

excess of earnings and profits for 1998, 75u,

reduces the 100u of passive limitation foreign

personal holding company income. Thus, A includes 25u of passive limitation foreign personal

holding company income in gross income, and

CFC has 75u in its passive limitation/foreign

personal holding company income recapture account.

(iii) For purposes of computing post-1986 undistributed earnings in each separate category the

rules of sections 902 and 960, including the rules

of § 1.960–1(i), apply. Under § 1.960– 1(i), the

shipping limitation deficit of (200u) is allocated

proportionately to reduce general limitation earnings of 400u and passive limitation earnings of

100u. Thus, general limitation earnings are reduced by 160u to 240u (400u general limitation

earnings/500u total earnings in positive separate

categories x (200u) shipping deficit = 160u reduction), and passive limitation earnings are reduced

by 40u to 60u (100u passive earnings/500u total

earnings in positive separate categories x (200u)

shipping deficit = 40u reduction). Five-twelfths of

CFC’s post-1986 foreign income taxes with respect to passive limitation earnings are deemed

paid by A under section 960 with respect to the

subpart F inclusion (25u inclusion/60u passive

earnings). After the inclusion and deemed-paid

taxes are computed, at the close of 1998 CFC has

400u of general limitation earnings (275u opening

balance + 125u current earnings), 75u of passive

limitation earnings (100u of foreign personal holding company income - 25u inclusion), and a

(200u) deficit in shipping limitation earnings.

Example 4. (i) The facts are the same as in

Example 3 with the addition of the following

facts. In 1999, CFC earns 50u of general limitation earnings that are not subpart F income and

75u of passive limitation income that is foreign

personal holding company income. Thus, CFC has

125u of current earnings and profits. CFC distributes 200u to A. Under paragraph (f)(3)(i) of this

section, the recapture rules are applied first. Thus,

the amount by which 1999 current earnings and

profits exceed subpart F income, 50u, is

recharacterized as passive limitation foreign personal holding company income. CFC’s total subpart F income for 1999 is 125u of passive

limitation foreign personal holding company income (75u current earnings plus 50u recapture

account), and the passive limitation/foreign personal holding company income recapture account

is reduced from 75u to 25u.

(ii) CFC has 150u of previously-taxed earnings

and profits described in section 959(c)(2) (25u

attributable to 1998 and 125u attributable to

1999), all of which is passive limitation earnings

and profits. Under section 959(c), 150u of the

200u distribution is deemed to be made from

earnings and profits described in section 959(c)(2).

The remaining 50u is deemed to be made from

earnings and profits described in section 959(c)(3).

Under paragraph (f)(3)(ii) of this section, the

dividend distribution is deemed to be made first

out of the passive limitation recapture account to

the extent thereof (25u). Under paragraph

(f)(2)(iii) of this section, the passive limitation

recapture account is reduced from 25u to 0. The

remaining distribution of 25u is treated as made

out of CFC’s general limitation earnings and

profits.

(iii) For purposes of computing post-1986 undistributed earnings, the rules of section 902 and

960, including the rules of § 1.960–1(i), apply.

Thus, the shipping limitation accumulated deficit

of (200u) reduces general limitation earnings and

profits of 450u and passive limitation earnings and

profits of 150u on a proportionate basis. Thus,

100% of CFC’s post-1986 foreign income taxes

with respect to passive limitation earnings are

deemed paid by A under section 960 with respect

to the 1999 subpart F inclusion of 125u (100u

inclusion (numerator limited to denominator)/100u

passive earnings). No post-1986 foreign income

taxes remain to be deemed paid under section 902

in connection with the 25u distribution from the

passive limitation/foreign personal holding company income recapture account. One-twelfth of

CFC’s post-1986 foreign income taxes with respect to general limitation earnings are deemed

paid by A under section 902 with respect to the

distribution of 25u general limitation earnings and

profits described in section 959(c)(3) (25u

inclusion/300u general limitation earnings). After

the deemed-paid taxes are computed, at the close

of 1999 CFC has 425u of general limitation

earnings and profits (400u opening balance + 50u

current earnings - 25u distribution), 0 of passive

limitation earnings (75u recapture account + 75u

current foreign personal holding company income

- 125u inclusion - 25u distribution), and a (200u)

deficit in shipping limitation earnings.

(5) Effective date. Paragraph (e) of

this section and this paragraph (f) apply

to taxable years of a controlled foreign

corporation beginning after March 3,

1997.

Par. 3. In § 1.952–2, paragraph (c)(1)

is revised to read as follows:

§ 1.952–2 Determination of gross income and taxable income of a foreign

corporation.

section—(1) Nonapplication of certain

provisions. Except where otherwise distinctly expressed, the provisions of

subchapters F, G, H, L, M, N, S, and T

of chapter 1 of the Internal Revenue

Code shall not apply and, for taxable

years of a controlled foreign corporation

beginning after March 3, 1997, the

provisions of section 103 of the Internal

Revenue Code shall not apply.

Par. 4. In § 1.954–1, the Example in

paragraph (d)(4)(iii) is revised to read as

follows:

§ 1.954–1 Foreign base company income.

(d) * * *

(4) * * *

(iii) * * *

Example. During its 1995 taxable year, CFC, a

controlled foreign corporation, earns royalty income, net of taxes, of $100 that is foreign

personal holding company income. CFC has no

expenses associated with this royalty income. CFC

pays $50 of foreign income taxes with respect to

the royalty income. For 1995, CFC has current

earnings and profits of $50. CFC’s subpart F

income, as determined prior to the application of

this paragraph (d), exceeds its current earnings and

profits. Thus, under paragraph (d)(4)(ii) of this

section, the amount of CFC’s only net item of

income, the royalty income, will be limited to $50.

The remaining $50 will be subject to

recharacterization in a subsequent taxable year

under section 952(c)(2). Because the amount of

foreign income taxes paid with respect to this net

item of income is $50, the effective rate of tax on

the item, for purposes of this paragraph (d), is 50

percent ($50 of taxes/$50 net item + $50 of taxes).

Accordingly, an election under paragraph (d)(5) of

this section may be made to exclude the item of

income from the computation of subpart F income.

Par. 5. In § 1.954–2, paragraphs

(b)(3), (g)(2)(ii)(B)(1)(i) and (g)(2)(ii)(B)(2) are revised to read as follows:

§ 1.954–2 Foreign personal holding

company income.

(g) * * *

(2) * * *

(ii) * * *

(B) * * *

(1) * * *

(i) Arises from a transaction (other

than a hedging transaction) entered into,

or property used or held for use, in the

normal course of the controlled foreign

corporation’s trade or business, other

than the trade or business of trading

foreign currency;

(2) The foreign currency gain or loss

arises from a bona fide hedging transaction, as defined in paragraph (a)(4)(ii) of

this section, with respect to a transaction

or property that satisfies the requirements of paragraphs (g)(2)(ii)(B)(1)(i)

through (iii) of this section, provided

that any gain or loss arising from such

transaction or property that is attributable to changes in exchange rates is

clearly determinable from the records of

the CFC as being derived from such

transaction or property. For purposes of

this paragraph (g)(2)(ii)(B)(2), a hedging

transaction will satisfy the aggregate

hedging rules of § 1.1221–2(c)(7) only

if all (or all but a de minimis amount)

of the aggregate risk being hedged

arises in connection with transactions or

property that satisfy the requirements of

paragraphs (g)(2)(ii)(B)(1)(i) through

(iii) of this section, provided that any

gain or loss arising from such transactions or property that is attributable to

changes in exchange rates is clearly

determinable from the records of the

CFC as being derived from such transactions or property.

Par. 6. Section 1.957–1 is amended

by:

1. Removing the last sentence of

paragraph (c) Example 8 and adding

two sentences in its place.

2. Revising the last sentence of paragraph (c) Example 9

The addition and revision read as

follows:

(b) * * *

(3) Treatment of tax exempt interest.

For taxable years of a controlled foreign

corporation beginning after March 3,

1997, foreign personal holding company

income includes all interest income, in-

cluding interest that is described in

section 103 (see § 1.952–2(c)(1)).

§ 1.957–1 Definition of controlled foreign corporation.

Example 8. JV was a controlled foreign corporation on the following day because over 50

percent of the total value in the corporation was

held by a person that was a United States

shareholder under section 951(b). See § 1.951–

1(f).

Example 9. JV became a controlled foreign

corporation on the following day because over 50

percent of the total value in the corporation was

held by a person that was a United States

shareholder under section 951(b).

Par. 7. In § 1.960–1, paragraph (i) is

added to read as follows:

§ 1.960–1 Foreign tax credit with respect to taxes paid on earnings and

profits of controlled foreign corporations.

(i) Computation of deemed-paid taxes

in post-1986 taxable years—(1) General rule. If a domestic corporation is

eligible to compute deemed-paid taxes

under section 960(a)(1) with respect to

an amount included in gross income

under section 951(a), then, such domestic corporation shall be deemed to have

paid a portion of the foreign corporation’s post-1986 foreign income taxes

determined under section 902 and the

regulations under that section in the

same manner as if the amount so included were a dividend paid by such

foreign corporation (determined by applying section 902(c) in accordance with

section 904(d)(3)(B)).

(2) Ordering rule for computing

deemed-paid taxes under sections 902

and 960. If a domestic corporation computes deemed-paid taxes under both sections 902 and 960 in the same taxable

year, section 960 shall be applied first.

After the deemed-paid taxes are computed under section 960 with respect to

a deemed income inclusion, post-1986

undistributed earnings and post-1986

foreign income taxes in each separate

category shall be reduced by the appropriate amounts before deemed-paid taxes

are computed under section 902 with

respect to a dividend distribution.

(3) Computation of post-1986 undistributed earnings. Post-1986 undistributed earnings (or an accumulated deficit

in post-1986 undistributed earnings) are

computed under section 902 and the

regulations under that section.

(4) Allocation of accumulated deficits. For purposes of computing post1986 undistributed earnings under sections 902 and 960, a post-1986

accumulated deficit in a separate category shall be allocated proportionately

to reduce post-1986 undistributed earn-

ings in the other separate categories.

However, a deficit in any separate category shall not permanently reduce

earnings in other separate categories, but

after the deemed-paid taxes are computed the separate limitation deficit shall

be carried forward in the same separate

category in which it was incurred. In

addition, because deemed-paid taxes

may not exceed taxes paid or accrued

by the controlled foreign corporation, in

computing deemed-paid taxes with respect to an inclusion out of a separate

category that exceeds post-1986 undistributed earnings in that separate category, the numerator of the deemed-paid

credit fraction (deemed inclusion from

the separate category) may not exceed

the denominator (post-1986 undistributed earnings in the separate category).

(5) Examples. The application of this

paragraph (i) may be illustrated by the

following examples. See § 1.952–1(f)(4)

for additional illustrations of these rules.

facts. In 1999, CFC distributes 150u to A. CFC

has 100u of previously-taxed earnings and profits

described in section 959(c)(2) attributable to 1998,

all of which is passive limitation earnings and

profits. Under section 959(c), 100u of the 150u

distribution is deemed to be made from earnings

and profits described in section 959(c)(2). The

remaining 50u is deemed to be made from earnings and profits described in section 959(c)(3).

The entire dividend distribution of 50u is treated

as made out of CFC’s general limitation earnings

and profits. See section 904(d)(3)(D).

(ii) For purposes of computing post-1986 undistributed earnings under section 902 with respect to

the 1999 dividend of 50u, the shipping limitation

accumulated deficit of (50u) reduces general limitation earnings and profits of 100u to 50u. Thus,

100% of CFC’s post-1986 foreign income taxes

with respect to general limitation earnings are

deemed paid by A under section 902 with respect

to the 1999 dividend of 50u (50u dividend/50u

general limitation earnings). After the deemed-paid

taxes are computed, at the close of 1999 CFC has

50u of general limitation earnings (100u opening

balance - 50u distribution), 0 of passive limitation

earnings, and a (50u) deficit in shipping limitation

earnings. (6) Effective date. This paragraph (i)

applies to taxable years of a controlled foreign

corporation beginning after March 3, 1997.

Example 1. (i) A, a U.S. person, is the sole

shareholder of CFC, a controlled foreign corporation formed on January 1, 1998, whose functional

currency is the u. In 1998 CFC earns 100u of

general limitation income described in section

904(d)(1)(I) that is not subpart F income and 100u

of foreign personal holding company income that

is passive income described in section

904(d)(1)(A). In 1998 CFC also incurs a (50u)

loss in the shipping category described in section

904(d)(1)(D). CFC’s subpart F income for 1998,

100u, does not exceed CFC’s current earnings and

profits of 150u. Accordingly, all 100u of CFC’s

subpart F income is included in A’s gross income

under section 951(a)(1)(A). Under section

904(d)(3)(B) of the Internal Revenue Code and

paragraph (i)(1) of this section, A includes 100u of

passive limitation income in gross income for

1998.

(ii) For purposes of computing post-1986 undistributed earnings under sections 902, 904(d) and

960 with respect to the subpart F inclusion, the

shipping limitation deficit of (50u) is allocated

proportionately to reduce general limitation earnings of 100u and passive limitation earnings of

100u. Thus, general limitation earnings are reduced by 25u to 75u (100u general limitation

earnings/200u total earnings in positive separate

categories x (50u) shipping deficit = 25u reduction), and passive limitation earnings are reduced

by 25u to 75u (100u passive earnings/200u total

earnings in positive separate categories x (50u)

shipping deficit = 25u reduction). All of CFC’s

post-1986 foreign income taxes with respect to

passive limitation earnings are deemed paid by A

under section 960 with respect to the 100u subpart

F inclusion of passive income (75u inclusion

(numerator limited to denominator under paragraph (i)(4) of this section)/75u passive earnings).

After the inclusion and deemed-paid taxes are

computed, at the close of 1998 CFC has 100u of

general limitation earnings, 0 of passive limitation

earnings (100u of foreign personal holding company income - 100u inclusion), and a (50u) deficit

in shipping limitation earnings.

Example 2. (i) The facts are the same as in

Example 1 with the addition of the following

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved December 11, 1996.

Donald C. Lubick,

Assistant Secretary of the Treasury.

(Filed by the Office of the Federal Register on

December 31, 1996, 8:45 a.m., and published in

the issue of the Federal Register for January 2,

1997, 62 F.R. 17)

Section 6071.—Time for Filing

Returns and Other Documents

26 CFR 53.6071–1T: Time for filing returns

(temporary).

T.D. 8705

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 53

Requirement of Return and Time

for Filing

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Final and temporary regulations.

SUMMARY: This document contains

final and temporary regulations providing that disqualified persons and organization managers liable for Internal Revenue Code section 4958 excise taxes are

required to file Form 4720. The regulations also specify the filing date for

returns for the period to which the new

excise taxes applied retroactively. These

excise taxes are imposed on excess

benefit transactions between disqualified

persons, as statutorily defined, and sections 501(c)(3) and (4) organizations,

except for private foundations.

DATES: These regulations are effective

January 2, 1997.

For dates of applicability, see

§ 53.6071–1T(f) of these regulations.

FOR FURTHER INFORMATION CONTACT: Phyllis Haney, (202) 622–4290

(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document contains amendments

to the Foundation and Similar Excise

Taxes regulations (26 CFR part 53)

under sections 6011 and 6071. These

regulations provide guidance relating to

the requirement of a return to accompany payment of section 4958 excise

taxes and the time for filing that return.

These rules were first published in Notice 96–46 (1996–39 I.R.B. 7) (September 23, 1996).

Taxpayer Bill of Rights 2, Public Law

104–168, 110 Stat. 1452 (TBOR2), enacted July 30, 1996, added section 4958

to the Code. As described more fully

below, section 4958 imposes excise

taxes on excess benefit transactions.

Section 4958 taxes apply retroactively to

excess benefit transactions occurring on

or after September 14, 1995. The taxes

do not, however, apply to any benefit

arising from a transaction pursuant to

any written contract which was binding

on September 13, 1995, and at all times

thereafter before such transaction occurred.

An ‘‘excess benefit transaction’’ subject to tax under section 4958 is any

transaction in which an economic benefit is provided by an organization described in section 501(c)(3) (except for

a private foundation) or 501(c)(4) directly or indirectly to, or for the use of,

any disqualified person if the value of

the economic benefit provided exceeds

the value of the consideration (including

the performance of services) received

for providing the benefit. A ‘‘disqualified person’’ is any person who was, at

any time during the 5-year period ending on the date of the excess benefit

transaction, in a position to exercise

substantial influence over the affairs of

the organization. Disqualified persons

also include family members and certain

entities in which at least 35 percent of

the control or beneficial interest are held

by persons described in the preceding

sentence. An ‘‘organization manager’’ is

any officer, director, trustee, or any

individual having powers or responsibilities similar to those of any officer,

director, or trustee.

Section 4958 imposes three taxes. The

first tax is equal to 25 percent of the

excess benefit amount, and is to be paid

by any disqualified person who engages

in an excess benefit transaction. The

second tax is equal to 200 percent of the

excess benefit amount, and is to be paid

by any disqualified person if the excess

benefit transaction is not corrected

within the taxable period. The third tax

is equal to 10 percent of the excess

benefit amount, and is to be paid by any

organization manager who knowingly

participates in an excess benefit transaction. The maximum amount of this third

tax with respect to any one excess

benefit transaction may not exceed

$10,000. These regulations prescribe

Form 4720 for calculating and paying

the first and third taxes described above.

TBOR2 also amended section 6033(b)

to require section 501(c)(3) organizations to report the amounts of the taxes

paid under section 4958 with respect to

excess benefit transactions involving the

organization, as well as any other information the Secretary may require concerning those transactions. Section

6033(f) also was amended to impose the

same reporting requirements on section

501(c)(4) organizations. Those amendments to section 6033 only apply to

organizations’ returns for taxable years

beginning after July 30, 1996. These

and other TBOR2 amendments to the

reporting requirements for section

501(c)(3) and (4) organizations are reflected on IRS Forms 990 and 990–EZ

beginning with the 1996 versions.

Explanation of Provisions

The regulations provide that disqualified persons and organization managers,

as defined in sections 4958(f)(1) and

(2), who are liable for section 4958

excise taxes on excess benefit transactions, as defined in section 4958(c)(1),

are required to file a return on Form

4720. The general rule is that returns

will be due on or before the 15th day of

the fifth month following the close of

the disqualified person’s or organization

manager’s taxable year. The regulations

also provide that returns on Form 4720

for taxable years ending after September

13, 1995, and on or before July 30,

1996, will be due on or before Decem-

ber 15, 1996. See Notice 96–46

(1996–39 I.R.B. 7) (September 23,

1996).

Special Analyses

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

Therefore, a regulatory assessment is not

required. It also has been determined

that section 553(b) of the Administrative

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

not apply to these regulations, and because the regulation does not impose a

collection of information on small entities, the Regulatory Flexibility Act (5

U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Internal

Revenue Code, these temporary regulations will be submitted to the Chief

Counsel for Advocacy of the Small

Business Administration for comment on

their impact on small business.

Drafting Information

The principal author of these regulations is Phyllis Haney, Office of Associate Chief Counsel (Employee Benefits

and Exempt Organizations). However,

other personnel from the IRS and Treasury Department participated in their

development.

Adoption of Amendments to the

Regulations

Accordingly, 26 CFR part 53 is

amended as follows:

PART 53—FOUNDATION AND SIMILAR EXCISE TAXES

Paragraph 1. The authority citation for

part 53 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 2. In § 53.6011–1, paragraph (b)

is amended by:

1. Removing from the first sentence,

the language ‘‘or 4955(a),’’ and adding

‘‘, 4955(a), or 4958(a),’’ in its place.

2. Removing from the last sentence,

the language ‘‘or 4955(a),’’ and adding

‘‘, 4955(a), or 4958(a),’’ in its place.

Par. 3. Section 53.6071–1T is added

to read as follows:

§ 53.6071–1T Time for filing returns

(temporary).

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

guidance see § 53.6071–1(a) through

(e).

(f) Taxes imposed on excess benefit

transactions engaged in by organizations described in sections 501(c)(3)

(except private foundations) and

501(c)(4)—(1) General rule. A Form

4720 required by § 53.6011–1(b) for a

disqualified person or organization manager liable for tax imposed by section

4958(a) shall be filed by that person on

or before the 15th day of the fifth

month following the close of such person’s taxable year.

(2) Special rule for taxable years

ending after September 13, 1995, and

on or before July 30, 1996. A Form

4720 required by § 53.6011–1(b) for a

disqualified person or organization manager liable for tax imposed by section

4958(a) on an excess benefit transaction

occurring in such person’s taxable year

ending after September 13, 1995, and on

or before July 30, 1996, is due on or

before December 15, 1996.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved December 10, 1996.

Donald C. Lubick,

Assistant Secretary of the Treasury.

(Filed by the Office of the Federal Register on

December 31, 1996, 8:45 a.m., and published in

the issue of the Federal Register for January 2,

1997, 62 F.R. 25)

Section 6081.—Extension of Time

for Filing Returns

26 CFR 1.6081–4: Automatic extension of time for

filing individual income tax returns.

T.D. 8703

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1, 301, and 602

Automatic Extension of Time for

Filing Individual Income Tax

Returns; Automatic Extension of

Time to File Partnership Return of

Income, Trust Income Tax Return,

and U.S. Real Estate Mortgage

Investment Conduit Income Tax

Return

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains

final regulations that reflect new and

simpler procedures for an individual to

obtain an automatic extension of time to

file an individual income tax return.

This document also contains final regulations that provide new and simpler

procedures for a partnership, trust, and

Real Estate Mortgage Investment Conduit (REMIC) to obtain an automatic

extension of time to file partnership,

trust, and REMIC returns.

EFFECTIVE DATE: The regulations are

effective December 31, 1996.

FOR FURTHER INFORMATION CONTACT: Margaret A. Owens, (202) 622–

6232 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in these final regulations has been

reviewed and approved by the Office of

Management and Budget in accordance

with the Paperwork Reduction Act (44

U.S.C. 3504(h)) under control numbers

1545–1479 and 1545–0148. Responses

to this collection of information are

required to obtain a benefit (an automatic 4-month extension of time to file

an individual income tax return or an

automatic 3-month extension of time to

file a partnership return of income, a

trust income tax return, or a REMIC

income tax return).

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.

Estimates of the reporting burden in

these final regulations are reflected in

the burden estimates of either Form

4868, Application for Automatic Extension of Time to File U.S. Individual

Income Tax Return, or Form 8736,

Application for Automatic Extension of

Time To File U.S. Return for a Partnership, REMIC or for Certain Trusts.

Comments concerning the accuracy of

this burden estimate and suggestions for

reducing this burden should be sent to

the Internal Revenue Service, Attn:

IRS Reports Clearance Officer, T:FP,

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

Desk Officer for the Department of the

Treasury, Office of Information and

Regulatory Affairs, Washington, DC

20503.

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

long as their contents may become material in the administration of any internal revenue law. Generally, tax returns

and tax return information are confidential, as required by 26 U.S.C. 6103.

Background

Extensions for Individual Income Tax

Returns

On January 4, 1996, temporary regulations (T.D. 8651 [1996–1 C.B. 312])

providing new and simpler procedures

for individuals to obtain an automatic

extension of time to file an individual

income tax return were published in the

Federal Register (6l FR 260). A notice

of proposed rulemaking (IA–41–93

[1996–1 C.B. 770]) cross-referencing

the temporary regulations was published

in the Federal Register for the same

day (61 FR 338).

Written comments responding to the

notice of proposed rulemaking were received. No public hearing was requested

or held. After consideration of all the

comments, the temporary regulations under sections 6081 and 6651 relating to

the automatic extension of time to file

individual income tax returns are

adopted as revised by this Treasury

Decision, and the corresponding temporary regulations are removed. The comments and revisions are discussed below

in the section on Explanation of Provisions and Summary of Comments.

Extensions for Partnership Returns of

Income and Trust Income Tax Returns

On April 5, 1988, temporary regulations (T.D. 8190 [1988–1 C.B. 394])

relating to the automatic extension of

time to file partnership returns of income and trust income tax returns were

published in the Federal Register (53

FR 11066). A notice of proposed

rulemaking (LR–29–88 [1988–1 C.B.

934]) cross-referencing the temporary

regulations was published in the Federal Register for the same day (53 FR

11103).

In accordance with section 860F(e),

REMICs have been generally treated as

partnerships with regard to extensions of

time to file. A REMIC has been allowed

an automatic 3-month extension of time

to file if (1) an application was prepared

on Form 8736, (2) the application was

signed by the person duly authorized,

(3) the application was filed on or

before the date Form 1066, U.S. Real

Estate Mortgage Investment Conduit Income Tax Return, was due, (4) the

application showed the full amount

properly estimated as tax, and (5) the

application was accompanied by full

remittance of the amount properly esti-

mated as tax that was unpaid as of the

date prescribed for filing Form 1066.

Written comments responding to the

notice of proposed rulemaking and the

request for comments were received. No

public hearing was requested or held.

After consideration of all the comments,

the temporary regulations under section

6081 relating to the automatic extension

of time to file partnership returns of

income, trust income tax returns, and

REMIC income tax returns are adopted

as revised by this Treasury decision, and

the corresponding temporary regulations

are removed. The comments and revisions are discussed below.

Explanation of Provisions and Summary

of Comments

These final regulations provide that

individuals may obtain an automatic

4-month extension of time to file an

individual income tax return without

remitting the unpaid amount of any tax

properly estimated to be due with the

application for extension of time to file.

Under these final regulations, an individual’s inability to pay is not a condition for obtaining an automatic 4-month

extension. However, taxpayers are encouraged to make payments in order to

minimize interest and penalties imposed

on unpaid amounts.

The final regulations remove the

regulatory requirement that Forms 4868

be signed.

Most commentators responded favorably to the proposed and temporary

regulations. Some commentators suggested that the IRS should develop a

bulk method for submitting applications

for automatic extensions so that return

preparers could submit a list of the

required information for all their clients

on one Form 4868. The final regulations

provide that the IRS may prescribe other

methods for submitting an application in

lieu of a paper application on Form

4868. In April 1996, the IRS provided a

method of filing Forms 4868 electronically through the Electronic Transmitted

Documents System. See Publication

1346. The IRS continues to offer this

method of filing Forms 4868. If there is

still a need for other methods, suggestions should be sent to: CC:DOM:CORP:R (REG–209643–93), Room

5226, Internal Revenue Service, POB

7604, Ben Franklin Station, Washington,

DC 20044.

One commentator recommended that

the requirement to ‘‘properly estimate’’

the tax be dropped, since payment of the

unpaid amount of tax due is not a

condition of obtaining an automatic

4-month extension of time to file an

individual income tax return. The requirement has been retained to assist

taxpayers in determining the amount of

interest and penalties for which they

will be liable if timely tax payments are

not made, and to thereby encourage

payments, as large as possible, with the

application for extension of time to file.

The final regulations provide the requirements for partnerships, trusts, and

REMICs to obtain an automatic 3-month

extension of time to file partnership,

trust, and REMIC returns. The final

regulations remove the regulatory requirement that Forms 8736 be signed.

Notwithstanding the current instructions

to Form 8736, an unsigned Form 8736

will be processed. In addition, these

final regulations provide that trusts and

REMICs may obtain an automatic

3-month extension of time to file a trust

income tax return or a REMIC income

tax return without remitting the unpaid

amount of any tax properly estimated to

be due with the application for extension of time to file.

The final regulations provide that the

IRS may prescribe additional methods

of obtaining an extension of time to file

in lieu of a paper application on Form

8736.

Some commentators suggested that

allowing automatic extensions for partnership returns of income and trust

income tax returns will give rise to

filing difficulties for partners and trust

beneficiaries. The Treasury and the IRS

took this concern into account when

limiting partnership and trust extensions

to 3 months rather than the 4 months

permitted individuals.

Special Analyses

It has been determined that these final

regulations are not a significant regulatory action as defined in EO 12866.

Therefore, a regulatory assessment is not

required. It also has been determined

that section 553(b) of the Administrative

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

not apply to these regulations, and because the notices of proposed rulemaking preceding the regulations were issued prior to March 29, 1996, a

Regulatory Flexibility Analysis is not

required. Pursuant to section 7805(f) of

the Internal Revenue Code, a copy of

the notice of proposed rulemaking providing an automatic extension of time to

file an individual income tax return that

precedes these regulations was submitted to the Chief Counsel for Advocacy

of the Small Business Administration for

comment on their impact on small business.

Drafting Information

The principal authors of these regulations are Margaret A. Owens, and Philip

E. Bennet, Office of the Assistant Chief

Counsel (Income Tax & Accounting),

IRS. However, other personnel from the

IRS and the Treasury Department participated in their development.

Adoption of Amendments to the

Regulations

Accordingly, 26 CFR parts 1, 301,

and 602 are amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for

part 1 is amended by adding new entries

in numerical order to read as follows:

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

Section 1.6081–2 also issued under 26

U.S.C. 6081(a).

Section 1.6081–4 also issued under 26

U.S.C. 6081(a).

Section 1.6081–6 also issued under 26

U.S.C. 6081(a).

Section 1.6081–7 also issued under 26

U.S.C. 6081(a).* * *

Par. 2. Section 1.6081–2 is added to

read as follows:

§ 1.6081–2 Automatic extension of time

to file partnership return of income.

(a) In general. A partnership required

to file a return of income on Form 1065,

U.S. Partnership Return of Income, for

any taxable year will be allowed an

automatic 3-month extension of time to

file the return after the date prescribed

for filing the return if an application

under this section is filed in accordance

with paragraph (b) of this section. In the

case of a partnership described in

§ 1.6081–5(a)(1), the automatic extension allowed under this section runs

concurrently with an extension of time

to file granted pursuant to § 1.6081–

5(a).

(b) Requirements. In order to satisfy

this paragraph (b), an application for an

automatic extension under this section

must be—

(1) Submitted on Form 8736, Application for Automatic Extension of Time

To File U.S. Return for a Partnership,

REMIC or for Certain Trusts, or in any

other manner as may be prescribed by

the Commissioner;

(2) Filed on or before the later of—

(i) The date prescribed for filing the

partnership return (without regard to any

extensions of the time for filing such

return); or

(ii) The expiration of any extension

of time to file granted such partnership

pursuant to § 1.6081–5(a); and

(3) Filed with the Internal Revenue

Service office designated in the application’s instructions.

An automatic extension of time for

filing a partnership return under this

section does not extend the time for

payment of any amount due under section 7519, relating to required payments

for entities electing not to have a required taxable year.

(d) Section 444 election. An automatic extension of time for filing a

partnership return will run concurrently

with any extension of time for filing a

return allowed because of section 444,

relating to the election of a taxable year

other than a required taxable year.

(e) Effect of extension on partner. An

automatic extension of time for filing a

partnership return under this section

does not operate to extend the time for

filing a partner’s income tax return or

the time for the payment of any tax due

on the partner’s income tax return.

(f) Termination of automatic extension. The district director, including the

Assistant Commissioner (International),

or the director of a service center may

terminate at any time an automatic extension by mailing to the partnership a

notice of termination. The notice must

be mailed at least 10 days prior to the

termination date designated in such notice. The notice of termination must be

mailed to the address shown on Form

8736 or to the partnerships’s last known

address.

(g) Penalties. See section 6698 for

failure to file a partnership return.

(h) Coordination with § 1.6081–1.

Except in undue hardship cases, no

extension of time for filing a partnership

return of income will be granted under

§ 1.6081–1 until an automatic extension

has been allowed pursuant to the provisions of this section.

(i) Effective date. This section is effective for applications for an automatic

extension of time to file a partnership

return of income filed on or after December 31, 1996.

§ 1.6081–2T [Removed]

Par. 3. Section 1.6081–2T is removed.

§ 1.6081–3T [Removed]

Par. 4. Section 1.6081–3T is removed.

Par. 5. Section 1.6081–4 is amended

as follows:

1. Paragraphs (a) and (c) are revised.

2. Paragraphs (d) and (e) are added.

The revised and added provisions

read as follows:

§ 1.6081–4 Automatic extension of time

for filing individual income tax returns.

(a) In general—(1) Period of extension. An individual who is required to

file an individual income tax return will

be allowed an automatic 4-month extension of time to file the return after the

date prescribed for filing the return

provided the requirements contained in

paragraphs (a)(2), (3), and (4) of this

section are met. In the case of an

individual described in § 1.6081–5(a)(5)

or (6), the automatic 4-month extension

will run concurrently with the extension

of time to file granted pursuant to

§ 1.6081–5.

(2) Manner for submitting an application. An application must be submitted—

(i) On Form 4868, Application for

Automatic Extension of Time to File

U.S. Individual Income Tax Return; or

(ii) In any other manner as may be

prescribed by the Commissioner.

(3) Time and place for filing application. Except in the case of an individual

described in § 1.6081–5(a)(5) or (6), the

application must be filed on or before

the date prescribed for filing the individual income tax return. In the case of

an individual described in § 1.6081–

5(a)(5) or (6), the application must be

filed on or before the expiration of the

extension of time to file granted pursuant to § 1.6081–5. The application must

be filed with the Internal Revenue Service office designated in the application’s instructions.

(4) Proper estimate of tax. An application for extension must show the full

amount properly estimated as tax for the

taxable year.

(5) Coordination with § 1.6081–1.

Except in undue hardship cases, no

extension of time for filing an individual

income tax return will be granted under

§ 1.6081–1 until an automatic extension

has been allowed pursuant to the provisions of this paragraph (a).

Assistant Commissioner (International),

or the director of a service center may

terminate at any time an automatic extension by mailing to the taxpayer a

notice of termination. The notice must

be mailed at least 10 days prior to the

termination date designated in such notice. The notice of termination must be

mailed to the taxpayer at the address

shown on Form 4868 or to the taxpayer’s last known address.

(d) Penalties. See section 6651 for

failure to file an individual income tax

return or failure to pay the amount

shown as tax on the return. In particular,

see § 301.6651–1(c)(3) of this chapter

(relating to a presumption of reasonable

cause in certain circumstances involving

an automatic extension of time for filing

an individual income tax return).

(e) Effective date. This section is effective for applications for an automatic

extension of time to file an individual

income tax return filed on or after

December 31, 1996.

§ 1.6081–4T [Removed]

Par. 6. Section 1.6081–4T is removed.

Par. 7. Section 1.6081–6 is added

under the undesignated centerheading

‘‘Extension of Time for Filing Returns’’

to read as follows:

§ 1.6081–6 Automatic extension of time

to file trust income tax return.

(a) In general. A trust required to file

an income tax return on Form 1041,

U.S. Income Tax Return for Estates and

Trusts, for any taxable year will be

allowed an automatic 3-month extension

of time to file the return after the date

prescribed for filing the return if an

application under this section is filed in

accordance with paragraph (b) of this

section.

(b) Requirements. To satisfy this

paragraph (b), an application for an

automatic extension under this section

must—

(1) Be submitted on Form 8736, Application for Automatic Extension of

Time To File U.S. Return for a Partnership, REMIC or for Certain Trusts, or in

any other manner as may be prescribed

by the Commissioner;

(2) Be filed on or before the date

prescribed for filing the trust income tax

return with the Internal Revenue Service

office designated in the application’s

instructions; and

(3) Show the full amount properly

estimated as tax for the trust for the

taxable year.

An automatic extension of time to file a

trust income tax return under this section will not operate to extend the time

for filing the income tax return of a

beneficiary of the trust or the time for

the payment of any tax due on the

beneficiary’s income tax return.

(d) Termination of automatic extension. The district director, including the

Assistant Commissioner (International),

or the director of a service center may

terminate at any time an automatic extension by mailing to the trust a notice

of termination. The notice must be

mailed at least 10 days prior to the

termination date designated in such notice. The notice of termination must be

mailed to the address shown on Form

8736 or to the trust’s last known address.

(e) Penalties. See section 6651 for

failure to file a trust income tax return

or failure to pay the amount shown as

tax on the return.

(f) Coordination with § 1.6081–1.

Except in undue hardship cases, no

extension of time for filing a trust

income tax return will be granted under

§ 1.6081–1 until an automatic extension

has been allowed pursuant to the provisions of this section.

(g) Effective date. This section is effective for applications for an automatic

extension of time to file a trust income

tax return filed on or after December 31,

1996.

Par. 8. Section 1.6081–7 is added

under the undesignated centerheading

‘‘Extension of Time for Filing Returns’’

to read as follows:

§ 1.6081–7 Automatic extension of time

to file Real Estate Mortgage Investment

Conduit (REMIC) income tax return.

(a) In general. A Real Estate Mortgage Investment Conduit (REMIC) required to file an income tax return on

Form 1066, U.S. Real Estate Mortgage

Investment Conduit Income Tax Return,

for any taxable year will be allowed an

automatic 3-month extension of time to

file the return after the date prescribed

for filing the return if an application

under this section is filed in accordance

with paragraph (b) of this section.

(b) Requirements. To satisfy this

paragraph (b), an application for an

automatic extension under this section

must—

(1) Be submitted on Form 8736, Application for Automatic Extension of

Time To File U.S. Return for a Partnership, REMIC or for Certain Trusts, or in

any other manner as may be prescribed

by the Commissioner;

(2) Be filed on or before the date

prescribed for filing the REMIC income

tax return with the Internal Revenue

Service office designated in the application’s instructions; and

(3) Show the full amount properly

estimated as tax for the REMIC for the

taxable year.

regular interest holders. An automatic

extension of time to file a REMIC

income tax return under this section will

not operate to extend the time for filing

the income tax return of a residual or

regular interest holder of the REMIC or

the time for the payment of any tax due

on the residual or regular interest holder’s income tax return.

(d) Termination of automatic extension. The district director, including the

Assistant Commissioner (International),

or the director of a service center may

terminate at any time an automatic extension by mailing to the REMIC a

notice of termination. The notice must

be mailed at least 10 days prior to the

termination date designated in such notice. The notice of termination must be

mailed to the address shown on Form

8736 or to the REMIC’s last known

address.

(e) Penalties. See sections 6698 and

6651 for failure to file a REMIC income

tax return or failure to pay the amount

shown as tax on the return.

(f) Coordination with § 1.6081–1.

Except in undue hardship cases, no

extension of time for filing a REMIC

income tax return will be granted under

§ 1.6081–1 until an automatic extension

has been allowed pursuant to the provisions of this section.

(g) Effective date. This section is effective for applications for an automatic

extension of time to file a REMIC

income tax return filed on or after

December 31, 1996.

PART 301—PROCEDURE AND ADMINISTRATION

Par. 9. The authority citation for part

301 continues to read in part as follows:

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

Par. 10. Section 301.6651–1 is

amended by revising paragraph (c)(3) to

read as follows:

§ 301.6651–1 Failure to file tax return

or to pay tax.

(3) If, for a taxable year ending on or

after December 31, 1995, an individual

taxpayer satisfies the requirement of

§ 1.6081–4(a) of this chapter (relating

to automatic extension of time for filing

an individual income tax return), reasonable cause will be presumed, for the

period of the extension of time to file,

with respect to any underpayment of tax

if—

(i) The excess of the amount of tax

shown on the individual income tax

return over the amount of tax paid on or

before the regular due date of the return

(by virtue of tax withheld by the employer, estimated tax payments, and any

payment with an application for extension of time to file pursuant to

§ 1.6081–4 of this chapter) is no greater

than 10 percent of the amount of tax

shown on the individual income tax

return; and

(ii) Any balance due shown on the

individual income tax return is remitted

with the return.

§ 301.6651–1T [Removed]

Par. 11. Section 301.6651–1T is removed.

PART 602—OMB CONTROL NUMBERS UNDER THE PAPERWORK

REDUCTION ACT

Par. 12. The authority citation for part

602 continues to read as follow:

Authority: 26 U.S.C. 7805.

Par. 13. In § 602.101, paragraph (c)

is amended by removing the entries for

§ § 1.6081–2T,

1.6081–3T,

and

1.6081–4T from the table, revising the

entry for § 1.6081–4, and adding the

following entries in numerical order to

the table to read as follows:

§ 602.101 OMB Control numbers.

CFR part or section

where identified and

described

Current OMB

control No.

1.6081–2 . . . . . . . . . . . . . 1545–0148

1545–1054

1545–1036

CFR part or section

where identified and

described

1.6081–4 . . . . . . . . . . . . .

Current OMB

control No.

1545–0188

1545–1479

1.6081–6 . . . . . . . . . . . . . 1545–0148

1545–1054

1.6081–7 . . . . . . . . . . . . . 1545–0148

1545–1054

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved December 17, 1996.

Donald C. Lubick,

Acting Assistant Secretary

of the Treasury.

(Filed by the Office of the Federal Register on

December 29, 1996, and published in the issue of

the Federal Register for December 31, 1996, 61

F.R. 69027)

Part III. Administrative, Procedural, and Miscellaneous

Low-Income Housing Tax

Credit—1997 Calendar Year

Resident Population Estimates

Notice 97–14

This notice informs (1) state and local

housing credit agencies that allocate

low-income housing tax credits under

§ 42 of the Internal Revenue Code and

(2) states and other issuers of taxexempt private activity bonds under

§ 141, of the proper population figures

to be used for calculating the 1997

calendar year population-based component of the state housing credit ceiling

(Credit Ceiling) under § 42(h)(3)(C)(i)

and the 1997 calendar year volume cap

(Volume Cap) under § 146.

The population figures both for the

population-based component of the

Credit Ceiling and for the Volume Cap

are determined by reference to § 146(j).

That section provides generally that determinations of population for any calendar year are made on the basis of the

most recent census estimate of the resident population of a state (or issuing

authority) released by the Bureau of the

Census before the beginning of such

calendar year.

The proper population figures for calculating the Credit Ceiling and the Volume Cap for the 1997 calendar year are

the estimates of the resident population

of states for July 1, 1996, released by

the Bureau of the Census on December

30, 1996, in press release CB 96–224.

For convenience, these estimates are

reprinted below.

Resident Population Estimates

for July 1, 1996

State

Population

Alabama

Alaska

Arizona

Arkansas

California

Colorado

Connecticut

Delaware

D.C.

4,273,000

607,000

4,428,000

2,510,000

31,878,000

3,823,000

3,274,000

725,000

543,000

Florida

Georgia

Hawaii

Idaho

Illinois

14,400,000

7,353,000

1,184,000

1,189,000

11,847,000

State

Population

Indiana

Iowa

Kansas

Kentucky

5,841,000

2,852,000

2,572,000

3,884,000

Louisiana

Maine

Maryland

Massachusetts

Michigan

Minnesota

Mississippi

Missouri

Montana

4,351,000

1,243,000

5,072,000

6,092,000

9,594,000

4,658,000

2,716,000

5,359,000

879,000

Nebraska

Nevada

New Hampshire

New Jersey

New Mexico

New York

North Carolina

North Dakota

Ohio

Oklahoma

Oregon

Pennsylvania

1,652,000

1,603,000

1,162,000

7,988,000

1,713,000

18,185,000

7,323,000

644,000

11,173,000

3,301,000

3,204,000

12,056,000

Rhode Island

South Carolina

South Dakota

Tennessee

Texas

990,000

3,699,000

732,000

5,320,000

19,128,000

Utah

Vermont

Virginia

Washington

West Virginia

Wisconsin

Wyoming

2,000,000

589,000

6,675,000

5,533,000

1,826,000

5,160,000

481,000

The principal authors of this notice

are Christopher J. Wilson of the Office

of Assistant Chief Counsel (Passthroughs and Special Industries) and

Timothy L. Jones of the Office of

Assistant Chief Counsel (Financial Institutions and Products). For further information regarding this notice contact Mr.

Wilson on (202) 622–3040 (not a tollfree call).

Deposits of Excise Taxes

Notice 97–15

The Internal Revenue Service will

issue regulations amending the deposit

requirements under the Excise Tax Procedural Regulations to limit the availability of the look-back quarter safe

harbor in cases where a new excise tax

is enacted or an expired excise tax is

reinstated.

Section 40.6302(c)–1(c)(2) currently

provides, generally, that a person can

satisfy excise tax deposit obligations for

a calendar quarter by depositing an

amount equal to the person’s excise tax

liability for the second preceding quarter

(the look-back quarter). For this purpose, the tax liability for the look-back

quarter must be computed at current

rates, but the safe harbor does not

specifically address the effect of the

enactment of a new tax law or the

reinstatement of an expired tax.

In 1996, the aviation excise taxes,

which expired on December 31, 1995,

were reinstated for the period from

August 27 through December 31, 1996.

Because the taxes were not in effect

during the first and second quarters of

1996, airlines relying on the safe harbor

have deposited very little of the air

transportation taxes they collected in

1996.

The Service believes such a delay is

inconsistent with the overall policy and

structure of the excise tax deposit rules.

Accordingly, the Service will modify the

look-back safe harbor to prevent similar

delays with respect to future tax law

changes.

The new regulations will provide that

the safe harbor based on look-back

quarter liability will not apply to deposits of a tax that was not in effect

throughout the look-back quarter. The

revised regulations will apply to liabilities attributable to tax law changes after

February 10, 1997. Persons required to

remit air transportation taxes for the first

quarter of 1997 will satisfy their deposit

obligation for amounts billed or tickets

sold in December 1996 if they deposit

their look-back quarter safe harbor

amount in accordance with current regulations.

The principal author of this notice is

Ruth Hoffman, Office of Assistant Chief

Counsel (Passthroughs and Special Industries). For further information regarding this notice contact Ruth Hoffman on (202) 622–3130 (not a toll-free

number).

Part IV. Item of General Interest

Notice of Proposed Rulemaking

and Notice of Public Hearing

Credit for Increasing Research

Activities

REG–209494–90

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

SUMMARY: This document contains

proposed regulations under section 41 of

the Internal Revenue Code of 1986

describing when computer software

which is developed by (or for the benefit of) a taxpayer primarily for the

taxpayer’s internal use can qualify for

the credit for increasing research activities. The proposed regulations reflect a

change to section 41 made by the Tax

Reform Act of 1986. This document

also provides notice of a public hearing

on these proposed regulations.

DATES: Comments and outlines of topics to be discussed at the public hearing

scheduled for May 13, 1997 must be

received by April 22, 1997.

ADDRESSES: Send submissions to:

CC:DOM:CORP:R (REG–209494–90),

room 5228, Internal Revenue Service,

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

hand delivered between the hours of 8

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

(REG–209494–90), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue NW, Washington, DC. Alternatively, taxpayers may submit

comments electronically via the Internet

by selecting the ‘‘Tax Regs’’ option of

the IRS Home Page, or by submitting

comments directly to the IRS Internet

site at: http://www.irs.ustreas.gov/prod/

tax_regs/comments.html. The public

hearing will be held in the auditorium,

Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Lisa

J. Shuman or Robert B. Hanson, 202–

622–3120; concerning submissions and

the hearing, Christina Vasquez, 202–

622–7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

Section 41 of the Internal Revenue

Code provides a credit against tax for

1997–8

I.R.B.

increasing research activities. Eligibility

for the credit is determined in part on

the definition of qualified research under section 41(d)(1). Section 231 of the

Tax Reform Act of 1986 (the 1986 Act),

1986–3 C.B. 1, 87, established a new

definition of qualified research for purposes of the research credit. Qualified

research was narrowed to require that

research be undertaken for the purpose

of discovering information that is technological in nature and the application

of which is intended to be useful in

developing a new or improved business

component of the taxpayer. In addition,

research is eligible for the credit only if

substantially all of the activities of the

research constitute elements of a process

of experimentation for a new or improved function, performance, or reliability or quality. Treasury and the IRS

request comments on the appropriate

explanation of the terms used in the

definition of qualified research under the

1986 Act, in particular, the term process

of experimentation.

Section 231 of the 1986 Act also

specified that expenditures incurred in

certain research, research-related, and

non-research activities are to be excluded from eligibility for the credit

without reference to the general requirements for credit eligibility. Under section 41(d)(4)(E) of the Code, except to

the extent provided in regulations, qualified research does not include research

with respect to computer software developed by (or for the benefit of) the

taxpayer primarily for the taxpayer’s

own use (internal-use software), other

than for use in (1) an activity which

constitutes qualified research, or (2) a

production process whose development

meets the requirements in section

41(d)(1) for qualified research (as where

the taxpayer is developing robotics and

software for the robotics for use in

operating a manufacturing process, and

the taxpayer’s research costs of developing the robotics are eligible for the

credit).

The legislative history indicates that

Congress intended to limit the credit for

the costs of developing internal-use software to software meeting a high threshold of innovation. In particular, Congress intended that regulations would

permit internal-use software to qualify

for the credit only if, in addition to

satisfying the general requirements for

credit eligibility, the taxpayer can establish that the following three-part test is

satisfied: the software is innovative (as

where the software results in a reduction

in cost, or improvement in speed, that is

substantial and economically significant); the software development involves significant risk (as where the

taxpayer commits substantial resources

to the development of the software and

there is substantial uncertainty, because

of technical risk, that such resources

would not be recovered in a reasonable

period of time); and the software is not

commercially available for use by the

taxpayer (as where the software cannot

be purchased, leased, or licensed and

used for the intended purpose without

modifications that would satisfy the first

two requirements). See H.R. Rep. No.

841, 99th Cong., 2d Sess. II–73. Thus,

Congress did not intend that the threepart test in the legislative history would

apply in lieu of the general requirements

for credit eligibility but, rather, intended

that the general requirements for credit

eligibility of section 41(d) also would

have to be satisfied. See H.R. Rep. No.

841 at II–73.

The legislative history indicates, however, that Congress did not intend the

internal-use software exclusion in section 41(d)(4)(E) to apply to research

related to the development of a new or

improved package of software and hardware developed as a single product of

which the software is an integral part,

and that is used directly by the taxpayer

in providing technological services to

customers in its trade or business (as

where a taxpayer develops together a

new or improved high technology medical or industrial instrument containing

software that processes and displays

data received by the instrument, or

where a telecommunications company

develops a package of new or improved

switching equipment plus software to

operate the switches). See H.R. Rep.

No. 841 at II–74.

Congress intended that regulations incorporating the three-part test in the

legislative history as an exception to the

exclusion from the definition of qualified research under section 41(d)(4)(E)

would be effective on the same date

section 41(d)(4)(E) became effective. In

Notice 87–12 (1987–1 C.B. 432), the

IRS stated that regulations to be issued

under section 41(d)(4)(E) would be effective for taxable years beginning after

December 31, 1985.

Explanation of Provisions

The proposed regulations follow the

legislative history and provide that

internal-use software that meets the general requirements of section 41(d), is

innovative, involves significant economic risk, and is not commercially

available for use by the taxpayer is not

excluded from eligibility for the research credit under section 41(d)(4)(E).

Under the proposed regulations, this is a

facts and circumstances test. Treasury

and the IRS request comments on facts

and circumstances, other than those factors enumerated in the legislative history, to be considered in determining

whether internal-use software satisfies

the three-part test.

The rules of 26 CFR 601.601(a)(3)

apply to the hearing.

Persons that wish to present oral

comments at the hearing must submit

(in the manner described in the ADDRESSES portion of this preamble)

comments and an outline of the topics

to be discussed and the time to be

devoted to each topic by April 22, 1997.

A period of 10 minutes will be allotted to each person for making comments.

An agenda showing the scheduling of

the speakers will be prepared after the

deadline for receiving outlines has

passed. Copies of the agenda will be

available free of charge at the hearing.

Proposed Effective Dates

Proposed Amendments to the

Regulations

The amendments are proposed to be

effective for taxable years beginning

after December 31, 1985.

Accordingly, 26 CFR parts 1 and 602

are proposed to be amended as follows:

Special Analyses

It has been determined that this notice

of proposed rulemaking is not a significant regulatory action as defined in EO

12866. Therefore, a regulatory assessment is not required. It also has been

determined that section 553(b) of the

Administrative Procedure Act (5 U.S.C.

chapter 5) does not apply to these

regulations, and because these regulations do not impose a collection of

information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter

6) does not apply. Therefore, a Regulatory Flexibility Analysis is not required.

Pursuant to section 7805(f) of the Internal Revenue Code, this notice of proposed rulemaking will be submitted to

the Chief Counsel for Advocacy of the

Small Business Administration for comment on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are

adopted as final regulations, consideration will be given to any comments

that are submitted timely (in the manner

described in the ADDRESSES portion

of this preamble) to the IRS. All comments will be available for public inspection and copying.

A public hearing has been scheduled

for May 13, 1997, at 10 a.m. in the

auditorium, Internal Revenue Building,

1111 Constitution Avenue, NW, Washington, DC. Because of access restrictions, visitors will not be admitted beyond the building lobby more than 15

minutes before the hearing starts.

PART 1—INCOME TAXES

Paragraph 1. The authority citation for

part 1 is amended by adding an entry in

numerical order to read as follows:

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

Section 1.41–4 also issued under 26

U.S.C. 41(d)(4)(E). * * *

Par. 2. Section 1.41–0 is amended by

revising the entry for § 1.41–4 to read

as follows:

§ 1.41–0 Table of contents.

§ 1.41–4 Qualified research for taxable

years beginning after December 31,

1985.

(a) through (d) [Reserved].

(e) Internal-use computer software.

(1) General rule.

(2) Requirements.

(3) Computer software and hardware

developed as a single product.

(4) Primarily for internal use.

(5) Special rule.

(6) Application of special rule.

(7) Effective date.

Par. 3. Section 1.41–4 is revised to

read as follows:

§ 1.41–4 Qualified research for taxable

years beginning after December 31,

1985.

(a) through (d) [Reserved].

(e) Internal-use computer software—

(1) General rule. Research with respect

to computer software that is developed

by (or for the benefit of) the taxpayer

primarily for the taxpayer’s internal use

is eligible for the research credit only if

the software satisfies the requirements

of paragraph (e)(2) of this section. Generally, research with respect to computer

software is not eligible for the research

credit where software is used internally,

for example, in general and administrative functions (such as payroll, bookkeeping, or personnel management) or

in providing noncomputer services (such

as accounting, consulting, or banking

services).

(2) Requirements. The requirements

of this paragraph (e)(2) are—

(i) The software satisfies the requirements of section 41(d)(1);

(ii) The software is not otherwise

excluded under section 41(d)(4) (other

than section 41(d)(4)(E)); and

(iii) One of the following conditions

is met—

(A) The taxpayer uses the software in

an activity that constitutes qualified research (other than the development of

the internal-use software itself);

(B) The taxpayer uses the software in

a production process that meets the

requirements of section 41(d)(1); or

rule of paragraph (e)(5) of this section.

(3) Computer software and hardware

developed as a single product. This

paragraph (e) does not apply to the

development costs of a new or improved

package of computer software and hardware developed together by the taxpayer

as a single product, of which the software is an integral part, that is used

directly by the taxpayer in providing

technological services in its trade or

business to customers. In these cases,

eligibility for the research credit is to be

determined by examining the combined

hardware-software product as a single

product.

(4) Primarily for internal use. All

relevant facts and circumstances are to

be considered in determining if computer software is developed primarily

for the taxpayer’s internal use. If computer software is developed primarily

for the taxpayer’s internal use, the requirements of this paragraph (e) apply

even though the taxpayer intends to, or

subsequently does, sell, lease, or license

the computer software.

(5) Special rule. Computer software

satisfies the special rule of this para-

1997–8

I.R.B.

graph (e)(5) only if the taxpayer can

establish that—

(i) The software is innovative (as

where the software results in a reduction

in cost, or improvement in speed, that is

substantial and economically significant);

(ii) The software development involves significant economic risk (as

where the taxpayer commits substantial

resources to the development and there

is a substantial uncertainty, because of

technical risk, that such resources would

be recovered within a reasonable period); and

(iii) The software is not commercially

available for use by the taxpayer (as

where the software cannot be purchased,

leased, or licensed and used for the

intended purpose without modifications

that would satisfy the requirements of

paragraphs (e)(5)(i) and (ii) of this section).

(6) Application of special rule. In

determining if the special rule of paragraph (e)(5) of this section is satisfied

all of the facts and circumstances are

considered. The special rule allows the

costs of developing internal-use software

to be eligible for the research credit

only if the software meets a high threshold of innovation. The facts and circumstances analysis takes into account only

the results attributable to the development of the new or improved software

independent of the effect of any modifications to related hardware or other

software. The weight given to any fact

or circumstance will depend on the

particular case.

(7) Effective date. This paragraph (e)

is applicable for taxable years beginning

after December 31, 1985.

§§ 1.41–0A through

1.41–8A [Removed]

Par. 4. Sections 1.41–0A through

1.41–8A and

the

undesignated

centerheading preceding these sections

are removed.

PART 602—OMB CONTROL NUMBERS UNDER THE PAPERWORK

REDUCTION ACT

Par. 5. The authority citation for part

602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 6. In § 602.101, paragraph (c) is

amended by removing the following

entries from the table:

1997–8

I.R.B.

§ 602.101 OMB Control numbers.

CFR part or section

where identified and

described

Current OMB

control No.

1.41–4A. . . . . . . . . . . . . . 1545–0074

1.41–4(b) and (c) . . . . . . 1545–0074

Margaret Milner Richardson,

Commissioner of Internal Revenue.

(Filed by the Office of the Federal Register on

December 31, 1996, 8:45 a.m., and published in

the issue of the Federal Register for January 2,

1997, 62 F.R. 81)

Notice of Proposed Rulemaking

and Notice of Public Hearing

Determination of Earned Premiums

REG–209839–96

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

SUMMARY: This document contains

proposed regulations relating to the requirement that insurance companies

other than life insurance companies reduce by 20 percent their deductions for

increases in unearned premiums. This

requirement was enacted as part of the

Tax Reform Act of 1986. These regulations are necessary in order to provide

guidance to nonlife insurance companies

that are subject to the 20 percent reduction rule. This document also contains a

notice of a public hearing on the proposed regulations.

DATES: Written comments must be received by April 2, 1997. Requests to

speak and outlines of oral comments to

be discussed at the public hearing

scheduled for April 30, 1997 at 10:00

a.m. must be received by April 2, 1997.

ADDRESSES: Send submissions to:

CC:DOM:CORP:R (REG–209839–96),

room 5226, Internal Revenue Service,

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

hand delivered between the hours of 8

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

REG–209839–96), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue NW, Washington, DC. Alternatively, taxpayers may submit

comments electronically via the internet

by selecting the ‘‘Tax Regs’’ option on

the IRS Home Page, or by submitting

comments directly to the IRS internet

site at http://www.irs.ustreas.gov/prod/

tax_regs/comments.html. The public

hearing will be held in the Auditorium,

Internal Revenue Service Building, 1111

Constitution Avenue NW, Washington,

DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Gary

Geisler, (202) 622–3970; concerning

submissions and the hearing, Evangelista

Lee, (202) 622–7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

A nonlife insurance company’s underwriting income equals its premiums

earned on insurance contracts during the

taxable year less its losses incurred and

its expenses incurred. For taxable years

beginning on or after January 1, 1993, a

company’s premiums earned on insurance contracts during the taxable year is

an amount equal to the gross premiums

written on insurance contracts during the

taxable year, less return premiums and

premiums paid for reinsurance, plus 80

percent of unearned pre

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