Inbound Grantor Trusts With Foreign Grantors

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8831]

RIN 1545-AU90

Inbound Grantor Trusts With Foreign Grantors

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

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SUMMARY: This document contains regulations implementing sections

672(f) and 643(h) of the Internal Revenue Code, as amended by the Small

Business Job Protection Act of 1996, which relate to the application of

the grantor trust rules to certain trusts established by foreign

persons. These regulations affect primarily U.S. persons who are

beneficiaries of trusts established by foreign persons. This document

also contains temporary regulations defining the term grantor for

purposes of part I of subchapter J, chapter 1 of the Internal Revenue

Code. The text of these temporary regulations serves as the text of the

proposed regulations set forth in the notice of proposed rulemaking

published elsewhere in this issue of the Federal Register.

DATES: Effective Date: These regulations are effective August 10, 1999.

Applicability Dates: For dates of applicability of Sec. 1.643(h)-1,

see Sec. 1.643(h)-1(h). For dates of applicability of Sec. 1.671-2T(e),

see Sec. 1.671-2T(e)(7). For dates of applicability of Secs. 1.672(f)-1

through 1.672(f)-5, see Secs. 1.672(f)-1(c), 1.672(f)-2(e), 1.672(f)-

3(e), 1.672(f)-4(h), and 1.672(f)-5(c).

FOR FURTHER INFORMATION CONTACT: M. Grace Fleeman (202) 622-3880

concerning the regulations generally, and James A. Quinn (202) 0622-

3060 concerning Sec. 1.671-2T(e) and Sec. 1.672(f)-1 (not toll-free

numbers).

SUPPLEMENTARY INFORMATION:

Background

On June 5, 1997 (62 FR 37819) Treasury and the IRS published a

notice of proposed rulemaking (REG-252487-96) under sections 643(h),

671, 672(f), and 7701 of the Internal Revenue Code (Code). Comments

responding to the notice were received and a public hearing was held on

August 27, 1997. After consideration of the comments, the proposed

regulations under sections 643(h) and 672(f) are adopted as final

regulations as revised by this Treasury decision. The proposed

regulations under section 671 are issued as revised by this Treasury

decision as temporary regulations. The revisions are discussed below.

The proposed regulations under section 7701 are withdrawn. The

temporary regulations under section 671 are also being issued as

proposed regulations published elsewhere in this issue of the Federal

Register.

[[Page 43268]]

Explanation of Provisions and Revisions

1. Comments and Changes to Sec. 1.643(h)-1: Distributions by Certain

Foreign Trusts Through Intermediaries

Under the proposed regulations, any amount that was derived,

directly or indirectly, by a U.S. person from a foreign trust through

an intermediary generally was deemed to have been transferred directly

by the foreign trust to the U.S. person if any one of three specified

conditions was satisfied. In cases where the transfer from the

intermediary to the U.S. person did not occur in the same taxable year

of the U.S. person as the transfer from the foreign trust to the

intermediary, the proposed regulations looked to generally applicable

agency principles to determine when the transfer to the U.S. person was

deemed to occur.

Commenters said the proposed rules were too broad and could reach

virtually any transfer made to a U.S. person by any person who has

received a distribution from a foreign trust. They suggested that the

basic requirement for treating a transfer to a U.S. person as a

transfer directly from a foreign trust should be the existence of an

intention to avoid U.S. tax. Alternatively, they said there should at

least be a time limitation so that the rule would not apply to a

transfer of property received from a foreign trust more than, for

example, one year before the transfer to the U.S. person. In addition,

they said the proposed rule relying on generally applicable agency

principles for determining whether an intermediary is the agent of the

foreign trust or of the U.S. person would be difficult to apply because

different countries have different laws and the U.S. person should be

taxed prior to receipt only if the intermediary is clearly a nominee or

agent for the U.S. person.

In response to the comments, the final regulations treat any

property (including cash) that is transferred to a U.S. person by an

intermediary who has received property from a foreign trust as property

transferred directly by the foreign trust to the U.S. person if the

intermediary received the property from the foreign trust pursuant to a

plan one of the principal purposes of which was the avoidance of U.S.

tax. A transfer of property will be deemed to have been made pursuant

to a plan one of the principal purposes of which was the avoidance of

U.S. tax if all of certain specified factors are present. However, the

Commissioner may find that a transfer was made pursuant to a plan one

of the principal purposes of which was the avoidance of U.S. tax

whether or not any of the specified factors is present.

The factors that will cause a transfer to be deemed to have been

made pursuant to a plan one of the principal purposes of which was the

avoidance of U.S. tax are the following: (i) the U.S. person is related

to a grantor of the foreign trust or has another relationship with a

grantor of the foreign trust that establishes a reasonable basis for

concluding that the grantor of the foreign trust would make a

gratuitous transfer to the U.S. person; (ii) the U.S. person receives

from the intermediary, within the period beginning twenty-four months

before and ending twenty-four months after the intermediary's receipt

of property from the foreign trust, either the property the

intermediary received from the foreign trust, proceeds from such

property, or property in substitution for such property; and (iii) the

U.S. person cannot demonstrate to the satisfaction of the Commissioner

that (A) the intermediary has a relationship with the U.S. person that

establishes a reasonable basis for concluding that the intermediary

would make a gratuitous transfer to the U.S. person, (B) the

intermediary acted independently of the grantor and the trustee, (C)

the intermediary is not an agent of the U.S. person under generally

applicable U.S. agency principles, and (D) the U.S. person timely

complied with the reporting requirement of section 6039F, if

applicable, if the intermediary is a foreign person. See Notice 97-34

(1997-1 C.B. 422).

The final regulations also have been modified with respect to the

application of generally applicable agency principles. Under the final

regulations, property is treated as transferred to the U.S. person in

the year it is actually transferred to the U.S. person by the

intermediary unless the Commissioner determines, or the taxpayer can

demonstrate to the satisfaction of the Commissioner, that the

intermediary is an agent of the U.S. person under generally applicable

agency principles, in which case the property will be treated as

transferred to the U.S. person by the trust in the year the property

was transferred to the intermediary by the trust. As a corollary, the

final regulations provide that the fair market value of the property is

determined as of the date of the transfer to the U.S. person, unless

the intermediary is treated as an agent of the U.S. person, in which

case the fair market value will be determined as of the date of the

transfer to the intermediary. Examples illustrate the effect of changes

in the fair market value between the date of the transfer to the

intermediary and the date of the transfer to the U.S. person.

The final regulations clarify that they apply only to gratuitous

transfers. They also clarify that if property is treated as transferred

directly by a foreign trust to a U.S. person pursuant to the

regulations, the same property will not be taken into account in

computing the gross income of the intermediary (if such property would

otherwise be required to be so taken into account).

The final regulations under section 643(h) are applicable to

transfers made to U.S. persons after August 10, 1999.

2. Comments and Changes to Sec. 1.671-2(e): Definition of Grantor

The proposed regulations provided a definition of grantor for

purposes of part I of subchapter J, chapter 1 of the Code. This

document replaces the proposed regulations with temporary regulations

that are effective August 10, 1999. These temporary regulations are

also being issued as proposed regulations published elsewhere in this

issue of the Federal Register. In accordance with section 7805(e)(2),

the temporary regulations will expire before August 12, 2002.

Under the original proposed regulations, a grantor was defined to

include any person to the extent such person either (i) creates a trust

or (ii) directly or indirectly makes a gratuitous transfer to a trust.

Commenters questioned why a nominal creator who has made no transfer to

a trust should be treated as a grantor and asked for an explanation of

the tax significance of such treatment.

Treating a nominal creator as a grantor ensures that someone will

be responsible for reporting the creation of a foreign trust by a U.S.

person even if the trust is not immediately funded. See section

6048(a)(3)(A)(i) and (a)(4)(A). At the same time, Treasury and the IRS

believe that an accommodation grantor, such as an attorney who creates

a trust on behalf of a client, (although a grantor) should not be

treated as an owner of the trust. Accordingly, the temporary

regulations provide that a person who either creates a trust, or funds

a trust with an amount that is directly repaid to such person within a

reasonable period of time, but who makes no other transfers to the

trust that constitute gratuitous transfers, will not be treated as an

owner of any portion of the trust under sections 671 through 677 or

679.

Commenters also questioned a provision in the proposed regulations

that treated a distribution from one trust to another trust that is a

beneficiary of the first trust as a gratuitous transfer,

[[Page 43269]]

with the result that the first trust was a grantor of the second trust.

Under the temporary regulations, if a trust makes a gratuitous transfer

of property to another trust, the grantor of the transferor trust

generally is treated as the grantor of the transferee trust. However,

if a person with a general power of appointment over the transferor

trust exercises that power in favor of another trust, such person is

treated as the grantor of the transferee trust, even if the grantor of

the transferor trust is treated as the owner of the transferor trust

under subpart E of part I, subchapter J, chapter 1 of the Code. (These

rules do not affect the determination of whether or not the gratuitous

transfer from the transferor trust is a distribution subject to

sections 651 or 661.)

The proposed regulations provided that a person who acquires an

interest in a fixed investment trust from a grantor of the trust also

will be treated as a grantor of the trust. In response to comments

received, the temporary regulations extend the same treatment to

persons who acquire an interest in a liquidating trust or an

environmental remediation trust.

The temporary regulations include a new section that applies to

gratuitous transfers to trusts by partnerships and corporations. If the

transfer is entered into for a business purpose of the partnership or

corporation, the partnership or corporation, as the case may be,

generally is treated as the grantor of the trust. However, if the

transfer is not entered into for a business purpose of the partnership

or corporation--for example, if it is for the personal purposes of one

or more of the partners or shareholders--the transfer is treated as a

constructive distribution to such partners or shareholders under

federal tax principles, and the partners or shareholders, as the case

may be, are treated as the grantors of the trust. See, for example,

Epstein v. Commissioner, 53 T.C. 459 (1969), acq. on another issue,

1970-2 C.B. xix.

Commenters asked for guidance concerning the identification of the

grantor when the property contributed to the trust is jointly owned.

These temporary regulations do not provide specific guidance on the

treatment of joint owners that contribute property to a trust. Treasury

and the IRS invite comments with specific examples of areas that may

need clarification, such as, for example, the treatment of community

property or the joint ownership of property by noncitizen spouses.

3. Comments and Changes to Sec. 1.672(f)-1: Foreign Persons Not Treated

as Owners

The proposed regulations prescribed a two-step analysis for

implementing the general rule of section 672(f). First, the grantor

trust rules other than section 672(f) (the basic grantor trust rules)

were applied to determine the worldwide amount and the U.S. amount.

Then, the trust was treated as partially or wholly owned by a foreign

person based on an annual year-end comparison of the worldwide amount

and the U.S. amount. Commenters suggested that the two-step analysis

was unnecessarily complex and questioned whether it might produce

results that were unintended or inconsistent with the statute.

In response to these concerns, the final regulations provide that

the grantor trust rules other than section 672(f) must be applied first

to determine whether, under such rules, any portion of the trust would

be treated as owned by a person other than a U.S. citizen or resident

or domestic corporation. The determination of the portion of the trust

that is treated as owned by a grantor or other person is to be made

based on the terms of the trust and the application of the grantor

trust rules as found in Sec. 1.671-1 et seq. If it is determined that

any portion of the trust would be treated as owned by a person other

than a U.S. citizen or resident or domestic corporation, such person

will be treated as the owner of such portion only if such person is a

foreign corporation described in Sec. 1.672(f)-2(a) or if such portion

of the trust qualifies for one of the exceptions in Sec. 1.672(f)-3.

The final regulations under the general rule are generally

applicable to taxable years of a trust beginning after August 10, 1999.

4. Comments and Changes to Sec. 1.672(f)-2: Certain Foreign

Corporations

Under the proposed regulations, a controlled foreign corporation

(CFC) that created or funded a trust was treated as a domestic

corporation for purposes of section 672(f) only to the extent the

trust's income was subpart F income that was currently taken into

account in computing the gross income of a U.S. citizen, U.S. resident,

or domestic corporation. There were similar rules for passive foreign

investment companies (PFICs) and foreign personal holding companies

(FPHCs). Commenters questioned whether the proposed rules were

consistent with the statutory antideferral regime and the legislative

history. There also were suggestions that the proposed rules should not

apply where a CFC is wholly owned, directly or indirectly, by U.S.

shareholders. In addition, there were requests for simplification of

the rules pertaining to annual fluctuations in the portion of a trust

that is treated as owned by the grantor.

In response to the comments, Treasury and the IRS have developed

rules that are narrowly targeted to potentially abusive situations and

therefore are not inconsistent with the antideferral regime. Under the

final regulations, if the owner of a trust upon application of the

grantor trust rules without regard to section 672(f) is a CFC, PFIC, or

FPHC, the CFC, PFIC, or FPHC, as the case may be, will be treated as a

domestic corporation for purposes of applying the general rule of

Sec. 1.672(f)-1. Consequently, a CFC, PFIC, or FPHC generally will be

treated as an owner of a trust if it would be so treated under sections

671 through 678 without regard to section 672(f). A CFC, PFIC, or FPHC

will be treated as a domestic corporation solely for purposes of

applying the general rule of Sec. 1.672(f)-1. Thus, a CFC, PFIC, or

FPHC will be treated as a foreign corporation for purposes of

Sec. 1.672(f)-4, which is discussed below in part 6 of this

explanation.

If a trust to which a CFC, PFIC, or FPHC has made a gratuitous

transfer makes a gratuitous transfer to a U.S. person, the CFC, PFIC,

or FPHC, as the case may be, will be treated as a foreign corporation

for purposes of determining how the transfer will be treated in the

hands of the U.S. person, and the rules of Sec. 1.672(f)-4(c) will

apply. If a trust that a CFC, PFIC, or FPHC is treated as owning under

section 678 makes a gratuitous transfer to a U.S. person, the rules of

Sec. 1.672(f)-4(c) will apply as if the CFC, PFIC, or FPHC had made a

gratuitous transfer to the trust.

The final regulations for CFCs, PFICs, and FPHCs are generally

applicable to taxable years of shareholders of CFCs, PFICs, and FPHCs

beginning after August 10, 1999 and taxable years of CFCs, PFICs, and

FPHCs ending with or within such taxable years of the shareholders.

5. Comments and Changes to Sec. 1.672(f)-3: Exceptions To General Rule

A. Certain Revocable Trusts

Under the proposed regulations, the general rule of Sec. 1.672(f)-

1(a) did not apply to any portion of a trust if the power to revest

absolutely in the grantor title to such portion was exercisable solely

by the grantor without the approval or consent of any other person

[[Page 43270]]

for a period or periods aggregating 183 days or more during the taxable

year of the trust. The 183-day rule is targeted at potentially abusive

situations in which a power to revest is so limited that it is not

likely to be exercised.

In response to comments received, the final regulations clarify

that if the first or last taxable year of the trust is less than 183

days, the revocable trust exception will apply if the grantor has a

power to revest on each day of the first or last taxable year

(including the year of the grantor's death), as the case may be. The

final regulations also clarify that, consistent with the principle that

statutory exceptions should be construed narrowly, if a trust fails to

qualify for the revocable trust exception in a particular year, the

exception cannot apply in a later year even if the requirements would

otherwise be satisfied in such later year.

Commenters asked whether the revocable trust exception continues to

apply if the grantor becomes incapacitated. The final regulations

provide that the exception will continue to apply if, but only if,

there is a guardian or other person who has unrestricted authority to

exercise the necessary power on the grantor's behalf.

Some commenters disagreed with the result in Sec. 1.672(f)-3(a)(4)

Example 3 of the proposed regulations, which concluded that the

revocable trust exception does not apply where the grantor of the trust

can replace the trustee, who is not a related or subordinate party, at

any time for any reason. They said the example was inconsistent with

the existing grantor trust rules. See, e.g., Sec. 1.674(d)-2(a). After

careful consideration, Treasury and the IRS have concluded that Example

3 is consistent with the purposes of section 672(f) and should be

retained.

Commenters raised a number of issues concerning the grandfather

rules in Sec. 1.672(f)-3 (a)(2) and (b)(4) of the proposed regulations

for certain trusts that were in existence on September 19, 1995. In

response to the comments, the final regulations confirm that physical

separation of amounts that were gratuitously transferred to the trust

after September 19, 1995, is not required. The final regulations

further provide that initial separate accountings may be prepared at

any time up until the due date (including extensions) for the tax

return for the first taxable year of the trust beginning after August

10, 1999. In response to requests for more specific guidance, the final

regulations provide that the grandfather rules apply only if any

amounts that were gratuitously transferred to the trust after September

19, 1995, are treated as a separate portion of the trust that is

accounted for under the rules of Sec. 1.671-3(a)(2).

B. Certain Trusts That Can Distribute Only to the Grantor or the Spouse

of the Grantor

Under the proposed regulations, the general rule of Sec. 1.672(f)-1

did not apply if the only amounts distributable from a trust (or

portion of a trust) during the lifetime of the grantor were amounts

distributable to the grantor or the grantor's spouse. Treasury and the

IRS contemplate that the fact that the grantor and his or her spouse

might someday divorce or legally separate will be disregarded for

purposes of determining whether the exception is applicable.

Under the proposed regulations, amounts distributable in discharge

of a legal obligation of the grantor or the grantor's spouse generally

were treated as amounts distributable to the grantor or the grantor's

spouse. Commenters said these proposed rules were inconsistent with the

manner in which distributions in discharge of obligations are treated

in regulations promulgated under other provisions of the Code. For

example, under sections 677(a) and 662(a)(2), there is no exception for

obligations to family members that are not based on full and adequate

consideration in money or money's worth. Commenters also said the

proposed rules were likely to exclude most trusts from qualification

for the exception because, in most jurisdictions, a trust provision

that permits distributions to a particular person is construed to

permit distributions to be made in satisfaction of that person's

obligations, regardless of the source of the obligations.

Treasury and the IRS believe it is neither necessary nor

appropriate for the regulations promulgated under the statutory

exceptions to section 672(f) to be consistent with the regulations

promulgated under other provisions of part I of subchapter J, chapter 1

of the Code. Section 672(f) reflects a policy determination that

foreign persons should not be allowed ``to affirmatively use the

domestic anti-abuse rules concerning grantor trusts'' to avoid U.S. tax

on trust income distributed to U.S. beneficiaries. Dept. of the

Treasury, General Explanations of the Administration's Revenue

Proposals, at 12 (1995). Section 672(f) operates to implement that

policy determination by providing that the grantor trust rules

generally do not apply where their effect would be to treat a foreign

person as the owner of any portion of a trust. S. Rep. No. 35, 104th

Cong., 1st Sess. 161 (1995). The exceptions in section 672(f)(2) must

be interpreted narrowly to preserve the primary operation of the

general rule. See, for example, Commissioner v. Clark, 489 U.S. 726,

739 (1989) (``In construing provisions * * * in which a general

statement of policy is qualified by an exception, we usually read the

exception narrowly in order to preserve the primary operation of the

provision.'').

The final regulations continue to provide that a trust will not

fail to qualify for the exception solely because amounts are

distributable from the trust in discharge of a legal obligation of the

grantor (or grantor's spouse). An obligation to a related person is not

generally treated as a legal obligation unless it was contracted bona

fide and for adequate and full consideration in money or money's worth.

However, obligations to support certain individuals will be treated as

legal obligations if the individual is either permanently and totally

disabled or less than 19 years old. The final regulations expand the

list of potentially eligible individuals to include certain individuals

who are members of the grantor's (or grantor's spouse's) household and

have as their principal place of abode the grantor's (or grantor's

spouse's) home, but are not related to the grantor (or grantor's

spouse) through one of the relationships listed in section 152(a)(1)

through (8). The fact that amounts might become distributable from a

trust to support an individual who is not described in the regulations

will be disregarded if, at the time the applicability of the exception

is being determined, the potential obligation is not reasonably

expected to arise under the facts and circumstances.

Some commenters said the limitation in proposed Sec. 1.672(f)-

3(b)(2)(ii) for legal obligations to related persons is not needed in

the case of reinsurance trusts because, regardless of the sufficiency

of the consideration for the reinsurance, the funds in a reinsurance

trust can be utilized only to satisfy the legal obligations of the

reinsurer (or will be distributed to the reinsurer). In addition,

commenters pointed out that there already are other provisions, such as

sections 482 and 845, that apply to related-party reinsurance

arrangements.

The final regulations reserve on the application of the related-

party rule to reinsurance trusts. Treasury and the IRS are looking

carefully at this area, and they invite additional comments.

Commenters raised a number of issues concerning the grandfather

rules in Sec. 1.672(f)-3(b)(4) of the proposed regulations. These

issues are discussed above in connection with the

[[Page 43271]]

grandfather rules under Sec. 1.672(f)-3(a)(2) of the proposed

regulations.

C. Compensatory Trusts

The proposed regulations listed categories of trusts that

constitute compensatory trusts, without regard to whether any portion

of a particular trust would ever be treated as owned by the grantor or

another person under the grantor trust rules. Treasury and the IRS are

concerned that some taxpayers may find such a comprehensive list

confusing. Accordingly, the final regulations provide that the trusts

to which the compensatory trust exception applies are those to which

the application of section 672(f) is likely to be relevant: (i)

nonexempt employees' trusts described in section 402(b) and (ii) so-

called ``rabbi'' trusts. Treasury and the IRS believe the issue of

whether tax-exempt compensatory trusts can be treated as owned by a

foreign person is moot because there are special statutory rules that

govern those trusts.

Treasury and the IRS contemplate that a nonexempt employees' trust

described in section 402(b) will be treated as owned by a beneficiary

of the trust only to the extent provided in regulations section

1.402(b)-1(b)(6). See also proposed regulations Sec. 1.671-1(g) and

Sec. 1.671-1(h), which were published in the Federal Register (61 FR

50778) on September 27, 1996, for proposed rules describing when an

employer will be 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.

The final regulations also provide that the Commissioner may

designate additional categories of trusts to which the compensatory

trust exception applies.

6. Comments and Changes to Sec. 1.672(f)-4: Recharacterization of

Purported Gifts

The proposed regulations provided that a U.S. donee generally must

treat a purported gift from a foreign corporation as a distribution

from the foreign corporation unless the U.S. donee can establish that a

U.S. citizen or resident alien is a shareholder of the transferor and

that the U.S. citizen or resident took the amount into account for U.S.

tax purposes and subsequently made a gift to the U.S. donee. Similar

rules were proposed for purported gifts from partnerships (whether

domestic or foreign). There were exceptions for charitable

contributions to donees described in section 170(c) and for purported

gifts that did not exceed $10,000.

Section 1.672(f)-4(c) of the proposed regulations provided rules

for gratuitous transfers to U.S. donees from trusts created by

partnerships or foreign corporations. Under the proposed regulations,

if the partnership or foreign corporation was treated as the owner of

the trust under the grantor trust rules, the transfer was treated as a

purported gift from the partnership or foreign corporation. If the

partnership or foreign corporation was not treated as the owner of the

trust, the transfer was treated as an accumulation distribution from

the trust unless the resulting U.S. tax liability was less than the

U.S. tax that would be due if the transfer were treated as a purported

gift from the partnership or foreign corporation.

Commenters said the proposed regulations were overly broad and

exceeded the scope of the regulatory authority granted by Congress.

They suggested that a purported gift from a partnership or foreign

corporation should be treated as a deemed distribution to the partner

or shareholder followed by a deemed transfer to the U.S. donee.

Commenters also suggested that purported gifts should not be

recharacterized as taxable distributions unless it appeared, based on

all the facts and circumstances, that the partnership or foreign

corporation was being used principally as a device to avoid U.S. tax.

Treasury and the IRS believe the basic approach taken by the

proposed regulations is both necessary and appropriate to prevent the

avoidance of the purposes of section 672(f). See Code section 672(f)(4)

and (6). A rule that would recharacterize purported gifts only in

situations where the partnership or foreign corporation was being used

principally as a device to avoid U.S. tax would be unadministrable. It

would place a nearly insurmountable burden on the IRS to obtain

information, much of it outside the United States, and to establish

that the partnership or foreign corporation was being used to avoid

U.S. tax. Further, individuals do not normally receive gifts from

partnerships and corporations. See, for example, Commissioner v.

Duberstein, 363 U.S. 278 (1960).

The final regulations leave the basic approach essentially

unaltered, but expand the number of exceptions to the general rule.

They retain the exception for cases where the U.S. donee can establish

that a U.S. citizen or resident alien treated (and reported) the

purported gift for U.S. tax purposes as a distribution from the

partnership or foreign corporation and a subsequent gift to the donee.

In response to the commenters' concerns, they provide an additional

exception for cases where the U.S. donee can establish that a

nonresident alien individual treated and reported the purported gift

for purposes of the tax laws of the country in which the nonresident

alien is resident as a distribution from the partnership or foreign

corporation and a subsequent gift to the donee, provided the U.S. donee

timely complied with the filing requirements of section 6039F, if

applicable. Finally, they provide another new exception for purported

gifts from domestic partnerships that are beneficially owned (within

the meaning of Sec. 1.1441-1(c)(6)) exclusively by U.S. citizens or

residents or domestic corporations.

In response to other comments, the final regulations clarify that a

transfer to a U.S. donee that is a corporation will not be subject to

the general rule of Sec. 1.672(f)-4(a) to the extent the donee can

establish that the transfer was a contribution to capital. The final

regulations also expand the scope of the charitable contribution

exception to include a transfer from a transferor that has received a

ruling or determination letter from the Internal Revenue Service

recognizing its exempt status under section 501(c)(3), provided that

the transfer was made pursuant to the transferor's exempt purpose, the

ruling or determination letter has not been revoked or modified, and

there has been no material change, inconsistent with exemption, in the

character, purpose, or method of operation of the organization.

The final regulations revise the rules for gratuitous transfers to

U.S. donees from trusts to which partnerships or foreign corporations

have made gratuitous transfers. The revisions reflect the fact that,

under U.S. domestic law principles, the partners or shareholders might

be treated as grantors of the trust. See Sec. 1.671-2T(e)(4).

The final regulations also clarify that if the transferring

partnership or foreign corporation receives some consideration from the

U.S. donee, but the consideration is less than the fair market value of

the property transferred, only the excess will be treated as a

purported gift. Further, no portion will be treated as a purported gift

if the U.S. donee can establish that the U.S. donee is neither related

to a partner or shareholder of the transferor within the meaning of

Sec. 1.643(h)-1(e) nor has another relationship with a partner or

shareholder of the transferor such that there is a reasonable basis for

concluding that the partner or shareholder would make a gratuitous

transfer to the U.S. donee.

Commenters said the proposed regulations overturned an early

Supreme Court decision, Bogardus v.

[[Page 43272]]

Commissioner, 302 U.S. 34 (1937), which treated certain payments by an

acquiring corporation in a reorganization that were paid at the

instigation of former shareholders of the target corporation to

employees and former employees of the target corporation as nontaxable

gifts rather than as compensation. The result in Bogardus might well be

different today under section 102(c)(1) (enacted in 1986), which

provides that the exclusion from gross income for the value of property

acquired by gift does not apply to any amount transferred by or for an

employer to, or for the benefit of, an employee. Further, and more

importantly, the payor corporation in Bogardus was a domestic

corporation that did not treat the payments as a deductible expense and

there was no avoidance of U.S. tax. Thus, Bogardus is distinguishable

on its facts from a situation where a foreign corporation transfers

property to a U.S. person who treats the transfer as a gift or bequest

and there will be avoidance of U.S. tax if the purported gift is not

recharacterized.

The final regulations for purported gifts are generally applicable

to transfers made after August 10, 1999 by partnerships or foreign

corporations, or by trusts to which partnerships or foreign

corporations made gratuitous transfers after August 10, 1999.

7. Comments and Changes to Sec. 1.672(f)-5: Special Rules

Section 1.672(f)-5(b) of the proposed regulations provided that,

for purposes of Sec. 1.672(f)-1, where the taxable year of a trust was

different from the taxable year of a person who was taking an amount

into account, the amount was taken into account for the taxable year of

the person that included the last day of the taxable year of the trust.

This rule was deleted from the final regulations, because it is no

longer needed in light of the revisions to Sec. 1.672(f)-1, which are

described above in part 3 of this explanation.

Section 1.672(f)-5(c) of the proposed regulations provided that,

for purposes of Sec. 1.672(f)-4, a wholly owned business entity must be

treated as a corporation, separate from its single owner. Absent this

rule, an entity having a single owner could avoid the purported gift

rule by electing to be disregarded, with the result that the purported

gift would be received from the owner of the entity, rather than from

the entity itself. The final regulations clarify that this special rule

(renumbered as Sec. 1.672(f)-5(b)) applies solely for purposes of

Sec. 1.672(f)-4. Thus, it does not apply for purposes of

Secs. 1.672(f)-1 through 1.672(f)-3 or Sec. 1.672(f)-5 or for purposes

of any other provision of the Code or regulations.

Section 301.7701-2(c)(2)(iii) of the proposed regulations provided

that, solely for purposes of applying the rules of section 672(f)(4), a

wholly owned business entity will be treated as a corporation, separate

from its owner. This provision, which repeated the rule in

Sec. 1.672(f)-5(c) (renumbered as Sec. 1.672(f)-5(b)), is not included

in the final regulations.

Special Analyses

It has been determined that this Treasury decision is not a

significant regulatory action as defined in Executive Order 12866.

Therefore, a regulatory assessment is not required. It 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, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not

apply. Pursuant 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 the regulation's impact on small

business.

Drafting Information. The principal authors of these regulations

are M. Grace Fleeman of the Office of Associate Chief Counsel

(International) and James A. Quinn of the Office of the Assistant 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.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

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

entries in numerical order to read in part as follows:

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

Section 1.643(h)-1 also issued under 26 U.S.C. 643(a)(7).

Section 1.671-2T also issued under 26 U.S.C. 643(a)(7) and

672(f)(6).

Section 1.672(f)-1 also issued under 26 U.S.C. 643(a)(7) and

672(f)(6).

Section 1.672(f)-2 also issued under 26 U.S.C. 643(a)(7) and

672(f)(3) and (6).

Section 1.672(f)-3 also issued under 26 U.S.C. 643(a)(7) and

672(f)(2) and (6).

Section 1.672(f)-4 also issued under 26 U.S.C. 643(a)(7) and

672(f)(4) and (6).

Section 1.672(f)-5 also issued under 26 U.S.C. 643(a)(7) and

672(f)(6). * * *

Par. 2. Section 1.643(h)-1 is added to read as follows:

Sec. 1.643(h)-1 Distributions by certain foreign trusts through

intermediaries.

(a) In general--(1) Principal purpose of tax avoidance. Except as

provided in paragraph (b) of this section, for purposes of part I of

subchapter J, chapter 1 of the Internal Revenue Code, and section 6048,

any property (within the meaning of paragraph (f) of this section) that

is transferred to a United States person by another person (an

intermediary) who has received property from a foreign trust will be

treated as property transferred directly by the foreign trust to the

United States person if the intermediary received the property from the

foreign trust pursuant to a plan one of the principal purposes of which

was the avoidance of United States tax.

(2) Principal purpose of tax avoidance deemed to exist. For

purposes of paragraph (a)(1) of this section, a transfer will be deemed

to have been made pursuant to a plan one of the principal purposes of

which was the avoidance of United States tax if the United States

person--

(i) Is related (within the meaning of paragraph (e) of this

section) to a grantor of the foreign trust, or has another relationship

with a grantor of the foreign trust that establishes a reasonable basis

for concluding that the grantor of the foreign trust would make a

gratuitous transfer (within the meaning of Sec. 1.671-2T(e)(2)) to the

United States person;

(ii) Receives from the intermediary, within the period beginning

twenty-four months before and ending twenty-four months after the

intermediary's receipt of property from the foreign trust, either the

property the intermediary received from the foreign trust, proceeds

from such property, or property in substitution for such property; and

(iii) Cannot demonstrate to the satisfaction of the Commissioner

that--

(A) The intermediary has a relationship with the United

States person that establishes a reasonable basis for concluding

that the intermediary would make a gratuitous transfer to the United

States person;

(B) The intermediary acted independently of the grantor and the

trustee of the foreign trust;

(C) The intermediary is not an agent of the United States person

under generally applicable United States agency principles; and

[[Page 43273]]

(D) The United States person timely complied with the reporting

requirements of section 6039F, if applicable, if the intermediary is a

foreign person.

(b) Exceptions--(1) Nongratuitous transfers. Paragraph (a) of this

section does not apply to the extent that either the transfer from the

foreign trust to the intermediary or the transfer from the intermediary

to the United States person is a transfer that is not a gratuitous

transfer within the meaning of Sec. 1.671-2T(e)(2).

(2) Grantor as intermediary. Paragraph (a) of this section does not

apply if the intermediary is the grantor of the portion of the trust

from which the property that is transferred is derived. For the

definition of grantor, see Sec. 1.671-2T(e).

(c) Effect of disregarding intermediary--(1) General rule. Except

as provided in paragraph (c)(2) of this section, the intermediary is

treated as an agent of the foreign trust, and the property is treated

as transferred to the United States person in the year the property is

transferred, or made available, by the intermediary to the United

States person. The fair market value of the property transferred is

determined as of the date of the transfer by the intermediary to the

United States person. For purposes of section 665(d)(2), the term taxes

imposed on the trust includes any income, war profits, and excess

profits taxes imposed by any foreign country or possession of the

United States on the intermediary with respect to the property

transferred.

(2) Exception. If the Commissioner determines, or if the taxpayer

can demonstrate to the satisfaction of the Commissioner, that the

intermediary is an agent of the United States person under generally

applicable United States agency principles, the property will be

treated as transferred to the United States person in the year the

intermediary receives the property from the foreign trust. The fair

market value of the property transferred will be determined as of the

date of the transfer by the foreign trust to the intermediary. For

purposes of section 901(b), any income, war profits, and excess profits

taxes imposed by any foreign country or possession of the United States

on the intermediary with respect to the property transferred will be

treated as having been imposed on the United States person.

(3) Computation of gross income of intermediary. If property is

treated as transferred directly by the foreign trust to a United States

person pursuant to this section, the fair market value of such property

is not taken into account in computing the gross income of the

intermediary (if otherwise required to be taken into account by the

intermediary but for paragraph (a) of this section).

(d) Transfers not in excess of $10,000. This section does not apply

if, during the taxable year of the United States person, the aggregate

fair market value of all property transferred to such person from all

foreign trusts either directly or through one or more intermediaries

does not exceed $10,000.

(e) Related parties. For purposes of this section, a United States

person is treated as related to a grantor of a foreign trust if the

United States person and the grantor are related for purposes of

section 643(i)(2)(B), with the following modifications--

(1) For purposes of applying section 267 (other than section

267(f)) and section 707(b)(1), ``at least 10 percent'' is used instead

of ``more than 50 percent'' each place it appears; and

(2) The principles of section 267(b)(10), using ``at least 10

percent'' instead of ``more than 50 percent,'' apply to determine

whether two corporations are related.

(f) Definition of property. For purposes of this section, the term

property includes cash.

(g) Examples. The following examples illustrate the rules of this

section. In each example, FT is an irrevocable foreign trust that is

not treated as owned by any other person and the fair market value of

the property that is transferred exceeds $10,000. The examples are as

follows:

Example 1. Principal purpose of tax avoidance. FT was created in

1980 by A, a nonresident alien, for the benefit of his children and

their descendants. FT's trustee, T, determines that 1000X of

accumulated income should be distributed to A's granddaughter, B,

who is a resident alien. Pursuant to a plan with a principal purpose

of avoiding the interest charge that would be imposed by section

668, T causes FT to make a gratuitous transfer (within the meaning

of Sec. 1.671-2T(e)(2)) of 1000X to I, a foreign person. I

subsequently makes a gratuitous transfer of 1000X to B. Under

paragraph (a)(1) of this section, FT is deemed to have made an

accumulation distribution of 1000X directly to B.

Example 2. United States person unable to demonstrate that

intermediary acted independently. GM and her daughter, M, are both

nonresident aliens. M's daughter, D, is a resident alien. GM creates

and funds FT for the benefit of her children. On July 1, 2001, FT

makes a gratuitous transfer of XYZ stock to M. M immediately sells

the XYZ stock and uses the proceeds to purchase ABC stock. On

January 1, 2002, M makes a gratuitous transfer of the ABC stock to

D. D is unable to demonstrate that M acted independently of GM and

the trustee of FT in making the transfer to D. Under paragraph

(a)(2) of this section, FT is deemed to have distributed the ABC

stock to D. Under paragraph (c)(1) of this section, M is treated as

an agent of FT, and the distribution is deemed to have been made on

January 1, 2002.

Example 3. United States person demonstrates that specified

conditions are satisfied. Assume the same facts as in Example 2,

except that M receives 1000X cash from FT instead of XYZ stock. M

gives 1000X cash to D on January 1, 2002. Also assume that M

receives annual income of 5000X from her own investments and that M

has given D 1000X at the beginning of each year for the past ten

years. Based on this and additional information provided by D, D

demonstrates to the satisfaction of the Commissioner that M has a

relationship with D that establishes a reasonable basis for

concluding that M would make a gratuitous transfer to D, that M

acted independently of GM and the trustee of FT, that M is not an

agent of D under generally applicable United States agency

principles, and that D timely complied with the reporting

requirements of section 6039F. FT will not be deemed under paragraph

(a)(2) of this section to have made a distribution to D.

Example 4. Transfer to United States person less than 24 months

before transfer to intermediary. Several years ago, A, a nonresident

alien, created and funded FT for the benefit of his children and

their descendants. A has a close friend, C, who also is a

nonresident alien. A's granddaughter, B, is a resident alien. On

December 31, 2001, C makes a gratuitous transfer of 1000X to B. On

January 15, 2002, FT makes a gratuitous transfer of 1000X to C. B is

unable to demonstrate that C has a relationship with B that would

establish a reasonable basis for concluding that C would make a

gratuitous transfer to B or that C acted independently of A and the

trustee of FT in making the transfer to B. Under paragraph (a)(2) of

this section, FT is deemed to have distributed 1000X directly to B.

Under paragraph (c)(1) of this section, C is treated as an agent of

FT, and the distribution is deemed to have been made on December 31,

2001.

Example 5. United States person receives property in

substitution for property transferred to intermediary. GM and her

son, S, are both nonresident aliens. S's daughter, GD, is a resident

alien. GM creates and funds FT for the benefit of her children and

their descendants. On July 1, 2001, FT makes a gratuitous transfer

of ABC stock with a fair market value of approximately 1000X to S.

On January 1, 2002, S makes a gratuitous transfer of DEF stock with

a fair market value of approximately 1000X to GD. GD is unable to

demonstrate that S acted independently of GM and the trustee of FT

in transferring the DEF stock to GD. Under paragraph (a)(2) of this

section, FT is deemed to have distributed the DEF stock to GD. Under

paragraph (c)(1) of this section, S is treated as an agent of FT,

and the distribution is deemed to have been made on January 1, 2002.

Example 6. United States person receives indirect loan from

foreign trust. Several years ago, A, a nonresident alien, created

and funded FT for the benefit of her children and their descendants.

A's daughter, B, is a

[[Page 43274]]

resident alien. B needs funds temporarily while she is starting up

her own business. If FT were to loan money directly to B, section

643(i) would apply. FT deposits 500X with FB, a foreign bank, on

June 30, 2001. On July 1, 2001, FB loans 400X to B. Repayment of the

loan is guaranteed by FT's 500X deposit. B is unable to demonstrate

to the satisfaction of the Commissioner that FB has a relationship

with B that establishes a reasonable basis for concluding that FB

would make a loan to B or that FB acted independently of A and the

trustee of FT in making the loan. Under paragraph (a)(2) of this

section, FT is deemed to have loaned 400X directly to B on July 1,

2001. Under paragraph (c)(1) of this section, FB is treated as an

agent of FT. For the treatment of loans from foreign trusts, see

section 643(i).

Example 7. United States person demonstrates that specified

conditions are satisfied. GM, a nonresident alien, created and

funded FT for the benefit of her children and their descendants. One

of GM's children is M, who is a resident alien. During the year

2001, FT makes a gratuitous transfer of 500X to M. M reports the

500X on Form 3520 as a distribution received from a foreign trust.

During the year 2002, M makes a gratuitous transfer of 400X to her

son, S, who also is a resident alien. M files a Form 709 treating

the gratuitous transfer to S as a gift. Based on this and additional

information provided by S, S demonstrates to the satisfaction of the

Commissioner that M has a relationship with S that establishes a

reasonable basis for concluding that M would make a gratuitous

transfer to S, that M acted independently of GM and the trustee of

FT, and that M is not an agent of S under generally applicable

United States agency principles. FT will not be deemed under

paragraph (a)(2) of this section to have made a distribution to S.

Example 8. Intermediary as agent of trust; increase in FMV. A, a

nonresident alien, created and funded FT for the benefit of his

children and their descendants. On December 1, 2001, FT makes a

gratuitous transfer of XYZ stock with a fair market value of 85X to

B, a nonresident alien. On November 1, 2002, B sells the XYZ stock

to a third party in an arm's length transaction for 100X in cash. On

November 1, 2002, B makes a gratuitous transfer of 98X to A's

grandson, C, a resident alien. C is unable to demonstrate to the

satisfaction of the Commissioner that B acted independently of A and

the trustee of FT in making the transfer. Under paragraph (a)(2) of

this section, FT is deemed to have made a distribution directly to

C. Under paragraph (c)(1) of this section, B is treated as an agent

of FT, and FT is deemed to have distributed 98X to C on November 1,

2002.

Example 9. Intermediary as agent of United States person;

increase in FMV. Assume the same facts as in Example 8, except that

the Commissioner determines that B is an agent of C under generally

applicable United States agency principles. Under paragraph (c)(2)

of this section, FT is deemed to have distributed 85X to C on

December 1, 2001. C must take the gain of 15X into account in the

year 2002.

Example 10. Intermediary as agent of trust; decrease in FMV.

Assume the same facts as in Example 8, except that the value of the

XYZ stock on November 1, 2002, is only 80X. Instead of selling the

XYZ stock to a third party and transferring cash to C, B transfers

the XYZ stock to C in a gratuitous transfer. Under paragraph (c)(1)

of this section, FT is deemed to have distributed XYZ stock with a

value of 80X to C on November 1, 2002.

Example 11. Intermediary as agent of United States person;

decrease in FMV. Assume the same facts as in Example 10, except that

the Commissioner determines that B is an agent of C under generally

applicable United States agency principles. Under paragraph (c)(2)

of this section, FT is deemed to have distributed XYZ stock with a

value of 85X to C on December 1, 2001.

(h) Effective date. The rules of this section are applicable to

transfers made to United States persons after August 10, 1999.

Par. 3. In Sec. 1.671-2, paragraph (e) is revised to read as

follows:

Sec. 1.671-2 Applicable principles.

* * * * *

(e) [Reserved] For further guidance, see Sec. 1.671-2T(e).

Par. 4. Section 1.671-2T is added to read as follows:

Sec. 1.671-2T Applicable principles (temporary).

(a) Athrough (d) [Reserved]. For further guidance, see Sec. 1.671-

2(a) through (d).

(e)(1) For purposes of part I of subchapter J, chapter 1 of the

Internal Revenue Code, a grantor includes any person to the extent such

person either creates a trust, or directly or indirectly makes a

gratuitous transfer (within the meaning of paragraph (e)(2) of this

section) of property to a trust. For purposes of this section, the term

property includes cash. If a person creates or funds a trust on behalf

of another person, both persons are treated as grantors of the trust.

(See section 6048 for reporting requirements that apply to grantors of

foreign trusts.) However, a person who creates a trust but makes no

gratuitous transfers to the trust is not treated as an owner of any

portion of the trust under sections 671 through 677 or 679. Also, a

person who funds a trust with an amount that is directly reimbursed to

such person within a reasonable period of time and who makes no other

transfers to the trust that constitute gratuitous transfers is not

treated as an owner of any portion of the trust under sections 671

through 677 or 679. See also Sec. 1.672(f)-5(a).

(2)(i) A gratuitous transfer is any transfer other than a transfer

for fair market value. A transfer of property to a trust may be

considered a gratuitous transfer without regard to whether the transfer

is treated as a gift for gift tax purposes.

(ii) For purposes of this paragraph (e), a transfer is for fair

market value only to the extent of the value of property received from

the trust, services rendered by the trust, or the right to use property

of the trust. For example, rents, royalties, interest, and compensation

paid to a trust are transfers for fair market value only to the extent

that the payments reflect an arm's length price for the use of the

property of, or for the services rendered by, the trust. For purposes

of this determination, an interest in the trust is not property

received from the trust. In addition, a person will not be treated as

making a transfer for fair market value merely because the transferor

recognizes gain on the transaction. See, for example, section 684

regarding the recognition of gain on certain transfers to foreign

trusts.

(iii) For purposes of this paragraph (e), a gratuitous transfer

does not include a distribution to a trust with respect to an interest

held by such trust in either a trust described in paragraph (e)(3) of

this section or an entity other than a trust. For example, a

distribution to a trust by a corporation with respect to its stock

described in section 301 is not a gratuitous transfer.

(3) A grantor includes any person who acquires an interest in a

trust from a grantor of the trust if the interest acquired is an

interest in certain investment trusts described in Sec. 301.7701-4(c)

of this chapter, liquidating trusts described in Sec. 301.7701-4(d) of

this chapter, or environmental remediation trusts described in

Sec. 301.7701-4(e) of this chapter.

(4) If a gratuitous transfer is made by a partnership or

corporation to a trust and is for a business purpose of the partnership

or corporation, the partnership or corporation will generally be

treated as the grantor of the trust. For example, if a partnership

makes a gratuitous transfer to a trust in order to secure a legal

obligation of the partnership to a third party unrelated to the

partnership, the partnership will be treated as the grantor of the

trust. However, if a partnership or a corporation makes a gratuitous

transfer to a trust that is not for a business purpose of the

partnership or corporation but is, e.g., for the personal purposes of

one or more of the partners or shareholders, the gratuitous transfer

will be treated as a constructive distribution to such partners or

shareholders under federal tax principles and the partners or the

shareholders will be treated as the grantors of the trust. For example,

if a partnership makes a gratuitous transfer to a trust that is for the

benefit of a child of a partner, the gratuitous transfer will

[[Page 43275]]

be treated as a distribution to the partner under section 731 and a

subsequent gratuitous transfer by the partner to the trust.

(5) If a trust makes a gratuitous transfer of property to another

trust, the grantor of the transferor trust generally will be treated as

the grantor of the transferee trust. However, if a person with a

general power of appointment over the transferor trust exercises that

power in favor of another trust, then such person will be treated as

the grantor of the transferee trust, even if the grantor of the

transferor trust is treated as the owner of the transferor trust under

subpart E of part I, subchapter J, chapter 1 of the Internal Revenue

Code.

(6) The following examples illustrate the rules of this paragraph

(e). Unless otherwise indicated, all trusts are domestic trusts and all

other persons are United States persons.

The examples are as follows:

Example 1. A creates and funds a trust, T, for the benefit of

her children. B subsequently makes a gratuitous transfer to T. Under

paragraph (e)(1) of this section, both A and B are grantors of T.

Example 2. A makes an investment in a fixed investment trust, T,

that is classified as a trust under Sec. 301.7701-4(c)(1) of this

chapter. A is a grantor of T. B subsequently acquires A's entire

interest in T. Under paragraph (e)(3) of this section, B is a

grantor of T with respect to such interest.

Example 3. A, an attorney, creates a foreign trust, FT, on

behalf of A's client, B, and transfers $100 to FT out of A's funds.

A is reimbursed by B for the $100 transferred to FT. The trust

instrument states that the trustee has discretion to distribute the

income or corpus of FT to B, and B's children. Both A and B are

treated as grantors of FT under paragraph (e)(1) of this section. In

addition, B is treated as the owner of the entire trust under

section 677. Because A is reimbursed for the $100 transferred to FT

on behalf of B, A is not treated as transferring any property to FT.

Therefore, A is not an owner of any portion of T under sections 671

through 677 regardless of whether A retained any power over or

interest in T described in sections 673 through 677. A also is not

treated as an owner of any portion of T under section 679. Both A

and B are responsible parties for purposes of the reporting

requirements in section 6048.

Example 4. A creates and funds a trust, T. A is not treated as

an owner of any portion of the trust under subpart E. B holds an

unrestricted power, exercisable solely by B, to withdraw certain

amounts contributed to the trust before the end of the calendar year

and to vest those amounts in B. B is treated as an owner of the

portion of T that is subject to the withdrawal power under section

678(a)(1). However, B is not a grantor of T under paragraph (e)(1)

of this section because B neither created T nor made a gratuitous

transfer to T.

Example 5. A transfers cash to a trust, T, through a broker, in

exchange for units in T. The units in T are not property for

purposes of determining whether A has received fair market value

under paragraph (e)(2)(ii) of this section. Therefore, A has made a

gratuitous transfer to T, and, under paragraph (e)(1) of this

section, A is a grantor of T.

Example 6. A borrows cash from T, a trust. A has not made any

gratuitous transfers to T. Arm's length interest payments by A to T

will not be treated as gratuitous transfers under paragraph

(e)(2)(ii) of this section. Therefore, under paragraph (e)(1) of

this section, A is not a grantor of T with respect to the interest

payments.

Example 7. A, B's brother, creates a trust, T, for B's benefit

and contributes $50,000 to T. The trustee invests the $50,000 in

stock of Company X. C, B's uncle, sells property with a fair market

value of $1,000,000 to T in exchange for the stock when it has

appreciated to a fair market value of $100,000. Under paragraph

(e)(2)(ii) of this section, the $900,000 excess value is a

gratuitous transfer by C. Therefore, under paragraph (e)(1) of this

section, A is a grantor with respect to the portion of the trust

valued at $100,000, and C is a grantor of T with respect to the

portion of the trust valued at $900,000. In addition, A or C or both

will be treated as the owners of the respective portions of the

trust of which each person is a grantor if A or C or both retain

powers over or interests in such portions under sections 673 through

677.

Example 8. G creates and funds a trust, T1, for the benefit of

G's children and grandchildren. After G's death, under authority

granted to the trustees in the trust instrument, the trustees of T1

transfer a portion of the assets of T1 to another trust, T2, and

retain a power to revoke T2 and revest the assets of T2 in T1. Under

paragraphs (e)(1) and (5) of this section, G is the grantor of T1

and T2. In addition, because the trustees of T1 have retained a

power to revest the assets of T2 in T1, T1 is treated as the owner

of T2 under section 678(a).

Example 9. G creates and funds a trust, T1, for the benefit of

B. G retains a power to revest the assets of T1 in G within the

meaning of section 676. Under the trust agreement, B is given a

general power of appointment over the assets of T1. B exercises the

general power of appointment with respect to one-half of the corpus

of T1 in favor of a trust, T2, that is for the benefit of C, B's

child. Under paragraph (e)(1) of this section, G is the grantor of

T1, and under paragraphs (e)(1) and (5) of this section, B is the

grantor of T2.

(7) The rules of this section are applicable to any transfer to a

trust, or transfer of an interest in a trust, on or after August 10,

1999. In accordance with section 7805(e)(2), the rules of this section

will expire before August 12, 2002.

Par. 5. Sections 1.672(f)-1, 1.672(f)-2, 1.672(f)-3, 1.672(f)-4,

and 1.672(f)-5 are added to read as follows:

Sec. 1.672(f)-1 Foreign persons not treated as owners.

(a) General rule--(1) Application of the general rule. Section

672(f)(1) provides that subpart E of part I, subchapter J, chapter 1 of

the Internal Revenue Code (the grantor trust rules) shall apply only to

the extent such application results in an amount (if any) being

currently taken into account (directly or through one or more entities)

in computing the income of a citizen or resident of the United States

or a domestic corporation. Accordingly, the grantor trust rules apply

to the extent that any portion of the trust, upon application of the

grantor trust rules without regard to section 672(f), is treated as

owned by a United States citizen or resident or domestic corporation.

The grantor trust rules do not apply to any portion of the trust to the

extent that, upon application of the grantor trust rules without regard

to section 672(f), that portion is treated as owned by a person other

than a United States citizen or resident or domestic corporation,

unless the person is described in Sec. 1.672(f)-2(a) (relating to

certain foreign corporations treated as domestic corporations), or one

of the exceptions set forth in Sec. 1.672(f)-3 is met, (relating to:

trusts where the grantor can revest trust assets; trusts where the only

amounts distributable are to the grantor or the grantor's spouse; and

compensatory trusts). Section 672(f) applies to domestic and foreign

trusts. Any portion of the trust that is not treated as owned by a

grantor or another person is subject to the rules of subparts A through

D (section 641 and following), part I, subchapter J, chapter 1 of the

Internal Revenue Code.

(2) Determination of portion based on application of the grantor

trust rules. The determination of the portion of a trust treated as

owned by the grantor or other person is to be made based on the terms

of the trust and the application of the grantor trust rules and section

671 and the regulations thereunder.

(b) Example. The following example illustrates the rules of this

section:

Example. (i) A, a nonresident alien, funds an irrevocable

domestic trust, DT, for the benefit of his son, B, who is a United

States citizen, with stock of Corporation X. A's brother, C, who

also is a United States citizen, contributes stock of Corporation Y

to the trust for the benefit of B. A has a reversionary interest

within the meaning of section 673 in the X stock that would cause A

to be treated as the owner of the X stock upon application of the

grantor trust rules without regard to section 672(f). C has a

reversionary interest within the meaning of section 673 in the Y

stock that would cause C to be treated as the owner of the Y stock

upon application of the grantor trust rules without regard to

section 672(f). The trustee has discretion to accumulate or

currently distribute income of DT to B.

[[Page 43276]]

(ii) Because A is a nonresident alien, application of the

grantor trust rules without regard to section 672(f) would not

result in the portion of the trust consisting of the X stock being

treated as owned by a United States citizen or resident. None of the

exceptions in Sec. 1.672(f)-3 applies because A cannot revest the X

stock in A, amounts may be distributed during A's lifetime to B, who

is neither a grantor nor a spouse of a grantor, and the trust is not

a compensatory trust. Therefore, pursuant to paragraph (a)(1) of

this section, A is not treated as an owner under subpart E of part

I, subchapter J, chapter 1 of the Internal Revenue Code, of the

portion of the trust consisting of the X stock. Any distributions

from such portion of the trust are subject to the rules of subparts

A through D (641 and following), part I, subchapter J, chapter 1 of

the Internal Revenue Code.

(iii) Because C is a United States citizen, paragraph (a)(1) of

this section does not prevent C from being treated under section 673

as the owner of the portion of the trust consisting of the Y stock.

(c) Effective date. The rules of this section are applicable to

taxable years of a trust beginning after August 10, 1999.

Sec. 1.672(f)-2 Certain foreign corporations.

(a) Application of general rule. Subject to the provisions of

paragraph (b) of this section, if the owner of any portion of a trust

upon application of the grantor trust rules without regard to section

672(f) is a controlled foreign corporation (as defined in section 957),

a passive foreign investment company (as defined in section 1297), or a

foreign personal holding company (as defined in section 552), the

corporation will be treated as a domestic corporation for purposes of

applying the rules of Sec. 1.672(f)-1.

(b) Gratuitous transfers to United States persons--(1) Transfer

from trust to which corporation made a gratuitous transfer. If a trust

(or portion of a trust) to which a controlled foreign corporation,

passive foreign investment company, or foreign personal holding company

has made a gratuitous transfer (within the meaning of Sec. 1.671-

2T(e)(2)), makes a gratuitous transfer to a United States person, the

controlled foreign corporation, passive foreign investment company, or

foreign personal holding company, as the case may be, is treated as a

foreign corporation for purposes of Sec. 1.672(f)-4(c), relating to

gratuitous transfers from trusts (or portions of trusts) to which a

partnership or foreign corporation has made a gratuitous transfer.

(2) Transfer from trust over which corporation has a section 678

power. If a trust (or portion of a trust) that a controlled foreign

corporation, passive foreign investment company, or foreign personal

holding company is treated as owning under section 678 makes a

gratuitous transfer to a United States person, the controlled foreign

corporation, passive foreign investment company, or foreign personal

holding company, as the case may be, is treated as a foreign

corporation that had made a gratuitous transfer to the trust (or

portion of a trust) and the rules of Sec. 1.672(f)-4(c) apply.

(c) Special rules for passive foreign investment companies--(1)

Application of section 1297. For purposes of determining whether a

foreign corporation is a passive foreign investment company as defined

in section 1297, the grantor trust rules apply as if section 672(f) had

not come into effect.

(2) References to renumbered Internal Revenue Code section. For

taxable years of shareholders beginning on or before December 31, 1997,

and taxable years of passive foreign investment companies ending with

or within such taxable years of the shareholders, all references in

this Sec. 1.672(f)-2 to section 1297 are deemed to be references to

section 1296.

(d) Examples. The following examples illustrate the rules of this

section. In each example, FT is an irrevocable foreign trust, and CFC

is a controlled foreign corporation. The examples are as follows:

Example 1. Application of general rule. CFC creates and funds

FT. CFC is the grantor of FT within the meaning of Sec. 1.671-2T(e).

CFC has a reversionary interest in FT within the meaning of section

673 that would cause CFC to be treated as the owner of FT upon

application of the grantor trust rules without regard to section

672(f). Under paragraph (a) of this section, CFC is treated as a

domestic corporation for purposes of applying the general rule of

Sec. 1.672(f)-1. Thus, Sec. 1.672(f)-1 does not prevent CFC from

being treated as the owner of FT under section 673.

Example 2. Distribution from trust to which CFC made gratuitous

transfer. A, a nonresident alien, owns 40 percent of the stock of

CFC. A's brother B, a resident alien, owns the other 60 percent of

the stock of CFC. CFC makes a gratuitous transfer to FT. FT makes a

gratuitous transfer to A's daughter, C, who is a resident alien.

Under paragraph (b)(1) of this section, CFC will be treated as a

foreign corporation for purposes of Sec. 1.672(f)-4(c). For further

guidance, see Sec. 1.672(f)-4(g) Example 2 through Example 4.

(e) Effective date. The rules of this section are generally

applicable to taxable years of shareholders of controlled foreign

corporations, passive foreign investment companies, and foreign

personal holding companies beginning after August 10, 1999, and taxable

years of controlled foreign corporations, passive foreign investment

companies, and foreign personal holding companies ending with or within

such taxable years of the shareholders.

Sec. 1.672(f)-3 Exceptions to general rule.

(a) Certain revocable trusts--(1) In general. Subject to the

provisions of paragraph (a)(2) of this section, the general rule of

Sec. 1.672(f)-1 does not apply to any portion of a trust for a taxable

year of the trust if the power to revest absolutely in the grantor

title to such portion is exercisable solely by the grantor (or, in the

event of the grantor's incapacity, by a guardian or other person who

has unrestricted authority to exercise such power on the grantor's

behalf) without the approval or consent of any other person. If the

grantor can exercise such power only with the approval of a related or

subordinate party who is subservient to the grantor, such power is

treated as exercisable solely by the grantor. For the definition of

grantor, see Sec. 1.671-2T(e). For the definition of related or

subordinate party, see Sec. 1.672(c)-1. For purposes of this paragraph

(a), a related or subordinate party is subservient to the grantor

unless the presumption in the last sentence of Sec. 1.672(c)-1 is

rebutted by a preponderance of the evidence. A trust (or portion of a

trust) that fails to qualify for the exception provided by this

paragraph (a) for a particular taxable year of the trust will be

subject to the general rule of Sec. 1.672(f)-1 for that taxable year

and all subsequent taxable years of the trust.

(2) 183-day rule. For purposes of paragraph (a)(1) of this section,

the grantor is treated as having a power to revest for a taxable year

of the trust only if the grantor has such power for a total of 183 or

more days during the taxable year of the trust. If the first or last

taxable year of the trust (including the year of the grantor's death)

is less than 183 days, the grantor is treated as having a power to

revest for purposes of paragraph (a)(1) of this section if the grantor

has such power for each day of the first or last taxable year, as the

case may be.

(3) Grandfather rule for certain revocable trusts in existence on

September 19, 1995. Subject to the rules of paragraph (d) of this

section (relating to separate accounting for gratuitous transfers to

the trust after September 19, 1995), the general rule of Sec. 1.672(f)-

1 does not apply to any portion of a trust that was treated as owned by

the grantor under section 676 on September 19, 1995, as long as the

trust would continue to be so treated thereafter. However, the

preceding sentence does not apply to any portion of the trust

attributable to gratuitous transfers to the trust after September 19,

1995.

(4) Examples. The following examples illustrate the rules of this

paragraph (a):

[[Page 43277]]

Example 1. Grantor is owner. FP1, a foreign person, creates and

funds a revocable trust, T, for the benefit of FP1's children, who

are resident aliens. The trustee is a foreign bank, FB, that is

owned and controlled by FP1 and FP2, who is FP1's brother. The power

to revoke T and revest absolutely in FP1 title to the trust property

is exercisable by FP1, but only with the approval or consent of FB.

The trust instrument contains no standard that FB must apply in

determining whether to approve or consent to the revocation of T.

There are no facts that would suggest that FB is not subservient to

FP1. Therefore, the exception in paragraph (a)(1) of this section is

applicable.

Example 2. Death of grantor. Assume the same facts as in Example

1, except that FP1 dies. After FP1's death, FP2 has the power to

withdraw the assets of T, but only with the approval of FB. There

are no facts that would suggest that FB is not subservient to FP2.

However, the exception in paragraph (a)(1) of this section is no

longer applicable, because FP2 is not a grantor of T within the

meaning of Sec. 1.671-2T(e).

Example 3. Trustee is not related or subordinate party. Assume

the same facts as in Example 1, except that neither FP1 nor any

member of FP1's family has any substantial ownership interest or

other connection with FB. FP1 can remove and replace FB at any time

for any reason. Although FP1 can replace FB with a related or

subordinate party if FB refuses to approve or consent to FP1's

decision to revest the trust property in himself, FB is not a

related or subordinate party. Therefore, the exception in paragraph

(a)(1) of this section is not applicable.

Example 4. Unrelated trustee will consent to revocation. FP, a

foreign person, creates and funds an irrevocable trust, T. The

trustee is a foreign bank, FB, that is not a related or subordinate

party within the meaning of Sec. 1.672(c)-1. FB has the discretion

to distribute trust income or corpus to beneficiaries of T,

including FP. Even if FB would in fact distribute all the trust

property to FP if requested to do so by FP, the exception in

paragraph (a)(1) of this section is not applicable, because FP does

not have the power to revoke T.

(b) Certain trusts that can distribute only to the grantor or the

spouse of the grantor--(1) In general. The general rule of

Sec. 1.672(f)-1 does not apply to any trust (or portion of a trust) if

at all times during the lifetime of the grantor the only amounts

distributable (whether income or corpus) from such trust (or portion

thereof) are amounts distributable to the grantor or the spouse of the

grantor. For purposes of this paragraph (b), payments of amounts that

are not gratuitous transfers (within the meaning of Sec. 1.671-

2T(e)(2)) are not amounts distributable. For the definition of grantor,

see Sec. 1.671-2T(e).

(2) Amounts distributable in discharge of legal obligations--(i) In

general. A trust (or portion of a trust) does not fail to satisfy

paragraph (b)(1) of this section solely because amounts are

distributable from the trust (or portion thereof) in discharge of a

legal obligation of the grantor or the spouse of the grantor. Subject

to the provisions of paragraph (b)(2)(ii) of this section, an

obligation is considered a legal obligation for purposes of this

paragraph (b)(2)(i) if it is enforceable under the local law of the

jurisdiction in which the grantor (or the spouse of the grantor)

resides.

(ii) Related parties--(A) In general. Except as provided in

paragraph (b)(2)(ii)(B) of this section, an obligation to a person who

is a related person for purposes of Sec. 1.643(h)-1(e) (other than an

individual who is legally separated from the grantor under a decree of

divorce or of separate maintenance) is not a legal obligation for

purposes of paragraph (b)(2)(i) of this section unless it was

contracted bona fide and for adequate and full consideration in money

or money's worth (see Sec. 20.2043-1 of this chapter).

(B) Exceptions--(1) Amounts distributable in support of certain

individuals. Paragraph (b)(2)(ii)(A) of this section does not apply

with respect to amounts that are distributable from the trust (or

portion thereof) to support an individual who--

(i) Would be treated as a dependent of the grantor or the spouse of

the grantor under section 152(a)(1) through (9), without regard to the

requirement that over half of the individual's support be received from

the grantor or the spouse of the grantor; and

(ii) Is either permanently and totally disabled (within the meaning

of section 22(e)(3)), or less than 19 years old.

(2) Certain potential support obligations. The fact that amounts

might become distributable from a trust (or portion of a trust) in

discharge of a potential obligation under local law to support an

individual other than an individual described in paragraph

(b)(2)(ii)(B)(1) of this section is disregarded if such potential

obligation is not reasonably expected to arise under the facts and

circumstances.

(3) Reinsurance trusts. [Reserved]

(3) Grandfather rule for certain section 677 trusts in existence on

September 19, 1995. Subject to the rules of paragraph (d) of this

section (relating to separate accounting for gratuitous transfers to

the trust after September 19, 1995), the general rule of Sec. 1.672(f)-

1 does not apply to any portion of a trust that was treated as owned by

the grantor under section 677 (other than section 677(a)(3)) on

September 19, 1995, as long as the trust would continue to be so

treated thereafter. However, the preceding sentence does not apply to

any portion of the trust attributable to gratuitous transfers to the

trust after September 19, 1995.

(4) Examples. The following examples illustrate the rules of this

paragraph (b):

Example 1. Amounts distributable only to grantor or grantor's

spouse. H and his wife, W, are both nonresident aliens. H is 70

years old, and W is 65. H and W have a 30-year-old child, C, a

resident alien. There is no reasonable expectation that H or W will

ever have an obligation under local law to support C or any other

individual. H creates and funds an irrevocable trust, FT, using only

his separate property. H is the grantor of FT within the meaning of

Sec. 1.671-2T(e). Under the terms of FT, the only amounts

distributable (whether income or corpus) from FT as long as either H

or W is alive are amounts distributable to H or W. Upon the death of

both H and W, C may receive distributions from FT. During H's

lifetime, the exception in paragraph (b)(1) of this section is

applicable.

Example 2. Effect of grantor's death. Assume the same facts as

in Example 1. H predeceases W. Assume that W would be treated as

owning FT under section 678 if the grantor trust rules were applied

without regard to section 672(f). The exception in paragraph (b)(1)

of this section is no longer applicable, because W is not a grantor

of FT within the meaning of Sec. 1.671-2T(e).

Example 3. Amounts temporarily distributable to person other

than grantor or grantor's spouse. Assume the same facts as in

Example 1, except that C (age 30) is a law student at the time FT is

created and the trust instrument provides that, as long as C is in

law school, amounts may be distributed from FT to pay C's expenses.

Thereafter, the only amounts distributable from FT as long as either

H or W is alive will be amounts distributable to H or W. Even

assuming there is an enforceable obligation under local law for H

and W to support C while he is in school, distributions from FT in

payment of C's expenses cannot qualify as distributions in discharge

of a legal obligation under paragraph (b)(2) of this section,

because C is neither permanently and totally disabled nor less than

19 years old. The exception in paragraph (b)(1) of this section is

not applicable. After C graduates from law school, the exception in

paragraph (b)(1) still will not be applicable, because amounts were

distributable to C during the lifetime of H.

Example 4. Fixed investment trust. FC, a foreign corporation,

invests in a domestic fixed investment trust, DT, that is classified

as a trust under Sec. 301.7701-4(c)(1) of this chapter. Under the

terms of DT, the only amounts that are distributable from FC's

portion of DT are amounts distributable to FC. The exception in

paragraph (b)(1) of this section is applicable to FC's portion of

DT.

Example 5. Reinsurance trust. A domestic insurance company, DI,

reinsures a portion of its business with an unrelated foreign

insurance company, FI. To satisfy state regulatory requirements, FI

places the premiums in an irrevocable domestic trust, DT. The trust

funds are held by a United States bank and may be used only to pay

claims arising out of the reinsurance policies, which are legally

enforceable under the local

[[Page 43278]]

law of the jurisdiction in which FI resides. On the termination of

DT, any assets remaining will revert to FI. Because the only amounts

that are distributable from DT are distributable either to FI or in

discharge of FI's legal obligations within the meaning of paragraph

(b)(2)(i) of this section, the exception in paragraph (b)(1) of this

section is applicable.

Example 6. Trust that provides security for loan. FC, a foreign

corporation, borrows money from B, an unrelated bank, to finance the

purchase of an airplane. FC creates a foreign trust, FT, to hold the

airplane as security for the loan from B. The only amounts that are

distributable from FT while the loan is outstanding are amounts

distributable to B in the event that FC defaults on its loan from B.

When FC repays the loan, the trust assets will revert to FC. The

loan is a legal obligation of FC within the meaning of paragraph

(b)(2)(i) of this section, because it is enforceable under the local

law of the country in which FC is incorporated. Paragraph (b)(2)(ii)

of this section is not applicable, because B is not a related person

for purposes of Sec. 1.643(h)-1(e). The exception in paragraph

(b)(1) of this section is applicable.

(c) Compensatory trusts--(1) In general. The general rule of

Sec. 1.672(f)-1 does not apply to any portion of--

(i) A nonexempt employees' trust described in section 402(b),

including a trust created on behalf of a self-employed individual;

(ii) A trust, including a trust created on behalf of a self-

employed individual, that would be a nonexempt employees' trust

described in section 402(b) but for the fact that the trust's assets

are not set aside from the claims of creditors of the actual or deemed

transferor within the meaning of Sec. 1.83-3(e); and

(iii) Any additional category of trust that the Commissioner may

designate in revenue procedures, notices, or other guidance published

in the Internal Revenue Bulletin (see Sec. 601.601(d)(2) of this

chapter).

(2) Exceptions. The Commissioner may, in revenue rulings, notices,

or other guidance published in the Internal Revenue Bulletin (see

Sec. 601.601(d)(2) of this chapter), designate categories of

compensatory trusts to which the general rule of paragraph (c)(1) of

this section does not apply.

(d) Separate accounting for gratuitous transfers to grandfathered

trusts after September 19, 1995. If a trust that was treated as owned

by the grantor under section 676 or 677 (other than section 677(a)(3))

on September 19, 1995, contains both amounts held in the trust on

September 19, 1995, and amounts that were gratuitously transferred to

the trust after September 19, 1995, paragraphs (a)(3) and (b)(3) of

this section apply only if the amounts that were gratuitously

transferred to the trust after September 19, 1995, are treated as a

separate portion of the trust that is accounted for under the rules of

Sec. 1.671-3(a)(2). If the amounts that were gratuitously transferred

to the trust after September 19, 1995 are not so accounted for, the

general rule of Sec. 1.672(f)-1 applies to the entire trust. If such

amounts are so accounted for, and without regard to whether there is

physical separation of the assets, the general rule of Sec. 1.672(f)-1

does not apply to the portion of the trust that is attributable to

amounts that were held in the trust on September 19, 1995.

(e) Effective date. The rules of this section are generally

applicable to taxable years of a trust beginning after August 10, 1999.

The initial separate accounting required by paragraph (d) of this

section must be prepared by the due date (including extensions) for the

tax return of the trust for the first taxable year of the trust

beginning after August 10, 1999.

Sec. 1.672(f)-4 Recharacterization of purported gifts.

(a) In general--(1) Purported gifts from partnerships. Except as

provided in paragraphs (b), (e), and (f) of this section, and without

regard to the existence of any trust, if a United States person (United

States donee) directly or indirectly receives a purported gift or

bequest (as defined in paragraph (d) of this section) from a

partnership, the purported gift or bequest must be included in the

United States donee's gross income as ordinary income.

(2) Purported gifts from foreign corporations. Except as provided

in paragraphs (b), (e), and (f) of this section, and without regard to

the existence of any trust, if a United States donee directly or

indirectly receives a purported gift or bequest (as defined in

paragraph (d) of this section) from any foreign corporation, the

purported gift or bequest must be included in the United States donee's

gross income as if it were a distribution from the foreign corporation.

If the foreign corporation is a passive foreign investment company

(within the meaning of section 1297), the rules of section 1291 apply.

For purposes of section 1012, the United States donee is not treated as

having basis in the stock of the foreign corporation. However, for

purposes of section 1223, the United States donee is treated as having

a holding period in the stock of the foreign corporation on the date of

the deemed distribution equal to the weighted average of the holding

periods of the actual interest holders (other than any interest holders

who treat the portion of the purported gift attributable to their

interest in the foreign corporation in the manner described in

paragraph (b)(1) of this section). For purposes of section 902, a

United States donee that is a domestic corporation is not treated as

owning any voting stock of the foreign corporation.

(b) Exceptions--(1) Partner or shareholder treats transfer as

distribution and gift. Paragraph (a) of this section does not apply to

the extent the United States donee can demonstrate to the satisfaction

of the Commissioner that either--

(i) A United States citizen or resident alien individual who

directly or indirectly holds an interest in the partnership or foreign

corporation treated and reported the purported gift or bequest for

United States tax purposes as a distribution to such individual and a

subsequent gift or bequest to the United States donee; or

(ii) A nonresident alien individual who directly or indirectly

holds an interest in the partnership or foreign corporation treated and

reported the purported gift or bequest for purposes of the tax laws of

the nonresident alien individual's country of residence as a

distribution to such individual and a subsequent gift or bequest to the

United States donee, and the United States donee timely complied with

the reporting requirements of section 6039F, if applicable.

(2) All beneficial owners of domestic partnership are United States

citizens or residents or domestic corporations. Paragraph (a)(1) of

this section does not apply to a purported gift or bequest from a

domestic partnership if the United States donee can demonstrate to the

satisfaction of the Commissioner that all beneficial owners (within the

meaning of Sec. 1.1441-1(c)(6)) of the partnership are United States

citizens or residents or domestic corporations.

(3) Contribution to capital of corporate United States donee.

Paragraph (a) of this section does not apply to the extent a United

States donee that is a corporation can establish that the purported

gift or bequest was treated for United States tax purposes as a

contribution to the capital of the United States donee to which section

118 applies.

(4) Charitable transfers. Paragraph (a) of this section does not

apply if either--

(i) The United States donee is described in section 170(c); or

(ii) The transferor has received a ruling or determination letter,

which has been neither revoked nor modified, from the Internal Revenue

Service recognizing its exempt status under section 501(c)(3), and the

transferor made the transfer pursuant to an exempt

[[Page 43279]]

purpose for which the transferor was created or organized. For purposes

of the preceding sentence, a ruling or determination letter recognizing

exemption may not be relied upon if there is a material change,

inconsistent with exemption, in the character, the purpose, or the

method of operation of the organization.

(c) Certain transfers from trusts to which a partnership or foreign

corporation has made a gratuitous transfer--(1) Generally treated as

distribution from partnership or foreign corporation. Except as

provided in paragraphs (c)(2) and (3) of this section, if a United

States donee receives a gratuitous transfer (within the meaning of

Sec. 1.671-2T(e)(2)) from a trust (or portion of a trust) to which a

partnership or foreign corporation has made a gratuitous transfer, the

United States donee must treat the transfer as a purported gift or

bequest from the partnership or foreign corporation that is subject to

the rules of paragraph (a) of this section (including the exceptions in

paragraphs (b) and (f) of this section). This paragraph (c) applies

without regard to who is treated as the grantor of the trust (or

portion thereof) under Sec. 1.671-2T(e)(4).

(2) Alternative rule. Except as provided in paragraph (c)(3) of

this section, if the United States tax computed under the rules of

paragraphs (a) and (c)(1) of this section does not exceed the United

States tax that would be due if the United States donee treated the

transfer as a distribution from the trust (or portion thereof),

paragraph (c)(1) of this section does not apply and the United States

donee must treat the transfer as a distribution from the trust (or

portion thereof) that is subject to the rules of subparts A through D

(section 641 and following), part I, subchapter J, chapter 1 of the

Internal Revenue Code. For purposes of paragraph (f) of this section,

the transfer is treated as a purported gift or bequest from the

partnership or foreign corporation that made the gratuitous transfer to

the trust (or portion thereof).

(3) Exception. Neither paragraph (c)(1) of this section nor

paragraph (c)(2) of this section applies to the extent the United

States donee can demonstrate to the satisfaction of the Commissioner

that the transfer represents an amount that is, or has been, taken into

account for United States tax purposes by a United States citizen or

resident or a domestic corporation. A transfer will be deemed to be

made first out of amounts that have not been taken into account for

United States tax purposes by a United States citizen or resident or a

domestic corporation, unless the United States donee can demonstrate to

the satisfaction of the Commissioner that another ordering rule is more

appropriate.

(d) Definition of purported gift or bequest--(1) In general.

Subject to the provisions of paragraphs (d)(2) and (3) of this section,

a purported gift or bequest for purposes of this section is any

transfer of property by a partnership or foreign corporation other than

a transfer for fair market value (within the meaning of Sec. 1.671-

2T(e)(2)(ii)) to a person who is not a partner in the partnership or a

shareholder of the foreign corporation (or to a person who is a partner

in the partnership or a shareholder of a foreign corporation, if the

amount transferred is inconsistent with the partner's interest in the

partnership or the shareholder's interest in the corporation, as the

case may be). For purposes of this section, the term property includes

cash.

(2) Transfers for less than fair market value--(i) Excess treated

as purported gift or bequest. Except as provided in paragraph

(d)(2)(ii) of this section, if a transfer described in paragraph (d)(1)

of this section is for less than fair market value, the excess of the

fair market value of the property transferred over the value of the

property received, services rendered, or the right to use property is

treated as a purported gift or bequest.

(ii) Exception for transfers to unrelated parties. No portion of a

transfer described in paragraph (d)(1) of this section will be treated

as a purported gift or bequest for purposes of this section if the

United States donee can demonstrate to the satisfaction of the

Commissioner that the United States donee is not related to a partner

or shareholder of the transferor within the meaning of Sec. 1.643(h)-

1(e) or does not have another relationship with a partner or

shareholder of the transferor that establishes a reasonable basis for

concluding that the transferor would make a gratuitous transfer to the

United States donee.

(e) Prohibition against affirmative use of recharacterization by

taxpayers. A taxpayer may not use the rules of this section if a

principal purpose for using such rules is the avoidance of any tax

imposed by the Internal Revenue Code. Thus, with respect to such

taxpayer, the Commissioner may depart from the rules of this section

and recharacterize (for all purposes of the Internal Revenue Code) the

transfer in accordance with its form or its economic substance.

(f) Transfers not in excess of $10,000. This section does not apply

if, during the taxable year of the United States donee, the aggregate

amount of purported gifts or bequests that is transferred to such

United States donee directly or indirectly from all partnerships or

foreign corporations that are related (within the meaning of section

643(i)) does not exceed $10,000. The aggregate amount must include

gifts or bequests from persons that the United States donee knows or

has reason to know are related to the partnership or foreign

corporation (within the meaning of section 643(i)).

(g) Examples. The following examples illustrate the rules of this

section. In each example, the amount that is transferred exceeds

$10,000. The examples are as follows:

Example 1. Distribution from foreign corporation. FC is a

foreign corporation that is wholly owned by A, a nonresident alien

who is resident in Country C. FC makes a gratuitous transfer of

property directly to A's daughter, B, who is a resident alien. Under

paragraph (a)(2) of this section, B generally must treat the

transfer as a dividend from FC to the extent of FC's earnings and

profits and as an amount received in excess of basis thereafter. If

FC is a passive foreign investment company, B must treat the amount

received as a distribution under section 1291. B will be treated as

having the same holding period as A. However, under paragraph

(b)(1)(ii) of this section, if B can establish to the satisfaction

of the Commissioner that, for purposes of the tax laws of Country C,

A treated (and reported, if applicable) the transfer as a

distribution to himself and a subsequent gift to B, B may treat the

transfer as a gift (provided B timely complied with the reporting

requirements of section 6039F, if applicable).

Example 2. Distribution of corpus from trust to which foreign

corporation made gratuitous transfer. FC is a foreign corporation

that is wholly owned by A, a nonresident alien who is resident in

Country C. FC makes a gratuitous transfer to a foreign trust, FT,

that has no other assets. FT immediately makes a gratuitous transfer

in the same amount to A's daughter, B, who is a resident alien.

Under paragraph (c)(1) of this section, B must treat the transfer as

a transfer from FC that is subject to the rules of paragraph (a)(2)

of this section. Under paragraph (a)(2) of this section, B must

treat the transfer as a dividend from FC unless she can establish to

the satisfaction of the Commissioner that, for purposes of the tax

laws of Country C, A treated (and reported, if applicable) the

transfer as a distribution to himself and a subsequent gift to B and

that B timely complied with the reporting requirements of section

6039F, if applicable. The alternative rule in paragraph (c)(2) of

this section would not apply as long as the United States tax

computed under the rules of paragraph (a)(2) of this section is

equal to or greater than the United States tax that would be due if

the transfer were treated as a distribution from FT.

Example 3. Accumulation distribution from trust to which foreign

corporation made gratuitous transfer. FC is a foreign corporation

that is wholly owned by A, a nonresident alien. FC is not a passive

foreign

[[Page 43280]]

investment company (as defined in section 1297). FC makes a

gratuitous transfer of 100X to a foreign trust, FT, on January 1,

2001. FT has no other assets on January 1, 2001. Several years

later, FT makes a gratuitous transfer of 1000X to A's daughter, B,

who is a United States resident. Assume that the section 668

interest charge on accumulation distributions will apply if the

transfer is treated as a distribution from FT. Under the alternative

rule of paragraph (c)(2) of this section, B must treat the transfer

as an accumulation distribution from FT, because the resulting

United States tax liability is greater than the United States tax

that would be due if the transfer were treated as a transfer from FC

that is subject to the rules of paragraph (a) of this section.

Example 4. Transfer from trust that is treated as owned by

United States citizen. Assume the same facts as in Example 3, except

that A is a United States citizen. Assume that A treats and reports

the transfer to FT as a constructive distribution to himself,

followed by a gratuitous transfer to FT, and that A is properly

treated as the grantor of FT within the meaning of Sec. 1.671-2T(e).

A is treated as the owner of FT under section 679 and, as required

by section 671 and the regulations thereunder, A includes all of

FT's items of income, deductions, and credit in computing his

taxable income and credits. Neither paragraph (c)(1) nor paragraph

(c)(2) of this section is applicable, because the exception in

paragraph (c)(3) of this section applies.

Example 5. Transfer for less than fair market value. FC is a

foreign corporation that is wholly owned by A, a nonresident alien.

On January 15, 2001, FC transfers property directly to A's daughter,

B, a resident alien, in exchange for 90X. The Commissioner later

determines that the fair market value of the property at the time of

the transfer was 100X. Under paragraph (d)(2)(i) of this section,

10X will be treated as a purported gift to B on January 15, 2001.

(h) Effective date. The rules of this section are generally

applicable to any transfer after August 10, 1999, by a partnership or

foreign corporation, or by a trust to which a partnership or foreign

corporation makes a gratuitous transfer after August 10, 1999.

1.672(f)-5 Special rules.

(a) Transfers by certain beneficiaries to foreign grantor--(1) In

general. If, but for section 672(f)(5), a foreign person would be

treated as the owner of any portion of a trust, any United States

beneficiary of the trust is treated as the grantor of a portion of the

trust to the extent the United States beneficiary directly or

indirectly made transfers of property to such foreign person (without

regard to whether the United States beneficiary was a United States

beneficiary at the time of any transfer) in excess of transfers to the

United States beneficiary from the foreign person. The rule of this

paragraph (a) does not apply to the extent the United States

beneficiary can demonstrate to the satisfaction of the Commissioner

that the transfer by the United States beneficiary to the foreign

person was wholly unrelated to any transaction involving the trust. For

purposes of this paragraph (a), the term property includes cash, and a

transfer of property does not include a transfer that is not a

gratuitous transfer (within the meaning of Sec. 1.671-2T(e)(2)). In

addition, a gift is not taken into account to the extent such gift

would not be characterized as a taxable gift under section 2503(b). For

a definition of United States beneficiary, see section 679.

(2) Examples. The following examples illustrate the rules of this

section:

Example 1. A, a nonresident alien, contributes property to FC, a

foreign corporation that is wholly owned by A. FC creates a foreign

trust, FT, for the benefit of A and A's children. FT is revocable by

FC without the approval or consent of any other person. FC funds FT

with the property received from A. A and A's family move to the

United States. Under paragraph (a)(1) of this section, A is treated

as a grantor of FT. (A may also be treated as an owner of FT under

section 679(a)(4).)

Example 2. B, a United States citizen, makes a gratuitous

transfer of $1 million to B's uncle, C, a nonresident alien. C

creates a foreign trust, FT, for the benefit of B and B's children.

FT is revocable by C without the approval or consent of any other

person. C funds FT with the property received from B. Under

paragraph (a)(1) of this section, B is treated as a grantor of FT.

(B also would be treated as an owner of FT as a result of section

679.)

(b) Entity characterization. Entities generally are characterized

under United States tax principles for purposes of Secs. 1.672(f)-1

through 1.672(f)-5. See Secs. 301.7701-1 through 301.7701-4 of this

chapter. However, solely for purposes of Sec. 1.672(f)-4, a transferor

that is a wholly owned business entity is treated as a corporation,

separate from its single owner.

(c) Effective date. The rules in paragraph (a) of this section are

applicable to transfers to trusts on or after August 10, 1999. The

rules in paragraph (b) of this section are applicable August 10, 1999.

John M. Dalrymple,

Acting Deputy Commissioner of Internal Revenue.

Approved: July 23, 1999.

Donald C. Lubick,

Assistant Secretary of the Treasury.

[FR Doc. 99-19928 Filed 8-5-99; 2:09 pm]

BILLING CODE 4830-01-P