# Certain Investment Income Under the Qualifying Income Provisions of Section 7704 and the Application of the Passive Activity Loss Rules to Publicly Traded Partnerships

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URL: https://www.frixlaw.com/law-library/documents/fr%3A98-33345

## Record

- **Collection:** Federal Register
- **Document type:** Rule
- **Published:** December 17, 1998
- **Citation:** 63 FR 69551

## Text

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8799]
RIN 1545-AV15

Certain Investment Income Under the Qualifying Income Provisions
of Section 7704 and the Application of the Passive Activity Loss Rules
to Publicly Traded Partnerships

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

-----------------------------------------------------------------------

SUMMARY: This document contains final regulations relating to the
treatment of certain investment income under the qualifying income
provisions of section 7704 and the application of the passive activity
loss rules to publicly traded partnerships. These regulations provide
guidance on calculating a publicly traded partnership's qualifying
income under section 7704. The regulations will affect the
classification of certain partnerships for federal tax purposes and
also will affect the passive activity loss limitations with respect to
items attributable to publicly traded partnerships.

DATES: Effective Date: These regulations are effective December 17,
1998.
Applicability Dates: See Effective Dates under SUPPLEMENTARY
INFORMATION of the preamble.

FOR FURTHER INFORMATION CONTACT: Christopher Kelley or Terri Belanger
at (202) 622-3080 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

The final regulations add Sec. 1.7704-3 to the Income Tax
Regulations (26 CFR part 1) relating to the definition of qualifying
income for publicly traded partnerships under section 7704(d) of the
Internal Revenue Code (Code). The final regulations also amend
Sec. 1.469-10 of the Income Tax Regulations relating to the application
of section 469 to publicly traded partnerships.
On December 19, 1997, proposed regulations (REG-105163-97, 1998-8
I.R.B. 31) were published in the Federal Register (62 FR 66575). A
number of written comments were received on the proposed regulations
under section 7704(d). Two speakers provided testimony at a public
hearing held on April 28, 1998. After consideration of all the
comments, the proposed regulations under section 7704 are adopted, as
revised by this Treasury decision.
No comments were received on the proposed regulations under section
469. The proposed regulations under section 469 are adopted without
revision by this Treasury decision.

Explanation of Revisions and Summary of Comments

1. Determination of Gross Income for Purposes of Section 7704(c)(2)

a. Capital Losses
Section 7704(d)(1)(F) provides that, except as otherwise provided,
the term qualifying income includes any gain from the sale or
disposition of a capital asset (or property described in section
1231(b)) held for the production of income described in section
7704(d). Several commentators requested clarification as to how capital
losses incurred by the partnership are treated in determining gross
income of the partnership for purposes of section 7704(c)(2). The final
regulations clarify that, in general, all losses are ignored in the
computation of gross income.
b. Straddles
The proposed regulations requested comments on the appropriate way
to compute the gross income for a partnership that makes a mixed
straddle account election under Sec. 1.1092(b)-4T. The final
regulations provide that, for purposes of applying the general rule
that a capital gain on an investment is taken into account but a
capital loss is not, certain rules shall apply that generally net
capital gains and losses recognized in a taxable year with respect to a
straddle. This treatment applies to all straddles, not just mixed
straddle accounts, and to other interests in property that produce a
substantial diminution of the partnership's risk of loss similar to
that of straddles. In addition, the final regulations contain a wash
sale rule for gains in certain

[[Page 69552]]

straddle and straddle-like transactions. This rule provides that, for
purposes of section 7704(c)(2), if a partnership recognizes gain with
respect to the disposition of one or more positions of a straddle or
similar arrangement, and the partnership acquires a substantially
similar position or positions within a period beginning 30 days before
and ending 30 days after the date of the disposition, then the gain
shall not be taken into account to the extent of the amount of
unrecognized loss (as of the close of the taxable year) in one or more
offsetting positions of the straddle or similar arrangement.
c. Mark-to-Market
The proposed regulations provide that qualifying income includes
capital gain from the sale of stock. The final regulations clarify that
gain recognized with respect to a position that is marked to market
(for example, under section 475(f), section 1256, section 1259, or
section 1296) will not fail to be qualifying income solely because
there is no sale or disposition.
d. Certain Ordinary Income
Under certain provisions of the Code, capital gain or loss with
respect to certain transactions is recharacterized as ordinary income
or loss. However, such gain or loss may be recognized with respect to a
capital asset in a manner that is consistent with section
7704(d)(1)(F). Accordingly, the final regulations provide that gain
will not fail to be qualifying income solely because it is
characterized as ordinary income under section 475(f), section 988,
section 1258, or section 1296.

2. Income Derived From Securities Lending Activities

Several commentators requested that the final regulations clarify
that income from securities lending activities of a trader is
qualifying income. Section 7704(d)(4) provides that qualifying income
includes income that qualifies under section 851(b)(2). Section
851(b)(2), which includes income from security loans, does not
specifically state that it applies to the business of trading, as
opposed to the business of investing. Thus, commentators have suggested
that there is uncertainty under section 7704 as to whether income from
security loans from the business of trading is qualifying income.
The IRS and Treasury Department believe that section 851(b)(2)
generally encompasses income from the business of trading as well as
investing. Thus, income from the securities lending activities of a
trader will be qualifying income under section 7704. A special
provision in these final regulations for this income is not necessary
and could create a negative implication as to the qualification of
trading income under section 851(b)(2) generally. Accordingly, the
final regulations do not adopt this comment.

3. Income Derived From Investments in Foreign Corporations

One commentator requested that the final regulations clarify that
income from investments in foreign corporations is qualifying income.
Because taxable income may arise with respect to an investment in a
foreign corporation that may not literally constitute a dividend, the
commentator suggested that it is unclear whether these investments
generate qualifying income under section 7704(d). Specifically, the
commentator requested clarification regarding whether a U.S.
shareholder would have qualifying income from an inclusion under (1)
section 551 (foreign personal holding company income); (2) section
951(a)(1) (A) or (B) (subpart F income or a section 956 amount); (3)
section 1291 (excess distributions of a passive foreign investment
company (PFIC)); and (4) section 1293 (earnings of a PFIC that is a
qualified electing fund). The commentator requested that the final
regulations clarify that income realized under these tax regimes with
respect to stock ownership in a foreign corporation is included in the
definition of qualifying income under section 7704(d).
Section 551(b) characterizes amounts included in gross income under
section 551(a) as dividends for federal tax purposes. Thus, an
inclusion under section 551 is qualifying income under section
7704(d)(1)(B). No clarification is necessary in the final regulations.
Section 851(b)(2), which is cross-referenced in section 7704(d),
provides rules on the extent to which certain inclusions of subpart F
income under section 951(a)(1)(A)(i) and certain inclusions under
section 1293(a) are treated as dividends and, thus, qualifying income
for purposes of section 851(b)(2). Any expansion of qualifying income
with respect to investments in foreign corporations should be addressed
under section 851(b)(2) and the regulations thereunder. Accordingly,
the final regulations do not adopt this comment.

4. Limitation on the Definition of Qualifying Income

The proposed regulations provide that qualifying income includes
capital gain from the sale of stock, income from holding annuities,
income from notional principal contracts, and other substantially
similar income from ordinary and routine investments to the extent
determined by the Commissioner. Several commentators stated that
partnerships must know that an investment generates qualifying income
before entering into the transaction. Because passive-type investments
evolve constantly and rapidly, the commentators suggested that a
requirement that a type of investment generates qualifying income only
to the extent determined by the Commissioner creates uncertainty for
partnerships considering new investments. Thus, these commentators
requested that the final regulations not include this restriction in
the definition of qualifying income.
The IRS and Treasury Department do not believe that the language in
the proposed regulations creates significant uncertainty in the
definition of qualifying income. Instead, the standard in the proposed
regulations provides necessary flexibility to consider the effect of
new types of financial investments as such investments evolve. The IRS
and Treasury Department do not believe that it would be appropriate to
create a broader and more generic rule that would allow taxpayers to
determine for themselves whether new types of investments generate
qualifying income. Thus, the final regulations do not adopt this
comment.

5. List of Specific Items Generating Qualifying Income

Several commentators requested that the final regulations expand
the list of specific investments that generate qualifying income. The
IRS and Treasury Department do not believe that it is appropriate to
expand the list of specific investments enumerated in the proposed
regulations. Therefore, the final regulations do not adopt this
comment.

6. Partnership Reporting Requirements

Several commentators indicated that the current reporting
requirements for partnerships do not specifically compel a lower-tier
partnership to provide the data necessary for an upper-tier partnership
to determine whether it meets the gross income requirement of section
7704(c)(2). These commentators requested that the final regulations
specifically require a lower-tier partnership to report in a level of
detail that would permit an upper-tier partnership to make the
necessary calculations.
The final regulations do not adopt this comment. The current
reporting requirements for a partnership in

[[Page 69553]]

Sec. 1.6031(b)-1T(a)(3)(ii) require a partnership to furnish its
partners with statements that include, to the extent provided by form
or the accompanying instructions, any additional information that a
partner may need to apply particular provisions of the Code with
respect to items related to the partnership. The instructions to Form
1065, ``U.S. Partnership Return of Income,'' specifically require a
partnership to include on a Schedule K-1 any information a partner may
need to file its return that is not shown anywhere else on the
schedule. The information that an upper-tier partnership needs to make
its gross income calculations must be provided by the lower-tier
partnership under the current reporting requirements. An additional
reporting requirement in these final regulations is not necessary.

7. Private Placement Safe Harbor Under Sec. 1.7704-1(h)(1)(ii)

Several commentators requested that the final regulations amend the
requirements of the private placement safe harbor under Sec. 1.7704-
1(h)(1) to reflect the adoption of new rules by the Securities and
Exchange Commission regarding knowledgeable employees. Specifically,
the commentators requested that the private placement safe harbor be
amended to provide that knowledgeable employees are not counted for
purposes of the 100 partner limitation. This issue is beyond the scope
of these final regulations. Therefore, the final regulations do not
adopt this comment.

8. Effective Dates

The proposed regulations provide that the regulations will be
effective for taxable years of a partnership beginning on or after the
date final regulations are published in the Federal Register.
Commentators stated that this effective date would preclude taxpayers
from relying upon the revised definition of qualifying income in the
proposed regulations until the regulations are final. These
commentators requested that the effective date of the regulations be
changed so that a partnership may rely upon the revised definition of
qualifying income for taxable years beginning on or after the date the
regulations were published as proposed regulations in the Federal
Register.
The final regulations provide that these regulations apply to
taxable years of a partnership beginning on or after December 17, 1998.
However, in response to the comments, the final regulations also
include a provision that allows a partnership to apply the regulations
retroactively.

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 regulations do not
impose a collection of information on small entities, a Regulatory
Flexibility Analysis is not required. Pursuant to section 7805(f) of
the Internal Revenue Code, the notice of proposed rulemaking preceding
these regulations was submitted to the Chief Counsel for Advocacy of
the Small Business Administration for comment on its impact on small
business.
Drafting information. The principal authors of these regulations
are Christopher Kelley and Terri Belanger, Office of Chief Counsel
(Passthroughs and Special Industries). 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.

Amendments to the Regulations

PART 1--[AMENDED]

Accordingly, 26 CFR part 1 is amended as follows:
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:

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

Par. 2. Section 1.469-10 is revised to read as follows:

Sec. 1.469-10 Application of section 469 to publicly traded
partnerships.

(a) [Reserved].
(b) Publicly traded partnership--(1) In general. For purposes of
section 469(k), a partnership is a publicly traded partnership only if
the partnership is a publicly traded partnership as defined in
Sec. 1.7704-1.
(2) Effective date. This section applies for taxable years of a
partnership beginning on or after December 17, 1998.
Par. 3. Section 1.7704-3 is added to read as follows:

Sec. 1.7704-3 Qualifying income.

(a) Certain investment income--(1) In general. For purposes of
section 7704(d)(1), qualifying income includes capital gain from the
sale of stock, income from holding annuities, income from notional
principal contracts (as defined in Sec. 1.446-3), and other
substantially similar income from ordinary and routine investments to
the extent determined by the Commissioner. Income from a notional
principal contract is included in qualifying income only if the
property, income, or cash flow that measures the amounts to which the
partnership is entitled under the contract would give rise to
qualifying income if held or received directly by the partnership.
(2) Limitations. Qualifying income described in paragraph (a)(1) of
this section does not include income derived in the ordinary course of
a trade or business. For purposes of the preceding sentence, income
derived from an asset with respect to which the partnership is a
broker, market maker, or dealer is income derived in the ordinary
course of a trade or business; income derived from an asset with
respect to which the taxpayer is a trader or investor is not income
derived in the ordinary course of a trade or business.
(b) Calculation of gross income and qualifying income--(1)
Treatment of losses. Except as otherwise provided in this section, in
computing the gross income and qualifying income of a partnership for
purposes of section 7704(c)(2) and this section, losses do not enter
into the computation.
(2) Certain positions that are marked to market. Gain recognized
with respect to a position that is marked to market (for example, under
section 475(f), 1256, 1259, or 1296) shall not fail to be qualifying
income solely because there is no sale or disposition of the position.
(3) Certain items of ordinary income. Gain recognized with respect
to a capital asset shall not fail to be qualifying income solely
because it is characterized as ordinary income under section 475(f),
988, 1258, or 1296.
(4) Straddles. In computing the gross income and qualifying income
of a partnership for purposes of section 7704(c)(2) and this section, a
straddle (as defined in section 1092(c)) shall be treated as set forth
in this paragraph (b)(4). For purposes of the preceding sentence, two
or more straddles that are part of a larger straddle shall be treated
as a single straddle. The amount of the gain from any straddle to be
taken into account shall be computed as follows:
(i) Straddles other than mixed straddle accounts. With respect to
each straddle (whether or not a straddle during the taxable year) other
than a mixed straddle account, the amount of gain taken into account
shall be the excess, if any, of gain recognized during the taxable year
with respect to property that was at any time a position in that
straddle over any loss recognized during

[[Page 69554]]

the taxable year with respect to property that was at any time a
position in that straddle (including loss realized in an earlier
taxable year).
(ii) Mixed straddle accounts. With respect to each mixed straddle
account (as defined in Sec. 1.1092(b)-4T(b)), the amount of gain taken
into account shall be the annual account gain for that mixed straddle
account, computed pursuant to Sec. 1.1092(b)-4T(c)(2).
(5) Certain transactions similar to straddles. In computing the
gross income and qualifying income of a partnership for purposes of
section 7704(c)(2) and this section, related interests in property
(whether or not personal property as defined in section 1092(d)(1))
that produce a substantial diminution of the partnership's risk of loss
similar to that of a straddle (as defined in section 1092(c)) shall be
combined so that the amount of gain taken into account by the
partnership in computing its gross income shall be the excess, if any,
of gain recognized during the taxable year with respect to such
interests over any loss recognized during the taxable year with respect
to such interests.
(6) Wash sale rule--(i) Gain not taken into account. Solely for
purposes of section 7704(c)(2) and this section, if a partnership
recognizes gain in a section 7704 wash sale transaction with respect to
one or more positions in either a straddle (as defined in section
1092(c)) or an arrangement described in paragraph (b)(5) of this
section, then the gain shall not be taken into account to the extent of
the amount of unrecognized loss (as of the close of the taxable year)
in one or more offsetting positions of the straddle or arrangement
described in paragraph (b)(5) of this section.
(ii) Section 7704 wash sale transaction. For purposes of this
paragraph (b)(6), a section 7704 wash sale transaction is a transaction
in which--
(A) A partnership disposes of one or more positions of a straddle
(as defined in section 1092(c)) or one or more related positions
described in paragraph (b)(5) of this section; and
(B) The partnership acquires a substantially similar position or
positions within a period beginning 30 days before the date of the
disposition and ending 30 days after such date.
(c) Effective date. This section applies to taxable years of a
partnership beginning on or after December 17, 1998. However, a
partnership may apply this section in its entirety for all of the
partnership's open taxable years beginning after any earlier date
selected by the partnership.
Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
Approved: December 7, 1998.
Donald C. Lubick,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 98-33345 Filed 12-16-98; 8:45 am]
BILLING CODE 4830-01-U

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A98-33345. Public record. Not legal advice.