Application of the Grantor Trust Rules to Nonexempt Employees' Trusts

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-209826-96]

RIN 1545-AU29

Application of the Grantor Trust Rules to Nonexempt Employees'

Trusts

AGENCY: Internal Revenue Service (IRS), Treasury.

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

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SUMMARY: This document contains proposed regulations relating to the

application of the grantor trust rules to nonexempt employees' trusts.

The proposed regulations clarify that the grantor trust rules generally

do not apply to domestic nonexempt employees' trusts, and clarify the

interaction between the grantor trust rules, the rules generally

governing the taxation of nonqualified deferred compensation

arrangements, and the antideferral rules for United States persons

holding interests in foreign entities. The proposed regulations affect

nonexempt employees' trusts funding deferred compensation arrangements,

as well as U.S. persons holding interests in certain foreign

corporations and foreign partnerships with deferred compensation

arrangements funded through foreign nonexempt employees' trusts. In

addition, the proposed regulations affect U.S. persons that have

deferred compensation arrangements funded through certain foreign

nonexempt employees' trusts. This document also provides notice of a

public hearing on these proposed regulations.

DATES: Written comments must be received by December 26, 1996. Requests

to speak (with outlines of oral comments to be discussed) at the public

hearing scheduled for January 15, 1997, at 10:00 a.m. must be submitted

by December 24, 1996.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-209826-96), 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-209826-96), Courier's

Desk, Internal Revenue Service, 1111 Constitution Avenue, NW.,

Washington, DC. The public hearing will be held in room 2615, Internal

Revenue Building, 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.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, James A.

Quinn, (202) 622-3060; Linda S. F. Marshall, (202) 622-6030; Kristine

K. Schlaman (202) 622-3840; and M. Grace Fleeman (202) 622-3850;

concerning submissions and the hearing, Michael Slaughter, (202) 622-

7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in this notice of proposed

rulemaking has been submitted to the Office of Management and Budget

for review in accordance with the Paperwork Reduction Act of 1995 (44

U.S.C. 3507(d)). Comments on the collection of information should be

sent to the Office of Management and Budget, Attn: Desk Officer for the

Department of the Treasury, Office of Information and Regulatory

Affairs, Washington, DC 20503, with copies to the Internal Revenue

Service, Attn: IRS Reports Clearance Officer, T:FP, Washington, DC

20224. Comments on the collection of information should be received by

November 26, 1996. Comments are specifically requested concerning:

Whether the proposed collection of information is necessary for the

proper performance of the functions of the Internal Revenue Service,

including whether the information will have practical utility;

The accuracy of the estimated burden associated with the proposed

collection of information (see below);

How the quality, utility, and clarity of the information to be

collected may be enhanced;

How the burden of complying with the proposed collection of

information may be minimized, including through the application of

automated collection techniques or other forms of information

technology; and

Estimates of capital or start-up costs and costs of operation,

maintenance, and purchase of services to provide information.

The collection of information in this proposed regulation is in

Sec. 1.671-1(h)(3)(iii). This information is required by the IRS to

determine accurately the portion of certain foreign employees' trusts

properly treated as owned by the employer. This information will be

used to notify the Commissioner that certain

[[Page 50779]]

entities are relying on an exception for reasonable funding. The

collection of information is mandatory. The likely respondents are

businesses or other for-profit organizations.

Estimated total annual reporting burden: 1,000 hours.

The estimated annual burden per respondent varies from .5 hours to

1.5 hours, depending on individual circumstances, with an estimated

average of 1 hour.

Estimated number of respondents: 1,000.

Estimated annual frequency of responses: On occasion.

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

to respond to, a collection of information unless the collection of

information displays a valid control number assigned by the Office of

Management and Budget.

Books or records relating to a collection of information must be

retained as long as their contents may become material in the

administration of any internal revenue law. Generally, tax returns and

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

Background

On May 7, 1993, the IRS issued proposed regulations under section

404A (58 FR 27219). The section 404A proposed regulations provide that

section 404A is the exclusive means by which an employer may take a

deduction or reduce earnings and profits for amounts used to fund

deferred compensation in situations other than those in which a

deduction or reduction of earnings and profits is permitted under

section 404 (the ``exclusive means'' rule).

The section 404A proposed regulations do not provide rules

regarding the treatment of income and ownership of assets of foreign

trusts established to fund deferred compensation arrangements, but

refer to ``other applicable provisions,'' including the grantor trust

rules of subpart E of the Internal Revenue Code of 1986, as amended.

Thus, the 1993 proposed section 404A regulations imply that, if an

employer cannot or does not elect section 404A treatment for a foreign

trust established to fund the employer's deferred compensation

arrangements, the employer may be treated as the owner of the entire

trust for purposes of subtitle A of the Code under sections 671 through

679 even though all or part of the trust assets are set aside for

purposes of satisfying liabilities under the plan. Conversely, some

commentators believe that, for U.S. tax purposes, a foreign employer

would not be treated as the owner of any portion of a foreign trust

established to fund a section 404A qualified foreign plan even though

all or part of the trust assets might be used for purposes other than

satisfying liabilities under the plan. A number of different rules, in

addition to the grantor trust rules, potentially affect the taxation of

foreign trusts established to fund deferred compensation arrangements.

These rules include: the nonexempt deferred compensation trust rules of

sections 402(b) and 404(a)(5); the partnership rules of subchapter K;

and the antideferral rules, which include subpart F and the passive

foreign investment company (PFIC) rules (sections 1291 through 1297).

Following publication of the proposed 1993 regulations and

enactment of section 956A in August of 1993, comments were received

concerning both the asset ownership rules for foreign employees' trusts

and the ``exclusive means'' rule for deductions or reductions in

earnings and profits. These proposed regulations address only comments

concerning income and asset ownership rules for foreign employees'

trusts for federal income tax purposes. A foreign employees' trust is a

nonexempt employees' trust described in section 402(b) that is part of

a deferred compensation plan, and that is a foreign trust within the

meaning of section 7701(a)(31). Comments concerning the ``exclusive

means'' rule will be addressed in future regulations.

Statutory Background

1. Transfers of Property Not Complete for Tax Purposes

In certain situations, assets that are owned by a trust as a legal

matter may be treated as owned by another person for tax purposes.

Thus, assets may be treated as owned by a pension trust for non-tax

legal purposes but not for tax purposes. This occurs, for example, if

the person who has purportedly transferred assets to the trust retains

the benefits and burdens of ownership. See, e.g., Frank Lyon Co. v.

United States, 435 U.S. 561 (1978); Corliss v. Bowers, 281 U.S. 376

(1930); Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221

(1981); Rev. Proc. 75-21 (1975-1 C.B. 715). If, under these principles,

no assets have been transferred to an employees' trust for federal tax

purposes, these proposed regulations do not apply.

2. Subpart E--Grantors and Others Treated as Substantial Owners

Even if there has been a completed transfer of trust assets, the

subpart E rules may apply to treat the grantor as the owner of a

portion of the trust for federal income tax purposes. Subpart E of part

I of subchapter J, chapter 1 of the Code (sections 671 through 679)

taxes income of a trust to the grantor or another person

notwithstanding that the grantor or other person may not be a

beneficiary of the trust. Under section 671, a grantor or another

person includes in computing taxable income and credits those items of

income, deduction, and credit against tax that are attributable to or

included in any portion of a trust of which that person is treated as

the owner.

Sections 673 through 679 set forth the rules for determining when

the grantor or another person is treated as the owner of a portion of a

trust for federal income tax purposes. Under sections 673 through 678,

the grantor trust rules apply only if the grantor or other person has

certain powers or interests. For example, section 676 provides that the

grantor is treated as the owner of a portion of a trust where, at any

time, the power to revest in the grantor title to that portion is

exercisable by the grantor or a nonadverse party, or both. A grantor

who is the owner of a trust under subpart E is treated as the owner of

the trust property for federal income tax purposes. See Rev. Rul. 85-13

(1985-1 C.B. 184). This document is made available by the

Superintendent of Documents, U.S. Government Printing Office,

Washington, DC 20402.

Section 679 generally applies to a U.S. person who directly or

indirectly transfers property to a foreign trust, subject to certain

exceptions described below. Section 679 generally treats a U.S. person

transferring property to a foreign trust as the owner of the portion of

the trust attributable to the transferred property for any taxable year

of that person for which there is a U.S. beneficiary of any portion of

the trust. In general, a trust is treated as having a U.S. beneficiary

for a taxable year of the U.S. transferor unless, under the terms of

the trust, no part of the income or corpus of the trust may be paid or

accumulated during the taxable year to or for the benefit of a U.S.

person, and unless no part of the income or corpus of the trust could

be paid to or for the benefit of a U.S. person if the trust were

terminated at any time during the taxable year. A U.S. person is

treated as having made an indirect transfer to the foreign trust of

property if a non-U.S. person acts as a conduit with respect to the

transfer or if the U.S. person has sufficient control over the non-U.S.

person to direct the transfer by the non-U.S. person rather than

itself.

[[Page 50780]]

Section 679(a) provides several exceptions from the application of

section 679 for certain compensatory trusts. Under these exceptions,

section 679 does not apply to a trust described in section 404(a)(4) or

section 404A. Pursuant to amendments made in section 1903(b) of the

Small Business Job Protection Act of 1996 (SBJPA), section 679 also

does not apply to any transfer of property after February 6, 1995, to a

trust described in section 402(b).

3. Taxability of Beneficiary of Nonexempt Employees' Trust

Section 402(b) provides rules for the taxability of beneficiaries

of a nonexempt employees' trust. Under section 402(b)(1), employer

contributions to a nonexempt employees' trust generally are included in

the gross income of the employee in accordance with section 83. Section

402(b)(2) provides that amounts distributed or made available from a

nonexempt employees' trust generally are taxable to the distributee

under the rules of section 72 in the taxable year in which distributed

or made available. Section 402(b)(4) provides that, under certain

circumstances, a highly compensated employee is taxed each year on the

employee's vested accrued benefit (other than the employee's investment

in the contract) in a nonexempt employees' trust. Under section

402(b)(3), a beneficiary of a nonexempt employees' trust generally is

not treated as the owner of any portion of the trust under subpart E.

The rules of section 402(b) apply to a beneficiary of a nonexempt

employees' trust regardless of whether the trust is a domestic trust or

a foreign trust.

4. Employer Deduction for Contributions to a Nonexempt Employees' Trust

Section 404(a)(5) provides rules regarding the deductibility of

contributions to a nonqualified deferred compensation plan. Under

section 404(a)(5), any contribution paid by an employer under a

deferred compensation plan, if otherwise deductible under chapter 1 of

the Code, is deductible only in the taxable year in which an amount

attributable to the contribution is includible in the gross income of

employees participating in the plan, and only if separate accounts are

maintained for each employee. Section 1.404(a)-12(b)(1) clarifies that

an employer's deduction for contributions to a nonexempt employees'

trust is restricted to the amount of the contribution, and excludes any

income received by the trust with respect to contributed amounts.

5. The Partnership Rules of Subchapter K

A partnership is not subject to income taxation. However, a partner

must take into account separately on its return its distributive share

of the partnership's income, gain, loss, deduction, or credit. A U.S.

partner of a foreign partnership is subject to U.S. tax on its

distributive share of partnership income. In addition, a foreign

partnership may have a controlled foreign corporation (CFC) partner

which must take into account its distributive share of partnership

income, gain, loss, or deduction in determining its taxable income.

These distributive share inclusions of the CFC may result in subpart F

income and thus income to a U.S. shareholder of the CFC. If the grantor

trust rules do not apply to any portion of a foreign employees' trust,

a foreign partnership could fund a foreign employees' trust in excess

of the amount needed to meet its obligations to its employees under its

deferred compensation plan and yet retain control over the excess

amount. As a result, the foreign partnership would not have to include

items in taxable income attributable to the excess amount, and

consequently the U.S. partner or CFC would not have to include those

items in its income.

6. The Antideferral Rules of Subpart F, Including Section 956A, and

PFIC

A U.S. person that owns stock in a foreign corporation generally

pays no U.S. tax currently on income earned by the foreign corporation.

Instead, the United States defers taxation of that income until it is

distributed to the U.S. person. The antideferral rules, however, which

include subpart F and the PFIC rules, limit this deferral in certain

situations.

Subpart F of part III of Subchapter N (sections 951 through 964)

applies to CFCs. A foreign corporation is a CFC if more than 50 percent

of the total voting power of all classes of stock entitled to vote, or

the total value of the stock in the corporation, is owned by ``U.S.

shareholders'' (defined as U.S. persons who own ten percent or more of

the voting power of all classes of stock entitled to vote) on any day

during the foreign corporation's taxable year. The United States

generally taxes U.S. shareholders of the CFC currently on their pro

rata share of the CFC's subpart F income and sections 956 and 956A

amounts. In effect, the U.S. shareholders are treated as having

received a distribution out of the earnings and profits (E&P) of the

CFC.

The types of income earned by a foreign employees' trust

(dividends, interest, income equivalent to interest, rents and

royalties, and annuities) are generally subpart F income. The inclusion

under section 956 is based on the CFC's investment in U.S. property,

which generally includes stock of a U.S. shareholder of the CFC. A U.S.

shareholder's section 956A amount for a taxable year is the lesser of

two amounts. The first amount is the excess of the U.S. shareholder's

pro rata share of the CFC's ``excess passive assets'' over the portion

of the CFC's E&P treated as previously included in gross income by the

U.S. shareholder under section 956A. For purposes of section 956A,

``passive asset'' includes any asset which produces (or is held for the

production of) passive income, and generally includes property that

produces dividends, interest, income equivalent to interest, rents and

royalties, and annuities, subject to exceptions that generally are not

relevant in this context. The second amount is the U.S. shareholder's

pro rata share of the CFC's ``applicable earnings'' to the extent

accumulated in taxable years beginning after September 30, 1993.

Section 1501(a)(2) of SBJPA repeals section 956A. The repeal is

effective for taxable years of foreign corporations beginning after

December 31, 1996, and for taxable years of U.S. shareholders with or

within which such taxable years of foreign corporations end.

If a CFC employer is not treated for federal income tax purposes as

the owner of any portion of a foreign employees' trust under the

grantor trust rules, then to the extent that passive assets contributed

by a CFC to a nonexempt employees' trust would otherwise result in

subpart F consequences for the CFC and its shareholders, the CFC's

contribution could allow those consequences to be avoided. For example,

a contribution by a CFC of passive assets to its foreign employees'

trust could reduce the CFC's subpart F earnings and profits, and its

applicable earnings or passive assets for section 956A purposes, and

could affect the CFC's increase in investment in U.S. property for

purposes of section 956, all of which could affect a U.S. shareholder's

pro rata subpart F inclusions for the taxable year.

In contrast to the subpart F rules, the PFIC rules apply to any

U.S. person who directly or indirectly owns any stock in a foreign

corporation that is a PFIC under either an income or asset test. A

foreign corporation, including a CFC, is

[[Page 50781]]

a PFIC if either (1) 75 percent or more of its gross income for the

taxable year is passive income or (2) at least 50 percent of the value

of the corporation's assets produce passive income or are held for the

production of passive income. For this purpose, passive income

generally is the same type of income (dividends, interest, income

equivalent to interest, rents and royalties, and annuities) that would

be earned by a foreign employees' trust.

Under the PFIC rules, a U.S. person who is a direct or indirect

shareholder of a PFIC is subject to a special tax regime upon either

disposition of the PFIC's stock or receipt of certain distributions

(excess distributions) from the PFIC. A shareholder, however, may avoid

the application of this special regime by electing to include its pro

rata share of certain of the PFIC's passive income in the year in which

the foreign corporation earns it.

If the grantor trust rules did not apply to any portion of a

foreign employees' trust, a contribution by a foreign corporation of

passive assets to a nonexempt employees' trust would enable a U.S.

person to avoid the PFIC rules if those assets would otherwise generate

PFIC consequences for the foreign corporation and its shareholders. For

example, by transferring passive assets to its nonexempt employees'

trust in excess of the amount needed to meet obligations to its

employees under its deferred compensation plan while retaining control

over the excess amount, a foreign corporation could divest itself of a

sufficient amount of passive assets and the passive income they produce

to avoid meeting the income and asset tests. Furthermore, a foreign

corporation that is a PFIC could minimize income inclusions for a U.S.

shareholder that has made an election to include PFIC income currently

by transferring income-producing assets to a foreign employees' trust.

Overview of Proposed Regulations

Under the proposed regulations, an employer is not treated as an

owner of any portion of a domestic nonexempt employees' trust described

in section 402(b) for federal income tax purposes. Section 404(a)(5)

and Sec. 1.404(a)-12(b) provide a deduction to the employer solely for

contributions to a nonexempt employees' trust, and not for any income

of the trust. This rule is inconsistent with treating the employer as

owning any portion of a nonexempt employees' trust, which would require

the employer to recognize the trust's income that it may not deduct

under section 404(a)(5). Accordingly, such a trust is treated as a

separate taxable trust that is taxed under the rules of section 641 et

seq. The rule in the proposed regulations is consistent with the

holdings of a number of private letter rulings with respect to

nonexempt employees' trusts and with the Service's treatment of trusts

that no longer qualify as exempt under 501(a) (because they are no

longer described in section 401(a)) as separate taxable trusts rather

than as grantor trusts. See also Rev. Rul. 74-299 (1974-1 C.B. 154).

This document is made available by the Superintendent of Documents,

U.S. Government Printing Office, Washington, DC 20402.

Under the proposed regulations, an employer generally is not

treated as the owner of any portion of a foreign nonexempt employees'

trust for federal income tax purposes, except as provided under section

679. The proposed regulations, however, also provide that the grantor

trust rules apply to determine whether an employer that is a CFC or a

U.S. employer is treated as the owner of a specified ``fractional

interest'' in a foreign employees' trust. This rule applies whether or

not the employer elects section 404A treatment for the trust. Under the

proposed regulations, this rule also applies in the case of an employer

that is a foreign partnership with one or more partners that are U.S.

persons or CFCs (U.S.-related partnership). Such an employer is treated

as the owner of a portion of a foreign employees' trust under these

proposed regulations only if the employer retains a grantor trust power

or interest over a foreign employees' trust and has a specified

``fractional interest'' in the trust.

Under these proposed regulations, the grantor trust rules of

subpart E do not apply to a foreign employees' trust with respect to a

foreign employer other than a CFC or a U.S.-related foreign

partnership, except for cases in which assets are transferred to a

foreign employees' trust with a principal purpose of avoiding the PFIC

rules. The IRS and Treasury will continue to consider whether these

regulations should provide additional antiabuse rules that may be

necessary for other purposes, including for purposes of calculating

earnings and profits, determining the foreign tax credit limitation,

and applying the interest allocation rules of Sec. 1.882-5.

Explanation of Provisions

1. Sec. 1.671-1(g): Domestic Nonexempt Employees' Trusts

The proposed regulations provide that an employer is not treated

for federal income tax purposes as an owner of any portion of a

nonexempt employees' trust described in section 402(b) that is part of

a deferred compensation plan, and that is not a foreign trust within

the meaning of section 7701(a)(31), regardless of whether the employer

has a power or interest described in sections 673 through 677 over any

portion of the trust. This rule is analogous to the rule set forth in

Sec. 1.641(a)-0, which provides that subchapter J, including the

grantor trust rules, does not apply to tax-exempt employees' trusts.

2. Sec. 1.671-1(h): Subpart E Rules for Certain Foreign Employees'

Trusts

The proposed regulations provide Subpart E rules for foreign

employees' trusts of CFCs, foreign partnerships, and U.S. employers

that apply for all federal income tax purposes. Under the proposed

regulations, except as provided under section 679 or the proposed

regulations (as described below), an employer is not treated as an

owner of any portion of a foreign employees' trust for federal income

tax purposes. If an employer is treated as the owner of a portion of a

foreign employees' trust for federal income tax purposes as described

below, then the employer is considered to own the trust assets

attributable to that portion of the trust for all federal income tax

purposes. Thus, for example, if an employer is treated as the owner of

a portion of a foreign employees' trust for federal income tax purposes

as described below, then income of the trust that is attributable to

that portion of the trust increases the employer's earnings and profits

for purposes of sections 312 and 964.

A foreign employees' trust is a nonexempt employees' trust

described in section 402(b) that is part of a deferred compensation

plan, and that is a foreign trust within the meaning of section

7701(a)(31). The proposed regulations apply to any foreign employees'

trust of a CFC or U.S.-related foreign partnership, whether or not a

trust funds a qualified foreign plan (as defined in section 404A(e)).

The proposed regulations clarify that the income inclusion and asset

ownership rules apply to the entity whose employees or independent

contractors are covered under the deferred compensation plan.

A. Plan of CFC Employer

The proposed regulations provide that, if a CFC maintains a

deferred compensation plan funded through a foreign employees' trust,

then, with respect to the CFC, the provisions of subpart E apply to the

portion of the

[[Page 50782]]

trust that is the fractional interest of the trust described in the

proposed regulations.

B. Plan of U.S. Employer

The proposed regulations provide that if a U.S. person maintains a

deferred compensation plan funded through a foreign employees' trust,

then, with respect to the U.S. person, the provisions of subpart E

apply to the portion of the trust that is the fractional interest of

the trust described in the proposed regulations.

C. Plan of U.S.-Related Foreign Partnership Employer

The proposed regulations provide that, if a U.S.-related foreign

partnership maintains a deferred compensation plan funded through a

foreign employees' trust, then, with respect to the U.S.-related

foreign partnership, the provisions of subpart E apply to the portion

of the trust that is the fractional interest of the trust described in

the proposed regulations. The IRS and Treasury solicit comments on

whether these regulations should provide a safe harbor rule for a U.S.-

related foreign partnership that maintains a deferred compensation plan

funded through a foreign employees' trust if U.S. or CFC partnership

interests are de minimis. The IRS and Treasury specifically solicit

comments concerning the amount of U.S. or CFC partnership interests

that would qualify as ``de minimis.''

D. Plan of Non-CFC Foreign Employer

The proposed regulations provide that a foreign employer that is

not a CFC is treated as an owner of a portion of a foreign employees'

trust only as provided in the antiabuse rule of Sec. 1.1297-4.

E. Fractional Interest

The fractional interest of a foreign employees' trust described

above is defined in the proposed regulations as an undivided fractional

interest in the trust for which the fraction is equal to the relevant

amount determined for the employer's taxable year divided by the fair

market value of trust assets determined for the employer's taxable

year.

F. Relevant Amount

The relevant amount for the employer's taxable year is defined in

the proposed regulations as the amount, if any, by which the fair

market value of trust assets, plus the fair market value of any assets

available to pay plan liabilities (including any amount held under an

annuity contract that exceeds the amount that is needed to satisfy the

liabilities provided for under the contract) that are held in the

equivalent of a trust within the meaning of section 404A(b)(5)(A),

exceed the plan's accrued liability, determined using a projected unit

credit funding method.

The relevant amount is reduced to the extent the taxpayer

demonstrates to the Commissioner that the relevant amount is

attributable to amounts that were properly contributed to the trust

pursuant to a reasonable funding method, or experience that is

favorable relative to any actuarial assumptions used that the

Commissioner determines to be reasonable. In addition, if an employer

that is a controlled foreign corporation otherwise would be treated as

the owner of a fractional interest in a foreign employees' trust, the

taxpayer may rely on this rule only if it so indicates on a statement

attached to a timely filed Form 5471. The IRS and Treasury solicit

comments regarding the most appropriate way in which to extend a filing

requirement to partners in U.S.-related foreign partnerships and other

affected taxpayers.

G. Plan's Accrued Liability

Under the proposed regulations, the plan's accrued liability for a

taxable year of the employer is computed as of the plan's measurement

date for the employer's taxable year. The plan's accrued liability is

determined using a projected unit credit funding method, taking into

account only liabilities relating to services performed for the

employer or a predecessor employer. In addition, the plan's accrued

liability is reduced (but not below zero) by any liabilities that are

provided for under annuity contracts held to satisfy plan liabilities.

Because CFCs generally are required to determine their taxable

income by reference to U.S. tax principles, the definition of a plan's

``accrued liability'' refers to Sec. 1.412(c)(3)-1. This definition

generally is intended to track the method used for calculating pension

costs under Statement of Financial Accounting Standards No. 87,

Employers' Accounting for Pensions (FAS 87), available from the

Financial Accounting Standards Board, 401 Merritt 7, Norwalk, CT 06856.

Under the method required to be used to calculate FAS 87's projected

benefit obligation (PBO), plan costs are based on projected salary

levels. Because many taxpayers already compute PBO annually to

determine the pension costs of their nonexempt employees' trusts for

financial reporting, the timing, interval and method to compute plan

liabilities under Sec. 1.671-1(h) should minimize taxpayer burden. The

IRS and Treasury solicit comments regarding the extent to which the

proposed regulations conform to existing procedures under FAS 87 and

applicable foreign law, and regarding appropriate conforming

adjustments.

H. Fair Market Value of Trust Assets

Under the proposed regulations, for a taxable year of the employer,

the fair market value of trust assets, and the fair market value of

retirement annuities or other assets held in the equivalent of a trust,

equals the fair market value of those assets, as of the measurement

date for the employer's taxable year. The fair market value of these

assets is adjusted to include contributions made between the

measurement date and the end of the employer's taxable year.

I. De Minimis Exception

The proposed regulations provide an exception to the general rule

for determining the relevant amount. If the relevant amount would not

otherwise be greater than the plan's normal cost for the plan year

ending with or within the employer's taxable year, then the relevant

amount is considered to be zero.

J. Proposed Effective Date and Transition Rules

The proposed regulations are proposed to be prospective. For

taxable years ending prior to September 27, 1996, employers generally

would not be treated for federal income tax purposes as owning the

assets of foreign nonexempt employees' trusts (except as provided under

section 679), consistent with the rules applying to domestic nonexempt

employees' trusts. A transition rule, for purposes of Sec. 1.671-1(h),

exempts certain amounts from the application of the proposed

regulations. This exemption is phased out over a ten-year period. There

is a special transition rule for any foreign corporation that becomes a

CFC after September 27, 1996. In addition, there is a special

transition rule for certain entities that become U.S.-related foreign

partnerships after September 27, 1996.

3. Sec. 1.671-2: General Asset Ownership Rules

The proposed regulations provide that a person who is treated as

the owner of any portion of a trust under subpart E is considered to

own the trust assets attributable to that portion of the trust for all

federal income tax purposes.

[[Page 50783]]

4. Sec. 1.1297-4: Subpart E Rules for Foreign Employers That Are Not

Controlled Foreign Corporations

Under the proposed regulations, a foreign employer other than a CFC

is not treated as the owner of any portion of a foreign nonexempt

employees' trust for purposes of sections 1291 through 1297, except for

cases in which a principal purpose for transferring property to the

trust is to avoid classification of a foreign corporation as a PFIC (as

defined in section 1296) or, if the foreign corporation is classified

as a PFIC, in cases in which a principal purpose for transferring

property to the trust is to avoid or to reduce taxation of U.S.

shareholders of the PFIC under section 1291 or 1293. The effective date

of this rule is September 27, 1996.

Income Inclusion and Related Asset Ownership Rules for Foreign Welfare

Benefit Plans

The IRS and Treasury solicit comments on the need for (and content

of) income inclusion and asset ownership rules for foreign welfare

benefit trusts.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in Executive Order

12866. Therefore, a regulatory assessment is not required. It is hereby

certified that these regulations do not have a significant economic

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

based on the fact that these regulations will primarily affect U.S.

owners of significant interests in foreign entities, which owners

generally are large multinational corporations. This certification is

also based on the fact that the burden imposed by the collection of

information in the regulation, which is a requirement that certain

entities may rely on an exception for reasonable funding only if they

indicate such reliance on a statement attached to a timely filed Form

5471, is minimal, and, therefore, the collection of information will

not impose a significant economic impact on such entities. Therefore, a

Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5

U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of the

Internal Revenue Code, this notice of proposed rulemaking will be

submitted to the Chief Counsel for Advocacy of the Small Business

Administration for comment on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any written comments (a signed original

and eight (8) copies) that are submitted timely to the IRS. All

comments will be available for public inspection and copying.

A public hearing has been scheduled for January 15, 1997, at 10:00

a.m. in room 2615, Internal Revenue Building, 1111 Constitution Avenue,

NW., Washington DC. Because of access restrictions, visitors will not

be admitted beyond the Internal Revenue Building lobby more than 15

minutes before the hearing starts.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons that wish to present oral comments at the hearing must

submit written comments by December 26, 1996, and submit an outline of

the topics to be discussed and the time to be devoted to each topic

(signed original and eight (8) copies) by December 24, 1996.

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

comments.

An agenda showing the scheduling of the speakers will be prepared

after the deadline for receiving outlines has passed. Copies of the

agenda will be available free of charge at the hearing.

Drafting Information

The principal authors of these regulations are James A. Quinn of

the Office of Assistant Chief Counsel (Passthroughs and Special

Industries), Linda S. F. Marshall of the Office of Associate Chief

Counsel (Employee Benefits and Exempt Organizations), and Kristine K.

Schlaman and M. Grace Fleeman of the Office of Associate Chief Counsel

(International). However, other personnel from the IRS and Treasury

Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

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

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by

removing the entry for sections 1.1291-10T, 1.1294-1T, 1.1295-1T, and

1.1297-3T and adding entries in numerical order to read as follows:

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

Section 1.671-1 also issued under 26 U.S.C. 404A(h) and

672(f)(2)(B). * * *

Section 1.1291-10T also issued under 26 U.S.C. 1291(d)(2).

Section 1.1294-1T also issued under 26 U.S.C. 1294.

Section 1.1295-1T also issued under 26 U.S.C. 1295.

Section 1.1297-3T also issued under 26 U.S.C. 1297(b)(1).

Section 1.1297-4 also issued under 26 U.S.C. 1297(f). * * *

Par. 2. Section 1.671-1 is amended by adding paragraphs (g) and (h)

to read as follows:

Sec. 1.671-1 Grantors and others treated as substantial owners; scope.

* * * * *

(g) Domestic nonexempt employees' trust--(1) General rule. An

employer is not treated as an owner of any portion of a nonexempt

employees' trust described in section 402(b) that is part of a deferred

compensation plan, and that is not a foreign trust within the meaning

of section 7701(a)(31), regardless of whether the employer has a power

or interest described in sections 673 through 677 over any portion of

the trust. See section 402(b)(3) and Sec. 1.402(b)-1(b)(6) for rules

relating to treatment of a beneficiary of a nonexempt employees' trust

as the owner of a portion of the trust.

(2) Example. The following example illustrates the rules of

paragraph (g)(1) of this section:

Example. Employer X provides nonqualified deferred compensation

through Plan A to certain of its management employees. Employer X

has created Trust T to fund the benefits under Plan A. Assets of

Trust T may not be used for any purpose other than to satisfy

benefits provided under Plan A until all plan liabilities have been

satisfied. Trust T is classified as a trust under Sec. 301.7701-4 of

this chapter, and is not a foreign trust within the meaning of

section 7701(a)(31). Under Sec. 1.83-3(e), contributions to Trust T

are considered transfers of property to participants within the

meaning of section 83. On these facts, Trust T is a nonexempt

employees' trust described in section 402(b). Because Trust T is a

nonexempt employees' trust described in section 402(b) that is part

of a deferred compensation plan, and that is not a foreign trust

within the meaning of section 7701(a)(31), Employer X is not treated

as an owner of any portion of Trust T.

(h) Foreign employees' trust--(1) General rules. Except as provided

under section 679 or as provided under this paragraph (h)(1), an

employer is not treated as an owner of any portion of a foreign

employees' trust (as defined in paragraph (h)(2) of this section),

regardless of whether the employer has a power or interest described in

sections

[[Page 50784]]

673 through 677 over any portion of the trust.

(i) Plan of CFC employer. If a controlled foreign corporation (as

defined in section 957) maintains a deferred compensation plan funded

through a foreign employees' trust, then, with respect to the

controlled foreign corporation, the provisions of subpart E apply to

the portion of the trust that is the fractional interest described in

paragraph (h)(3) of this section.

(ii) Plan of U.S. employer. If a United States person (as defined

in section 7701(a)(30)) maintains a deferred compensation plan that is

funded through a foreign employees' trust, then, with respect to the

U.S. person, the provisions of subpart E apply to the portion of the

trust that is the fractional interest described in paragraph (h)(3) of

this section.

(iii) Plan of U.S.-related foreign partnership employer--(A)

General rule. If a U.S.-related foreign partnership (as defined in

paragraph (h)(1)(iii)(B) of this section) maintains a deferred

compensation plan funded through a foreign employees' trust, then, with

respect to the U.S.-related foreign partnership, the provisions of

subpart E apply to the portion of the trust that is the fractional

interest described in paragraph (h)(3) of this section.

(B) U.S.-related foreign partnership. For purposes of this

paragraph (h), a U.S.-related foreign partnership is a foreign

partnership in which a U.S. person or a controlled foreign corporation

owns a partnership interest either directly or indirectly through one

or more partnerships.

(iv) Application of Sec. 1.1297-4 to plan of foreign non-CFC

employer. A foreign employer that is not a controlled foreign

corporation may be treated as an owner of a portion of a foreign

employees' trust as provided in Sec. 1.1297-4.

(v) Application to employer entity. The rules of paragraphs

(h)(1)(i) through (h)(1)(iv) of this section apply to the employer

whose employees benefit under the deferred compensation plan funded

through a foreign employees' trust, or, in the case of a deferred

compensation plan covering independent contractors, the recipient of

services performed by those independent contractors, regardless of

whether the plan is maintained through another entity. Thus, for

example, where a deferred compensation plan benefitting employees of a

controlled foreign corporation is funded through a foreign employees'

trust, the controlled foreign corporation is considered to be the

grantor of the foreign employees' trust for purposes of applying

paragraph (h)(1)(i) of this section.

(2) Foreign employees' trust. A foreign employees' trust is a

nonexempt employees' trust described in section 402(b) that is part of

a deferred compensation plan, and that is a foreign trust within the

meaning of section 7701(a)(31).

(3) Fractional interest for paragraph (h)(1)--(i) In general. The

fractional interest for a foreign employees' trust used for purposes of

paragraph (h)(1) of this section for a taxable year of the employer is

an undivided fractional interest in the trust for which the fraction is

equal to the relevant amount for the employer's taxable year divided by

the fair market value of trust assets for the employer's taxable year.

(ii) Relevant amount--(A) In general. For purposes of applying

paragraph (h)(3)(i) of this section, and except as provided in

paragraph (h)(3)(iii) of this section, the relevant amount for the

employer's taxable year is the amount, if any, by which the fair market

value of trust assets, plus the fair market value of any assets

available to pay plan liabilities that are held in the equivalent of a

trust within the meaning of section 404A(b)(5)(A), exceed the plan's

accrued liability. The following rules apply for this purpose:

(1) The plan's accrued liability is determined using a projected

unit credit funding method that satisfies the requirements of

Sec. 1.412(c)(3)-1, taking into account only liabilities relating to

services performed through the measurement date for the employer or a

predecessor employer.

(2) The plan's accrued liability is reduced (but not below zero) by

any liabilities that are provided for under annuity contracts held to

satisfy plan liabilities.

(3) Any amount held under an annuity contract that exceeds the

amount that is needed to satisfy the liabilities provided for under the

contract (e.g., the value of a participation right under a

participating annuity contract) is added to the fair market value of

any assets available to pay plan liabilities that are held in the

equivalent of a trust.

(4) If the relevant amount as determined under this paragraph

(h)(3)(ii), without regard to this paragraph (h)(3)(ii)(A)(4), is

greater than the fair market value of trust assets, then the relevant

amount is equal to the fair market value of trust assets.

(B) Permissible actuarial assumptions for accrued liability. For

purposes of paragraph (h)(3)(ii)(A) of this section, a plan's accrued

liability must be calculated using an interest rate and other actuarial

assumptions that the Commissioner determines to be reasonable. It is

appropriate in determining this interest rate to look to available

information about rates implicit in current prices of annuity

contracts, and to look to rates of return on high-quality fixed-income

investments currently available and expected to be available during the

period prior to maturity of the plan benefits. If the qualified

business unit computes its income or earnings and profits in dollars

pursuant to the dollar approximate separate transactions method under

Sec. 1.985-3, the employer must use an exchange rate that can be

demonstrated to clearly reflect income, based on all relevant facts and

circumstances, including appropriate rates of inflation and commercial

practices.

(iii) Exception for reasonable funding. The relevant amount does

not include an amount that the taxpayer demonstrates to the

Commissioner is attributable to amounts that were properly contributed

to the trust pursuant to a reasonable funding method, applied using

actuarial assumptions that the Commissioner determines to be

reasonable, or any amount that the taxpayer demonstrates to the

Commissioner is attributable to experience that is favorable relative

to any actuarial assumptions used that the Commissioner determines to

be reasonable. For this paragraph (h)(3)(iii) to apply to a controlled

foreign corporation employer described in paragraph (h)(1)(i) of this

section, the taxpayer must indicate on a statement attached to a timely

filed Form 5471 that the taxpayer is relying on this rule. For purposes

of this paragraph (h)(3)(iii), an amount is considered contributed

pursuant to a reasonable funding method if the amount is contributed

pursuant to a funding method permitted to be used under section 412

(e.g., the entry age normal funding method) that is consistently used

to determine plan contributions. In addition, for purposes of this

paragraph (h)(3)(iii), if there has been a change to that method from

another funding method, an amount is considered contributed pursuant to

a reasonable funding method only if the prior funding method is also a

funding method described in the preceding sentence that was

consistently used to determine plan contributions. For purposes of this

paragraph (h)(3)(iii), a funding method is considered reasonable only

if the method provides for any initial unfunded liability to be

amortized over a period of at least 6 years, and for any net change in

accrued liability resulting from a change in

[[Page 50785]]

funding method to be amortized over a period of at least 6 years.

(iv) Reduction for transition amount. The relevant amount is

reduced (but not below zero) by any transition amount described in

paragraphs (h)(5), (h)(6), or (h)(7) of this section.

(v) Fair market value of assets. For purposes of paragraphs (h)(3)

(i) and (ii) of this section, for a taxable year of the employer, the

fair market value of trust assets, and the fair market value of other

assets held in the equivalent of a trust within the meaning of section

404A(b)(5)(A), equals the fair market value of those assets, as of the

measurement date for the employer's taxable year, adjusted to include

contributions made after the measurement date and by the end of the

employer's taxable year.

(vi) Annual valuation. For purposes of determining the relevant

amount for a taxable year of the employer, the fair market value of

plan assets, and the plan's accrued liability as described in

paragraphs (h)(3) (ii) and (iii) of this section, and the normal cost

as described in paragraph (h)(4) of this section, must be determined as

of a consistently used annual measurement date within the employer's

taxable year.

(vii) Special rule for plan funded through multiple trusts. In

cases in which a plan is funded through more than one foreign

employees' trust, the fractional interest determined under paragraph

(h)(3)(i) of this section in each trust is determined by treating all

of the trusts as if their assets were held in a single trust for which

the fraction is determined in accordance with the rules of this

paragraph (h)(3).

(4) De minimis exception. If the relevant amount is not greater

than the plan's normal cost for the plan year ending with or within the

employer's taxable year, computed using a funding method and actuarial

assumptions as described in paragraph (h)(3)(ii) of this section or as

described in paragraph (h)(3)(iii) of this section if the requirements

of that paragraph are met, that are used to determine plan

contributions, then the relevant amount is considered to be zero for

purposes of applying paragraph (h)(3)(i) of this section.

(5) General rule for transition amount--(i) General rule. If

paragraphs (h)(6) and (h)(7) of this section do not apply to the

employer, the transition amount for purposes of paragraph (h)(3)(iv) of

this section is equal to the preexisting amount multiplied by the

applicable percentage for the year in which the employer's taxable year

begins.

(ii) Preexisting amount. The preexisting amount is equal to the

relevant amount of the trust, determined without regard to paragraphs

(h)(3)(iv) and (h)(4) of this section, computed as of the measurement

date that immediately precedes September 27, 1996 disregarding

contributions to the trust made after the measurement date.

(iii) Applicable percentage. The applicable percentage is equal to

100 percent for the employer's first taxable year ending after this

document is published as a final regulation in the Federal Register and

prior taxable years of the employer, and is reduced (but not below

zero) by 10 percentage points for each subsequent taxable year of the

employer.

(6) Transition amount for new CFCs--(i) General rule. In the case

of a new controlled foreign corporation employer, the transition amount

for purposes of paragraph (h)(3)(iv) is equal to the pre-change amount

multiplied by the applicable percentage for the year in which the new

controlled foreign corporation employer's taxable year begins.

(ii) Pre-change amount. The pre-change amount for purposes of

paragraph (h)(6)(i) is equal to the relevant amount of the trust,

determined without regard to paragraphs (h)(3)(iv) and (h)(4) of this

section and disregarding contributions to the trust made after the

measurement date, for the new controlled foreign corporation employer's

last taxable year ending before the corporation becomes a new

controlled foreign corporation employer.

(iii) Applicable percentage--(A) General rule. Except as provided

in paragraph (h)(6)(iii)(B) of this section, the applicable percentage

is equal to 100 percent for a new controlled foreign corporation

employer's first taxable year ending after the corporation becomes a

controlled foreign corporation. The applicable percentage is reduced

(but not below zero) by 10 percentage points for each subsequent

taxable year of the new controlled foreign corporation.

(B) Interim rule. For any taxable year of a new controlled foreign

corporation employer that ends on or before the date this document is

published as a final regulation in the Federal Register, the applicable

percentage is equal to 100 percent. The applicable percentage is

reduced by 10 percentage points for each subsequent taxable year of the

new controlled foreign corporation employer that ends after the date

this document is published as a final regulation in the Federal

Register.

(iv) New CFC employer. For purposes of paragraph (h)(6) of this

section, a new controlled foreign corporation employer is a corporation

that first becomes a controlled foreign corporation within the meaning

of section 957 after September 27, 1996. A new controlled foreign

corporation employer includes a corporation that was a controlled

foreign corporation prior to, but not on, September 27, 1996 and that

first becomes a controlled foreign corporation again after September

27, 1996.

(v) Anti-stuffing rule. Notwithstanding paragraph (h)(6)(iii) of

this section, if, prior to becoming a controlled foreign corporation, a

corporation contributes amounts to a foreign employees' trust with a

principal purpose of obtaining tax benefits by increasing the pre-

change amount, the applicable percentage with respect to those amounts

is 0 percent for all taxable years of the new controlled foreign

corporation employer.

(7) Transition amount for new U.S.-related foreign partnerships--

(i) General rule. In the case of a new U.S.-related foreign partnership

employer, the transition amount for purposes of paragraph (h)(3)(iv) of

this section is equal to the pre-change amount multiplied by the

applicable percentage for the year in which the new U.S.-related

foreign partnership employer's taxable year begins.

(ii) Pre-change amount. The pre-change amount for purposes of

paragraph (h)(7)(i) of this section is equal to the relevant amount of

the trust, determined without regard to paragraphs (h)(3)(iv) and

(h)(4) of this section and disregarding contributions to the trust made

after the measurement date, for the entity's last taxable year ending

before the entity becomes a new U.S.-related foreign partnership

employer.

(iii) Applicable percentage--(A) General rule. Except as provided

in paragraph (h)(7)(iii)(B) of this section, the applicable percentage

is equal to 100 percent for a new U.S.-related foreign partnership

employer's first taxable year ending after the entity becomes a new

U.S.-related foreign partnership employer. The applicable percentage is

reduced (but not below zero) by 10 percentage points for each

subsequent taxable year of the new U.S.-related foreign partnership

employer.

(B) Interim rule. For any taxable year of a new U.S.-related

foreign partnership employer that ends on or before the date this

document is published as a final regulation in the Federal Register,

the applicable percentage is equal to 100 percent. The applicable

percentage is reduced by 10 percentage points for each subsequent

[[Page 50786]]

taxable year of the new U.S.-related foreign partnership employer that

ends after the date this document is published as a final regulation in

the Federal Register.

(iv) New U.S.-related foreign partnership employer. For purposes of

paragraph (h)(7) of this section, a new U.S.-related foreign

partnership employer is an entity that was a foreign corporation other

than a controlled foreign corporation, or that was a foreign

partnership other than a U.S.-related foreign partnership, and that

changes from this status to a U.S.-related foreign partnership after

September 27, 1996. A new U.S.-related foreign partnership employer

includes a corporation that was a U.S.-related foreign partnership

prior to, but not on, September 27, 1996 and that first becomes a U.S.-

related foreign partnership again after September 27, 1996.

(v) Anti-stuffing rule. Notwithstanding paragraph (h)(7)(iii) of

this section, if, prior to becoming a new U.S.- related foreign

partnership employer, an entity contributes amounts to a foreign

employees' trust with a principal purpose of obtaining tax benefits by

increasing the pre-change amount, the applicable percentage with

respect to those amounts is 0 percent for all taxable years of the new

U.S.-related foreign partnership employer.

(8) Examples. The following examples illustrate the rules of

paragraph (h) of this section. In each example, the employer has a

power or interest described in sections 673 through 677 over the

foreign employees' trust, and the monetary unit is the applicable

functional currency (FC) determined in accordance with section 985(b)

and the regulations thereunder.

Example 1. (i) Employer X is a controlled foreign corporation

(as defined in section 957). Employer X maintains a defined benefit

retirement plan for its employees. Employer X's taxable year is the

calendar year. Trust T, a foreign employees' trust, is the sole

funding vehicle for the plan. Both the plan year of the plan and the

taxable year of Trust T are the calendar year.

(ii) As of December 31, 1997, Trust T's measurement date, the

fair market value (as described in paragraph (h)(3)(iv) of this

section) of Trust T's assets is FC 1,000,000, and the amount of the

plan's accrued liability is FC 800,000, which includes a normal cost

for 1997 of FC 50,000. The preexisting amount for Trust T is FC

40,000. Thus, the relevant amount for 1997 is FC 160,000 (which is

greater than the plan's normal cost for the year). Employer X's

shareholder does not indicate on a statement attached to a timely

filed Form 5471 that any of the relevant amount qualifies for the

exception described in paragraph (h)(3)(iii) of this section.

Therefore, the fractional interest for Employer X's taxable year

ending on December 31, 1997, is 16 percent. Employer X is treated as

the owner for federal income tax purposes of an undivided 16 percent

interest in each of Trust T's assets for the period from January 1,

1997 through December 31, 1997. Employer X must take into account a

16 percent pro rata share of each item of income, deduction or

credit of Trust T during this period in computing its federal income

tax liability.

Example 2. Assume the same facts as in Example 1, except that

Employer X's shareholder indicates on a statement attached to a

timely filed Form 5471 and can demonstrate to the satisfaction of

the Commissioner that, in reliance on paragraph (h)(3)(iii) of this

section, FC 100,000 of the fair market value of Trust T's assets is

attributable to favorable experience relative to reasonable

actuarial assumptions used. Accordingly, the relevant amount for

1997 is FC 60,000. Because the plan's normal cost for 1997 is less

than FC 60,000, the de minimis exception of paragraph (h)(4) of this

section does not apply. Therefore, the fractional interest for

Employer X's taxable year ending on December 31, 1997, is 6 percent.

Employer X is treated as the owner for federal income tax purposes

of an undivided 6 percent interest in each of Trust T's assets for

the period from January 1, 1997, through December 31, 1997. Employer

X must take into account a 6 percent pro rata share of each item of

income, deduction or credit of Trust T during this period in

computing its federal income tax liability.

(9) Effective date. Paragraphs (g) and (h) of this section apply to

taxable years of an employer ending after September 27, 1996.

Par. 3. Section 1.671-2 is amended by adding paragraph (f) to read

as follows:

Sec. 1.671-2 Applicable principles

* * * * *

(f) For purposes of subtitle A of the Internal Revenue Code, a

person that is treated as the owner of any portion of a trust under

subpart E is considered to own the trust assets attributable to that

portion of the trust.

Par. 4. Section 1.1297-4 is added to read as follows:

Sec. 1.1297-4 Application of subpart E of subchapter J with respect to

foreign employees' trusts.

(a) General rules. For purposes of part VI of subchapter P, chapter

1 of the Code, a foreign employer that is not a controlled foreign

corporation is not treated as the owner of any portion of a foreign

employees' trust (as defined in Sec. 1.671-1(h)(2)) except as provided

in this paragraph (a), regardless of whether the employer has a power

or interest described in sections 673 through 677 over any portion of

the trust.

(1) Principal purpose to avoid classification as a passive foreign

investment company. If a principal purpose for a transfer of property

by any person to a foreign employees' trust (as defined in Sec. 1.671-

1(h)(2)) is to avoid classification of a foreign corporation as a

passive foreign investment company, then the following rule applies. If

the foreign employer has a power or interest described in sections 673

through 677 over the trust, then the grantor trust rules of subpart E

of part I of subchapter J, chapter 1 of the Code will apply, for

purposes of part VI of subchapter P, to a fixed dollar amount in the

trust that is equal to the fair market value of the property that is

transferred for the purpose of avoiding classification as a passive

foreign investment company. Whether a principal purpose for a transfer

is the avoidance of classification as a passive foreign investment

company will be determined on the basis of all of the facts and

circumstances, including whether the amount of assets held by the

foreign employees' trust is reasonably related to the plan's

anticipated liabilities, taking into account any local law and practice

relating to proper funding levels.

(2) Principal purpose to reduce or eliminate taxation under section

1291 or 1293. If a principal purpose for a transfer of property by any

person to a foreign employees' trust (as defined in Sec. 1.671-1(h)(2))

is to reduce or eliminate taxation under section 1291 or 1293, then the

following rule applies. If the foreign employer has a power or interest

described in sections 673 through 677 over the trust, then the

provisions of subpart E will apply, for purposes of part VI of

subchapter P, to a fixed dollar amount in the trust that is equal to

the fair market value of the property transferred for the purpose of

reducing or eliminating taxation under section 1291 or 1293. Whether a

principal purpose for a transfer is to reduce or eliminate taxation

under section 1291 or 1293 will be determined on the basis of all the

facts and circumstances, including whether the amount of assets held by

the foreign employees' trust is reasonably related to the plan's

anticipated liabilities, taking into account any local law and practice

relating to proper funding levels.

(3) Application to employer entity. The rules of this section apply

to the employer whose employees benefit under the deferred compensation

plan funded through the foreign employees' trust, or, in the case of a

deferred compensation plan covering independent contractors, the

recipient of services performed by those independent contractors,

regardless of whether the plan is maintained through another entity.

Thus, for example, where a deferred compensation plan benefitting

employees of a foreign

[[Page 50787]]

employer that is not a controlled foreign corporation is funded through

a foreign employees' trust, the foreign employer is considered to be

the grantor of the foreign employees' trust for purposes of this

paragraph (a).

(b) Effective date. This section applies to taxable years of a

foreign corporation ending after September 27, 1996.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 96-24864 Filed 9-26-96; 8:45 am]

BILLING CODE 4830-01-U