Bulletin No. 2005-7February 14, 2005

HIGHLIGHTSOF THIS ISSUEThese synopses are intended only as aids to the reader inidentifying the subject matter covered. They may not berelied upon as authoritative interpretations.

INCOME TAX

REG–117969–00, page 533.Proposed regulations amend previously proposed regulationsthat provided a functional definition of “statutory merger orconsolidation” under section 368(a)(1)(A) of the Code. Theseproposed regulations delete the requirement that transactionsmust be carried out under domestic law in order to qualify asstatutory mergers or consolidations. A public hearing is sched-uled for May 19, 2005.

REG–125628–01, page 536.Proposed regulations amending the income tax regulationsunder various provisions of the Code to account for statu-tory mergers and consolidations under section 368(a)(1)(A)(including reorganizations described in section 368(a)(2)(D)and (E)) involving one or more foreign corporations. Theregulations are issued concurrently with proposed regulations(REG–117969–00) that would amend the definition of a reorga-nization under section 368(a)(1)(A) to include certain statutorymergers or consolidations effected pursuant to foreign law. Apublic hearing is scheduled for May 19, 2005.

Announcement 2005–12, page 555.For purposes of the Archer MSA pilot program, under section220(j)(2) of the Code, 2004 is not a cut-off year.

ADMINISTRATIVE

Rev. Rul. 2005–10, page 492.Partnership mergers. This ruling informs taxpayers that theTreasury Department and the Service intend to issue regula-tions under sections 704(c)(1)(B) and 737 of the Code imple-

menting the principles of Rev. Rul. 2004–43. Rev. Rul.2004–43 revoked.

Notice 2005–11, page 493.This notice provides interim guidance relating to section 6707Aof the Code, Penalty for failure to include reportable transac-tion information with return, as added by the American JobsCreation Act of 2004. This notice states that a taxpayer mayincur a penalty under section 6707A with respect to each fail-ure to disclose a reportable transaction within the time, and inthe form and manner, provided by section 6011 and its regu-lations.

Notice 2005–12, page 494.This notice provides interim guidance relating to section6662A of the Code, Imposition of accuracy-related penaltyon understatements with respect to reportable transactions,section 6662, Imposition of accuracy-related penalty on un-derpayments, and section 6664, Definitions and special rules.

Notice 2005–14, page 498.Income attributable to domestic production activities.This notice provides interim guidance to taxpayers regardingthe deduction for income attributable to domestic productionactivities under section 199 of the Code. Section 199 was en-acted as part of the American Jobs Creation Act of 2004, andallows a deduction equal to 3 percent (for 2005 and 2006)of the lesser of the qualified production activities income ofthe taxpayer for the taxable year, or the taxable income of thetaxpayer for the taxable year, subject to certain limits. The ap-plicable percentage rises to 6 percent for 2007, 2008, and2009, and 9 percent for 2010 and subsequent years.

(Continued on the next page)

Finding Lists begin on page ii.

Notice 2005–15, page 527.This notice provides that the Treasury Department and the Ser-vice intend to issue regulations involving partnerships undersections 704(c)(1)(B) and 737 of the Code implementing theprinciples of Rev. Rul. 2004–43, and that the regulations willbe effective for distributions occurring after the date on whichthe notice is released to the public.

Rev. Proc. 2005–14, page 528.Like-kind exchange of a principal residence. This proce-dure provides guidance on applying the exclusion of gain fromthe sale or exchange of a principal residence under section 121of the Code and the nonrecognition of gain from the exchangeof like-kind property under section 1031 to a single exchangeof property.

February 14, 2005 2005–7 I.R.B.

The IRS MissionProvide America’s taxpayers top quality service by helpingthem understand and meet their tax responsibilities and by

applying the tax law with integrity and fairness to all.

IntroductionThe Internal Revenue Bulletin is the authoritative instrument ofthe Commissioner of Internal Revenue for announcing officialrulings and procedures of the Internal Revenue Service and forpublishing Treasury Decisions, Executive Orders, Tax Conven-tions, legislation, court decisions, and other items of generalinterest. It is published weekly and may be obtained from theSuperintendent of Documents on a subscription basis. Bulletincontents are compiled semiannually into Cumulative Bulletins,which are sold on a single-copy basis.

It is the policy of the Service to publish in the Bulletin all sub-stantive rulings necessary to promote a uniform application ofthe tax laws, including all rulings that supersede, revoke, mod-ify, or amend any of those previously published in the Bulletin.All published rulings apply retroactively unless otherwise indi-cated. Procedures relating solely to matters of internal man-agement are not published; however, statements of internalpractices and procedures that affect the rights and duties oftaxpayers are published.

Revenue rulings represent the conclusions of the Service on theapplication of the law to the pivotal facts stated in the revenueruling. In those based on positions taken in rulings to taxpayersor technical advice to Service field offices, identifying detailsand information of a confidential nature are deleted to preventunwarranted invasions of privacy and to comply with statutoryrequirements.

Rulings and procedures reported in the Bulletin do not have theforce and effect of Treasury Department Regulations, but theymay be used as precedents. Unpublished rulings will not berelied on, used, or cited as precedents by Service personnel inthe disposition of other cases. In applying published rulings andprocedures, the effect of subsequent legislation, regulations,

court decisions, rulings, and procedures must be considered,and Service personnel and others concerned are cautionedagainst reaching the same conclusions in other cases unlessthe facts and circumstances are substantially the same.

The Bulletin is divided into four parts as follows:

Part I.—1986 Code.This part includes rulings and decisions based on provisions ofthe Internal Revenue Code of 1986.

Part II.—Treaties and Tax Legislation.This part is divided into two subparts as follows: Subpart A,Tax Conventions and Other Related Items, and Subpart B, Leg-islation and Related Committee Reports.

Part III.—Administrative, Procedural, and Miscellaneous.To the extent practicable, pertinent cross references to thesesubjects are contained in the other Parts and Subparts. Alsoincluded in this part are Bank Secrecy Act Administrative Rul-ings. Bank Secrecy Act Administrative Rulings are issued bythe Department of the Treasury’s Office of the Assistant Sec-retary (Enforcement).

Part IV.—Items of General Interest.This part includes notices of proposed rulemakings, disbar-ment and suspension lists, and announcements.

The last Bulletin for each month includes a cumulative indexfor the matters published during the preceding months. Thesemonthly indexes are cumulated on a semiannual basis, and arepublished in the last Bulletin of each semiannual period.

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

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

2005–7 I.R.B. February 14, 2005

Part I. Rulings and Decisions Under the Internal Revenue Codeof 1986Section 121.—Exclusionof Gain From Sale ofPrincipal Residence26 CFR 1.121–1: Exclusion of gain from sale or ex-change of a principal residence.

Guidance is provided on applying the exclusion ofgain from the sale or exchange of a principal resi-dence under § 121 of the Code and the nonrecognitionof gain from the exchange of like-kind property under§ 1031 of the Code to a single exchange of property.See Rev. Proc. 2005-14, page 528.

Section 704.—Partner’sDistributive Share

Partnership mergers. This ruling in-forms taxpayers that the Treasury Depart-ment and the Service intend to issue reg-ulations under sections 704(c)(1)(B) and737 of the Code implementing the princi-ples of Rev. Rul. 2004–43. Rev. Rul.2004–43 revoked.

Rev. Rul. 2005–10

Rev. Rul. 2004–43, 2004–18 I.R.B.842, issued on April 12, 2004, addressesthe application of §§ 704(c)(1)(B) and 737

to § 704(c) gain or loss that is created in anassets-over partnership merger. Rev. Rul.2004–43 holds that § 704(c)(1)(B) appliesto newly created § 704(c) gain or loss inproperty contributed by the transferor part-nership to the continuing partnership in anassets-over partnership merger, but doesnot apply to newly created reverse § 704(c)gain or loss resulting from a revaluationof property in the continuing partnership.The revenue ruling also holds that for pur-poses of § 737(b), net precontribution gainincludes newly created § 704(c) gain orloss in property contributed by the trans-feror partnership to the continuing partner-ship in an assets-over partnership merger,but does not include newly created reverse§ 704(c) gain or loss resulting from a reval-uation of property in the continuing part-nership.

Some commentators have arguedthat Rev. Rul. 2004–43 is not consis-tent with the current regulations under§§ 704(c)(1)(B) and 737, and that the con-clusions in the ruling should not be appliedretroactively. In response to these com-ments, the Treasury Department and theService intend to issue regulations under§§ 704(c)(1)(B) and 737 implementing theprinciples of Rev. Rul. 2004–43. The reg-

ulations will be effective for distributionsoccurring after January 19, 2005. SeeNotice 2005–15, published in this issue ofthe Internal Revenue Bulletin.

EFFECT ON OTHER REVENUERULING(S)

Rev. Rul. 2004–43 is revoked.

DRAFTING INFORMATION

The principal author of this revenue rul-ing is Laura Fields of the Office of As-sociate Chief Counsel (Passthroughs andSpecial Industries). For further informa-tion regarding this revenue ruling, con-tact Ms. Fields at (202) 622–3050 (not atoll-free call).

Section 1031.—Exchangeof Property Held forProductive Use orInvestment

Guidance is provided on applying the exclusion ofgain from the sale or exchange of a principal resi-dence under § 121 of the Code and the nonrecognitionof gain from the exchange of like-kind property under§ 1031 of the Code to a single exchange of property.See Rev. Proc. 2005-14, page 528.

2005–7 I.R.B. 492 February 14, 2005

Part III. Administrative, Procedural, and MiscellaneousNew Penalty Section 6707Aand Rescission Authority

Notice 2005–11

The purpose of this notice is to alerttaxpayers to new section 6707A of theInternal Revenue Code. This notice an-nounces that the Internal Revenue Serviceand the Treasury Department will issueregulations under section 6707A, whichwill apply to returns and statements thedue date for which is after October 22,2004, and provides guidance regarding theimposition and rescission of penalties un-der section 6707A. This notice also invitescomments from the public regarding rulesand standards relating to section 6707A.

BACKGROUND AND PRIOR LAW

Section 6011 and the regulations there-under require a taxpayer that has partic-ipated in a reportable transaction to dis-close certain information with respect tothe reportable transaction with its tax re-turn. Section 1.6011–4(b) of the IncomeTax Regulations describes six categoriesof reportable transactions. One categoryof reportable transactions is a transactionthat is the same as, or substantially similarto, one of the types of transactions that theInternal Revenue Service has determinedto be a tax avoidance transaction and iden-tified by notice, regulation, or other formof published guidance as a “listed transac-tion.” Section 1.6011–4(b)(2).

Section 1.6011–4(d) requires that ataxpayer file a disclosure statement onForm 8886, Reportable Transaction Dis-closure Statement, for each reportabletransaction in which the taxpayer partic-ipated. Section 1.6011–4(e)(1) providesthat a reportable transaction disclosurestatement is due when the taxpayer filesan original or amended return that reflectsthe taxpayer’s participation in a reportabletransaction. The taxpayer also must send acopy of the disclosure statement to the IRSOffice of Tax Shelter Analysis (OTSA) atthe same time that the taxpayer first filesa disclosure statement with a return. Incertain circumstances, a taxpayer may bedeemed to have satisfied its disclosureobligations by filing Schedule M–3, NetIncome (Loss) Reconciliation for Corpo-

rations With Total Assets of $10 Million orMore, as provided by Rev. Proc. 2004–45,2004–31 I.R.B. 140 (August 2, 2004).

Section 6011 also requires the disclo-sure of listed transactions under section20.6011–4 of the Estate Tax Regulations,section 25.6011–4 of the Gift Tax Regu-lations, section 31.6011–4 of the Employ-ment Tax Regulations, section 53.6011–4of the Foundation and Similar Excise TaxRegulations, section 54.6011–4 of thePension Excise Tax Regulations, and sec-tion 56.6011–4 of the Public Charity Taxon Excess Lobbying Expenditure Regula-tions.

Prior to the enactment of section6707A, there was no monetary penaltyfor the failure by a taxpayer to disclose areportable transaction.

THE AMERICAN JOBS CREATIONACT OF 2004

The American Jobs Creation Act of2004, P.L. 108–357, 118 Stat. 1418 (theAct) was enacted on October 22, 2004.Section 811 of the Act added section6707A to the Code to provide a monetarypenalty for the failure to include on anyreturn or statement any information re-quired to be disclosed under section 6011with respect to a reportable transaction.

Section 6707A(b)(1) provides that thepenalty for failure to include informationwith respect to a reportable transaction,other than a listed transaction, is $10,000in the case of a natural person, and $50,000in any other case. Section 6707A(b)(2)provides that the penalty for failure to in-clude information with respect to a listedtransaction is $100,000 in the case of anatural person, and $200,000 in any othercase.

Section 6707A(d)(1) grants the Com-missioner authority to rescind all or aportion of any penalty imposed by sec-tion 6707A if (1) the violation relatesto a reportable transaction that is not alisted transaction and (2) rescission of thepenalty would promote compliance withthe requirements of the Code and effectivetax administration. Section 6707A(d)(2)provides that the Commissioner’s deter-mination whether to rescind the penaltymay not be reviewed in any judicial pro-ceeding. The legislative history to section

6707A provides that “the IRS Commis-sioner or his delegate can rescind (orabate) the penalty.” H.R. Conf. Rep. No.755, 108th Cong., 2d Sess. at 373 (2004).

Section 6707A(e) also provides thata person that is required to file periodicreports under section 13 or 15(d) of the Se-curities Exchange Act of 1934, or requiredto be consolidated with another personfor purposes of those reports, must dis-close the requirement to pay the followingpenalties in the reports to the Securitiesand Exchange Commission for the peri-ods specified by the Secretary: (1) thepenalty under section 6707A for failureto disclose a listed transaction; (2) the 30percent penalty under section 6662A foran understatement attributable to an undis-closed listed transaction or undisclosedreportable avoidance transaction; and (3)the 40 percent penalty under section 6662for a gross valuation misstatement if the30 percent penalty under section 6662Awould have applied, but for the applica-tion of section 6662A(e)(2)(c)(ii). Section6707A(e) also provides that the failure tomake a disclosure on reports filed with theSecurities and Exchange Commission asrequired by the Secretary shall be treatedas a failure to include information withrespect to a listed transaction for whichthe penalty under section 6707A applies.

The penalty under section 6707A is inaddition to any other potentially applica-ble penalties, including accuracy-relatedpenalties under sections 6662 and 6662A.The penalty under section 6707A will beimposed regardless of whether the transac-tion results in an underpayment of tax.

Section 6707A is effective for returnsand statements the due date for which isafter October 22, 2004.

INTERIM GUIDANCE

The Internal Revenue Service and theTreasury Department intend to issue reg-ulations providing rules under section6707A. Because section 6707A is effec-tive for returns and statements the duedate for which is after October 22, 2004,however, the Service and Treasury areproviding the following interim guidanceregarding the imposition and rescissionof penalties under section 6707A. These

February 14, 2005 493 2005–7 I.R.B.

interim rules will apply until further guid-ance is issued.

A. Imposition of the Section 6707APenalty

The Service will impose a penalty un-der section 6707A with respect to eachfailure to disclose a reportable transactionwithin the time and in the form and mannerprovided by section 6011 and the regula-tions thereunder. Accordingly, a taxpayerwill be subject to a penalty under section6707A for: (1) the failure to attach a re-portable transaction disclosure statementto an original or amended return; or (2) thefailure to provide a copy of a disclosurestatement to OTSA, if required. A tax-payer that fails to attach a reportable trans-action disclosure statement to an originalor amended return and fails to provide acopy of a required disclosure statement toOTSA will be subject to a single penaltyunder section 6707A. The following exam-ples illustrate this provision:

Example 1: Taxpayer T was required to attach aForm 8886 to its original return for the 2005 taxableyear and to send a copy of the Form 8886 to OTSA atthe time it filed its original return. T failed to attachthe Form 8886 to its return and failed to send a copyof the Form 8886 to OTSA. Taxpayer T is subject to apenalty under section 6707A for a failure to disclosebecause Taxpayer T failed to comply with both ofthe disclosure requirements. A penalty under section6707A also would apply if T had failed to complywith either of the two requirements.

Example 2: Same as Example 1, except that Tsubsequently filed an amended return for 2005 thatreflects Taxpayer T’s participation in the reportabletransaction. Taxpayer T failed to attach a Form8886 to the amended return as required by section1.6011–4(e)(1). Accordingly, Taxpayer T is subjectto an additional penalty under section 6707A forfailing to disclose a reportable transaction.

The penalty under section 6707A ap-plies to each failure to provide a disclosurestatement that is required to be attached toan original or amended return filed afterOctober 22, 2004 (with a copy sent toOTSA, if required), regardless of whetherthe original return was due on or be-fore October 22, 2004. Under section1.6011–4(e)(1), a reportable transactiondisclosure statement is due upon the filingof a return or amended return reflectinga taxpayer’s participation in a reportabletransaction. Accordingly, a penalty undersection 6707A will not be imposed untila taxpayer fails to provide the requireddisclosure statement with an original oramended return, or fails to provide a copy

to OTSA, if applicable, even if the returnis filed after the due date. In addition,a penalty under section 6707A will notbe imposed if the disclosure statement isattached to a return that is filed after thedue date for filing the return unless thetaxpayer fails to provide a copy of the dis-closure statement to OTSA, if applicable.

B. Rescission Authority

If it has been determined that a tax-payer failed to disclose a reportable trans-action and a penalty is imposed under sec-tion 6707A, section 6707A(d) authorizesthe Commissioner to rescind all or anyportion of a penalty imposed under sec-tion 6707A only if (1) the violation re-lates to a reportable transaction other thana listed transaction and (2) rescission of thepenalty would promote compliance withthe requirements of the Code and effec-tive tax administration. In determiningwhether rescission would promote compli-ance with the requirements of the Code andeffective tax administration, the Commis-sioner (or his delegate) will take into ac-count all of the relevant facts and circum-stances, including: (1) whether the tax-payer has a history of complying with thetax laws; (2) whether the violation resultsfrom an unintentional mistake of fact; and(3) whether imposing the penalty would beagainst equity and good conscience. TheCommissioner’s determination whether torescind a penalty in whole or in part is notreviewable by the IRS Appeals Division orany court.

REQUEST FOR COMMENTS

The Service and Treasury invite inter-ested persons to submit comments regard-ing rules and standards relating to section6707A, including the factors that shouldbe considered in exercising the rescis-sion authority under section 6707A(d).Comments are also requested on howvoluntary, but untimely disclosures (e.g.,if a taxpayer failed to make a requireddisclosure upon filing a return, but sub-sequently submits the required disclosurestatement) should be treated in applyingthe section 6707A penalty. Comments areencouraged to be submitted by February28, 2005, to: Internal Revenue Service,CC:PA:LPD:PR (Notice 2005–11), room5203, P.O. Box 7604, Ben Franklin Sta-

tion, Washington, DC 20044. Submis-sions also may be hand delivered Mon-day through Friday between the hours of8 a.m. and 4 p.m. to: CC:PA:LPD:PR (No-tice 2005–11), Courier’s Desk, InternalRevenue Service, 1111 Constitution Av-enue, NW, Washington, DC. Alternatively,taxpayers may submit electronic com-ments directly to the IRS e-mail address:notice.comments@irscounsel.treas.gov.

DRAFTING INFORMATION

The principal author of this noticeis Matthew S. Cooper of the Office of As-sociate Chief Counsel (Procedure and Ad-ministration), Administrative Provisionsand Judicial Practice Division. For furtherinformation regarding this notice, con-tact Matthew S. Cooper at 202–622–4940(not a toll-free call).

Temporary Rules UnderSection 6662A and Sections6662 and 6664, as Amended

Notice 2005–12

The purpose of this notice is to alert tax-payers to the recent enactment of section6662A and amendments to sections 6662and 6664 of the Internal Revenue Code,provide interim guidance relating to theseprovisions and invite comments from thepublic regarding the rules and standards re-lating to section 6662A and sections 6662and 6664, as amended.

BACKGROUND

The American Jobs Creation Act of2004, Pub. L. No. 108–357, 118 Stat.1418 (the Act), was enacted on October 22,2004. Section 812 of the Act added section6662A, which provides a new penalty forunderstatements with respect to reportabletransactions. Section 812 also added sec-tion 6664(d), which provides a defenseto the penalty under section 6662A if thetaxpayer acted with reasonable cause andin good faith. Sections 812 and 819 of theAct amended section 6662(d) to modifythe accuracy-related penalty under section6662(d) for substantial understatements ofincome tax.

2005–7 I.R.B. 494 February 14, 2005

(1) Section 6662A, Imposition ofAccuracy-Related Penalty onUnderstatements with Respect toReportable Transactions.

Section 812 of the Act added section6662A to the Code, which provides that a20-percent accuracy-related penalty maybe imposed on any reportable transactionunderstatement. Under section 6662A, a“reportable transaction understatement”means the sum of (1) the product of (A) theamount of the increase (if any) in taxableincome which results from a differencebetween the proper tax treatment of anitem to which section 6662A applies andthe taxpayer’s treatment of such item (asshown on the taxpayer’s return of tax),and (B) the highest rate of tax imposedby section 1 (section 11 in the case of acorporation), and (2) the amount of thedecrease (if any) in the aggregate amountof credits determined under subtitle Awhich results from a difference betweenthe taxpayer’s treatment of an item towhich section 6662A applies (as shownon the taxpayer’s return of tax) and theproper tax treatment of such item.

The penalty provided by section 6662Aapplies only (1) to listed transactions and(2) to reportable transactions (other thana listed transaction) if a significant pur-pose of the transaction is the avoidance orevasion of Federal income tax. In addi-tion, a higher 30-percent penalty appliesto a reportable transaction understatementif a taxpayer does not adequately disclose,in accordance with regulations prescribedunder section 6011, the relevant facts af-fecting the tax treatment of the item giv-ing rise to the reportable transaction un-derstatement. The reasonable cause andgood faith defense is not available with re-spect to the 30-percent penalty. See I.R.C.§§ 6662A(c) and 6664(d)(2)(A).

Section 6662A(e)(3) sets forth a specialrule for amended returns. The tax treat-ment on an amendment or supplement toa return is not taken into account in deter-mining the amount of a reportable trans-action understatement if the amendment orsupplement is filed after the earlier of (1)the date the taxpayer is first contacted bythe IRS regarding an examination of the re-turn or (2) any other date specified by theSecretary.

(2) Section 6662, Imposition ofAccuracy-Related Penalty onUnderpayments.

Section 6662(d) imposes a 20-percentaccuracy-related penalty for any substan-tial understatement of income tax. Undersection 6662(d)(1)(B), as amended, in thecase of a corporation (other than an S cor-poration or a personal holding company),there is a substantial understatement of in-come tax for any taxable year if the amountof the understatement for the taxable yearexceeds the lesser of (1) 10 percent of thetax required to be shown on the return forthe taxable year (or, if greater, $10,000),or (2) $10,000,000. In the case of all othertaxpayers, an understatement is substantialif it exceeds the greater of 10 percent of thetax required to be shown on the return or$5,000.

Under section 6662(d)(2), an under-statement is the excess of (i) the amountof tax required to be shown on the returnfor the taxable year over (ii) the amount oftax imposed which is shown on the return,reduced by any rebate. This excess is de-termined without regard to items to whichsection 6662A applies. The reportabletransaction understatement, however, isadded to the understatement calculatedunder section 6662(d)(2) for purposes ofdetermining whether an understatementis substantial under section 6662(d)(1).Under section 6662A(e)(1)(B), in the caseof an understatement, the addition to taxunder section 6662(a) applies only to theexcess of the amount of the substantialunderstatement over the aggregate amountof the reportable transaction understate-ments. Accordingly, the accuracy-relatedpenalty attributable to substantial under-statement of income tax does not apply toan understatement on which the section6662A penalty is imposed.

Section 6662A does not apply to anyportion of an understatement on which thesection 6663 fraud penalty or the section6662(h) accuracy-related penalty for agross valuation misstatement is imposed.Section 6662(e) (substantial valuationmisstatement) does not apply to any por-tion of an understatement on which apenalty under section 6662A is imposed.

Under section 6662(d)(2), as amended,the understatement with respect to anyitem attributable to a tax shelter item,including tax shelter items of taxpayers

other than corporations, will not be re-duced even if the taxpayer has substantialauthority and a reasonable belief that thetax treatment of an item attributable to atax shelter item was more likely than notthe proper treatment. The taxpayer may,however, demonstrate reasonable causeand good faith under section 6664(c).

(3) Section 6664, Definitions and SpecialRules.

The accuracy-related penalty undersection 6662A does not apply with respectto any portion of a reportable transac-tion understatement if, pursuant to section6664(d), it is shown that there was rea-sonable cause and the taxpayer acted ingood faith with respect to that portion ofthe understatement. A taxpayer does nothave reasonable cause and did not act ingood faith unless (1) the relevant factsaffecting the tax treatment of the item areadequately disclosed in accordance withregulations prescribed under section 6011;(2) there is or was substantial authority;and (3) the taxpayer reasonably believedthat its treatment of the item was morelikely than not the proper tax treatment. Ataxpayer is treated as having a reasonablebelief only if the belief is based on thefacts and the law that exist at the time thereturn is filed and the belief relates solelyto the taxpayer’s chances of success on themerits of the tax treatment of the issue.

An opinion of a tax advisor may notbe relied upon to establish the reasonablebelief of the taxpayer if the advisor orthe opinion is disqualified. A tax advi-sor is disqualified if the tax advisor (1) isa material advisor under section 6111, asamended, and participates in the organiza-tion, management, promotion, or sale ofthe transaction or is related to any personwho so participates; (2) is compensated di-rectly or indirectly by a material advisorwith respect to the transaction; (3) has afee arrangement with respect to the trans-action that is contingent on all or part of theintended tax benefits from the transactionbeing sustained; or (4) has any other dis-qualifying financial interest with respect tothe transaction as identified by the Secre-tary.

An opinion is disqualified if the opin-ion (1) is based on unreasonable factualor legal assumptions (including assump-tions as to future events); (2) unreason-

February 14, 2005 495 2005–7 I.R.B.

ably relies on representations, statements,findings or agreements of the taxpayer orany other person; (3) does not identify andconsider all relevant facts; or (4) fails tomeet any other requirement as the Secre-tary may prescribe.

INTERIM PROVISIONS

The Treasury Department and the IRSintend to issue regulations implementingthe requirements of section 6662A andsections 6662 and 6664, as amended. Sec-tion 812 of the Act, which added section6662A and amended sections 6662 and6664 is effective for taxable years endingafter October 22, 2004. Section 819 ofthe Act, which separately amended sec-tion 6662, is effective for taxable yearsbeginning after October 22, 2004. TheTreasury Department and the IRS providethe following interim rules to implementthe requirements of sections 6662, 6662Aand 6664. These interim rules will applyuntil further guidance is issued.

(1) Adequate disclosure in accordancewith section 6011

As noted above, the 30-percent penaltyprovided by section 6662A applies to areportable transaction understatement ifthe taxpayer does not adequately disclosethe relevant facts affecting the tax treat-ment of the item under section 6011. Ataxpayer has adequately disclosed thefacts for purposes of section 6662A, andsection 6664(d)(2)(A), if the taxpayer hasfiled a disclosure statement in the formand manner prescribed by Treas. Reg.§ 1.6011–4(d) or the taxpayer has beendeemed to have satisfied its disclosureobligations under Rev. Proc. 2004–45,2004–31 I.R.B. 140 (August 2, 2004), asapplicable, or any other published guid-ance prescribing the form and manner ofdisclosure under section 6011.

(2) Special rule for amended returns

For purposes of determining the amountof any reportable transaction understate-ment, the IRS will not take into account anamendment or supplement to a return filedafter the dates specified in Treas. Reg.§ 1.6664–2(c)(3) and Notice 2004–38,2004–21 I.R.B. 949 (May 24, 2004), orany amendments thereto, which are the

dates after which a taxpayer may not file a“qualified amended return.”

(3) Disqualified tax advisor

As stated above, a taxpayer may notrely on the opinion of a disqualified tax ad-visor to establish reasonable belief undersection 6664(d). A disqualified tax advisoris any advisor who (a) is a material advisor(under section 6111, as amended) and whoparticipates in the organization, manage-ment, promotion or sale of the transactionor is related (within the meaning of section267(b) or 707(b)(1)) to any person who soparticipates, (b) has a disqualified compen-sation arrangement, or (c) has a disqualify-ing financial interest identified by the Sec-retary.

A material advisor is defined inTreas. Reg. § 301.6112–1. In addi-tion, the existing rules under Treas. Reg.§ 301.6112–1(c)(2), (c)(3) and (d) (with-out regard to the provisions relating to atransaction required to be registered underformer section 6111), including the min-imum fee amounts for listed transactionsunder Treas. Reg. § 301.6112–1(c)(3)(ii),shall apply. See Notice 2004–80, 2004–50I.R.B. 963 (December 13, 2004). The def-inition of material advisor, and the rulesdescribed here, will apply for purposes ofsection 6662A until the IRS issues furtherguidance.

(a) Organization, Management,Promotion or Sale

A material advisor participates in the“organization” of a transaction if the advi-sor:

(1) devises, creates, investigates or ini-tiates the transaction or tax strategy;

(2) devises the business or financialplans for the transaction or tax strategy;

(3) carries out those plans through ne-gotiations or transactions with others; or

(4) performs acts relating to the devel-opment or establishment of the transaction.

The performance of an act relating to thedevelopment or establishment of a trans-action includes preparing documents that(A) establish the structure used in connec-tion with the transaction, e.g., a partner-ship agreement or articles of incorpora-tion, (B) describe the transaction for usein the promotion or sale of the transac-tion, e.g., an offering memorandum, tax

opinion, prospectus, or other document de-scribing the transaction, or (C) register thetransaction with any federal, state or localgovernment body.

A material advisor participates in the“management” of a transaction if the ma-terial advisor is involved in the decision-making process regarding any business ac-tivity with respect to the transaction. Par-ticipation in the management of a trans-action includes managing assets, directingbusiness activity, or acting as general part-ner, trustee, director or officer of an entityinvolved in the transaction.

A material advisor participates in the“promotion or sale” of a transaction if thematerial advisor is involved in the market-ing of the transaction or tax strategy. Mar-keting activities include: (1) soliciting, di-rectly or through an agent, taxpayers to en-ter into a transaction or tax strategy us-ing direct contact, mail, telephone or othermeans; (2) placing an advertisement forthe transaction in a newspaper, magazine,or other publication or medium; or (3) in-structing or advising others with respect tomarketing of the transaction or tax strat-egy.

Consistent with the legislative history,a tax advisor, including a material advi-sor, will not be treated as participatingin the organization, management, promo-tion or sale of a transaction if the tax ad-visor’s only involvement is rendering anopinion regarding the tax consequences ofthe transaction. In the course of prepar-ing a tax opinion, a tax advisor is permit-ted to suggest modifications to the trans-action, but the tax advisor may not sug-gest material modifications to the trans-action that assist the taxpayer in obtain-ing the anticipated tax benefits. Merelyperforming support services or ministerialfunctions such as typing, photocopying, orprinting will not be considered participa-tion in the organization, management, pro-motion or sale of a transaction.

(b) Disqualified CompensationArrangements

As stated above, a disqualified tax ad-visor includes a tax advisor who has adisqualified compensation arrangement.A disqualified compensation arrangementincludes (1) an arrangement by which theadvisor is compensated directly or indi-rectly by a material advisor with respect

2005–7 I.R.B. 496 February 14, 2005

to the transaction or (2) a fee arrangementwith respect to the transaction that is con-tingent on all or part of the intended taxbenefits from the transaction being sus-tained. See I.R.C. § 6664(d)(3)(B)(ii).

Until further guidance is issued, a taxadvisor also will be treated as a disquali-fied tax advisor, even if not a material advi-sor, if the tax advisor has a referral fee or afee-sharing arrangement by which the ad-visor is compensated directly or indirectlyby a material advisor. In addition, an ar-rangement will be treated as a disqualifiedcompensation arrangement if there is anagreement or understanding (oral or writ-ten) with a material advisor of a reportabletransaction pursuant to which the tax advi-sor is expected to render a favorable opin-ion regarding the tax treatment of the trans-action to any person referred by the ma-terial advisor. A tax advisor will not betreated as having a disqualified compen-sation arrangement if a material advisormerely recommends the tax advisor whodoes not have an agreement or understand-ing with the material advisor to render afavorable opinion regarding the tax treat-ment of a transaction.

In addition, a disqualified compensa-tion arrangement includes a fee that iscontingent on all or part of the intendedtax benefits from the transaction beingsustained, including agreements that pro-vide that (1) a taxpayer has the right to afull or partial refund of fees if all or part ofthe tax consequences from the transactionare not sustained or (2) the amount of thefee is contingent on the taxpayer’s realiza-tion of tax benefits from the transaction.Transactions described in Treas. Reg.

§ 1.6011–4(b)(4)(iii) do not give rise to adisqualified compensation arrangement.

REQUEST FOR COMMENTS

The Treasury Department and the IRSintend to issue regulations implementingsection 6662A and the amendments to sec-tions 6662 and 6664 and invite interestedpersons to submit comments regardingrules and standards under sections 6662,6662A and 6664 in general and on thespecific matters set forth below, includingparticularly item 2 under “Definition andSpecial Rules” regarding the extent towhich a tax advisor should be permittedto suggest modifications to a transactionwithout becoming a “disqualified tax ad-visor.”

Section 6662A. Imposition ofAccuracy-Related Penalty onUnderstatements with Respect toReportable Transactions.

1. Definition of “reportable transactionunderstatement”;

2. Coordination of the reportable trans-action understatement penalty with thesubstantial understatement penalty, in-cluding the methodology for calculatingthe excess of the aggregate reportabletransaction understatement;

3. Coordination of the reportable trans-action understatement penalty with the ac-curacy-related penalty on underpayments,including the penalty on underpaymentsattributable to negligence or disregard ofrules or regulations, and the fraud penalty;and

4. Special rules for amended returns,including whether rules similar to the rules

provided in Rev. Proc. 94–69, 1994–2C.B. 804, should apply.

Section 6664. Definitions and SpecialRules.

1. Definition of “disqualified tax advi-sor,” including definition of “participatesin the management, organization, promo-tion or sale of a transaction”;

2. Providing suggested modificationsregarding the transaction;

3. Definition of “disqualifying finan-cial interest”;

4. Additional requirements relating to“disqualified opinions.”

Comments are encouraged to be sub-mitted by February 28, 2005, to: InternalRevenue Service, CC:PA:LPD:PR (Notice2005–12), room 5203, P.O. Box 7604, BenFranklin Station, Washington, DC 20224.Submissions may be hand delivered Mon-day through Friday between the hours of8 a.m. and 4 p.m. to: CC:PA:LPD:PR (No-tice 2005–12), Courier’s Desk, InternalRevenue Service, 1111 Constitution Av-enue, NW, Washington, DC. Alternatively,taxpayers may submit electronic com-ments directly to the IRS e-mail address:notice.comments@irscounsel.treas.gov.

DRAFTING INFORMATION

The principal author of this noticeis Heather L. Dostaler of the Office ofAssociate Chief Counsel (Procedure &Administration), Administrative Provi-sions and Judicial Practice Division. Forfurther information regarding this no-tice, contact Heather L. Dostaler at (202)622–4940 (not a toll-free call).

February 14, 2005 497 2005–7 I.R.B.

Section 199.—IncomeAttributable to DomesticProduction Activities

Notice 2005–14

CONTENTS

SECTION 1. PURPOSE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 502

SECTION 2. OVERVIEW OF § 199 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 502.01 In General. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 502.02 Qualified Production Activities Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 502.03 Pass-thru Entities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503.04 Individuals.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503.05 Patrons of Certain Cooperatives. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503.06 Expanded Affiliated Groups. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503.07 Trade or Business Requirement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503.08 Alternative Minimum Tax. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503.09 Authority to Prescribe Regulations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503

SECTION 3. EXPLANATION OF INTERIM GUIDANCE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 504.01 In General. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 504.02 Wage Limitation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 504

(1) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 504(2) Wages paid by other entities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 504(3) Acquisitions and dispositions of a trade or business (or major portion). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 504(4) Non-duplication rule. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 504(5) Definition of W–2 wages. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 504

(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 504(b) Methods for calculating W–2 wages. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 504

.03 Determining Qualified Production Activities Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 504

.04 Determining Domestic Production Gross Receipts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505(1) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505(2) Definition of “gross receipts.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505(3) Definition of “manufactured, produced, grown, or extracted.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505

(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505(b) Consistency with § 263A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505

(4) Definition of “by the taxpayer.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505(5) Definition of “in whole or in significant part.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 506

(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 506(b) Substantial in nature. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 506(c) Safe harbor. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507(d) Certain activities and costs disregarded. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507

(6) Definition of “United States.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507(7) Definition of “derived from the lease, rental, license, sale, exchange, or other disposition of qualifyingproduction property.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507

(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507(b) Allocation of gross receipts – embedded services. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 508(c) Advertising income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 508(d) Computer software. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 508

(8) Definition of “qualifying production property.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 508(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 508(b) Tangible personal property. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 508

2005–7 I.R.B. 498 February 14, 2005

(c) Computer software. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509(i) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509(ii) Tangible personal property not included. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509

(d) Sound recordings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509(9) Definition of “qualified film.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509

(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509(b) Production personnel. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509(c) Compensation for services. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510(d) Determination of 50 percent. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510

(10) Electricity, natural gas, and potable water. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510(b) Natural gas. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510(c) Potable water. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510

(11) Definition of “construction performed in the United States.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510(a) Construction of real property. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510(b) Activities constituting construction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510(c) Definition of “infrastructure.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511(d) Definition of “substantial renovation.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511(e) “Derived from construction.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511

(i) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511(ii) Taxpayers deriving gross receipts from construction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511

(12) Definition of “engineering and architectural services.”. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511(b) Performance of services in the United States.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511(c) Construction projects within the United States. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511

(13) Exception for sales of certain food and beverages. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511.05 Determining Costs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511

(1) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511(2) Allocation of cost of goods sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 512(3) Allocation and apportionment of deductions.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 512

(a) Three alternative methods. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 512(b) Treatment of certain deductions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 512

.06 Application of § 199 to Pass-thru Entities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 512(1) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 512(2) Gain or loss from the disposition of an interest in a pass-thru entity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513(3) Effective date of § 199 for pass-thru entities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513

.07 Patrons of Agricultural and Horticultural Cooperatives. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513

.08 Expanded Affiliated Groups. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513(1) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513(2) Computation of expanded affiliated group’s § 199 deduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513

(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513(b) Attribution of activities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513(c) Anti-avoidance rule. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513

(3) Allocation of expanded affiliated group’s § 199 deduction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513(4) Special rules for consolidated groups. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513(5) Identification of members of the expanded affiliated group. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514(6) Allocation of income and loss. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514

(a) Pro rata allocation method. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514(b) Closing of the books method. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514

(7) Total § 199 deduction for a corporation that is a member of an expanded affiliated group for some or all ofits taxable year.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514(8) Computation of § 199 deduction for members of expanded affiliated group with different taxable years. . . . 514

SECTION 4. INTERIM GUIDANCE. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514.01 In General. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514.02 Wage Limitation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514

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(1) Rules of application. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514(b) No application in determining whether amounts are wages for employment tax purposes.. . . . . . . . . . 514(c) Application in case of taxpayer with short taxable year. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514(d) Acquisitions and dispositions of a trade or business (or major portion). . . . . . . . . . . . . . . . . . . . . . . . . . 515(e) Non-duplication rule. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515

(2) Definition of “W–2 wages.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515(b) Methods for calculating W–2 wages. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515

(i) Unmodified box method. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515(ii) Modified Box 1 method. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515(iii) Tracking wages method. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515

.03 Determining Qualified Production Activities Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515(1) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515(2) Allocation of gross receipts.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515(3) Treatment of advance payments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516

.04 Determining Domestic Production Gross Receipts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516(1) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516(2) Definition of “gross receipts.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516(3) Definition of “manufactured, produced, grown, or extracted.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516

(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516(b) Consistency with § 263A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516

(4) Definition of “by the taxpayer.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 517(5) Definition of “in whole or in significant part.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 517

(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 517(b) Substantial in nature. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 517(c) Safe harbor. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 517

(6) Definition of “United States.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 517(7) Definition of “derived from the lease, rental, license, sale, exchange, or other disposition of qualifyingproduction property.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 517

(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 517(b) Allocation of gross receipts – embedded services. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518(c) Advertising income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518(d) Computer software. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518(e) Exception for certain oil and gas partnerships. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518

(8) Definition of “qualifying production property.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518(b) Tangible personal property. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518(c) Computer software. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518(d) Sound recordings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519

(9) Definition of “qualified film.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519(b) Compensation for services. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519(c) Determination of 50 percent. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519(d) Exception. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519

(10) Electricity, natural gas, and potable water. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519(b) Natural gas. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519(c) Potable water. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519(d) Exceptions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519

(i) Electricity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520(ii) Natural gas. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520(iii) Potable water. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520

(11) Definition of “construction performed in the United States.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520(a) Construction of real property. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520(b) Activities constituting construction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520

2005–7 I.R.B. 500 February 14, 2005

(c) Definition of “infrastructure.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520(d) Definition of “substantial renovation.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520(e) “Derived from construction.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520

(12) Definition of “engineering and architectural services.”. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520(b) Engineering services. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520(c) Architectural services. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520(d) De minimis exception for performance of services in the United States. . . . . . . . . . . . . . . . . . . . . . . . . . . 521

(13) Exception for sales of certain food and beverages. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521(14) Related persons.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521

.05 Determining Costs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521(1) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521(2) Costs of goods sold allocable to domestic production gross receipts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521

(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521(b) Allocating cost of goods sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521(c) Special rules for imported items or services. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521

(3) Other deductions allocable or apportionable to domestic production gross receipts. . . . . . . . . . . . . . . . . . . . . 521(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521(b) Rules that apply to all allocation and apportionment methods. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522

(i) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522(ii) Losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522(iii) Net operating losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522(iv) Deductions not attributable to the actual conduct of a trade or business. . . . . . . . . . . . . . . . . . . 522(v) Deductions related to de minimis gross receipts and embedded services included in domesticproduction gross receipts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522

(c) Section 861 method.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522(i) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522(ii) Deductions for charitable contributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522(iii) Research and experimental expenditures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522

(d) Simplified deduction method.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522(4) Small business simplified overall method.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522

(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522(b) Qualifying small taxpayer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522

(5) Average annual gross receipts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 523.06 Application of § 199 to Pass-thru Entities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 523

(1) Allocations to partners, shareholders, and similar interest holders. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 523(a) Partnerships. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 523

(i) Determination at partner level. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 523(ii) Expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 523(iii) W–2 wages. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 523

(b) S corporations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 523(i) Determination at S corporation shareholder level.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 523(ii) Expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 524(iii) W–2 wages. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 524

(2) Gain or loss from the disposition of an interest in a pass-thru entity. . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 524(3) Effective date of § 199 for pass-thru entities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 524

.07 Patrons of Agricultural and Horticultural Cooperatives. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 524

.08 Individuals.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 524

.09 Expanded Affiliated Groups. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525(1) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525(2) Computation of expanded affiliated group’s § 199 deduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525

(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525(b) Attribution of activities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525(c) Anti-avoidance rule. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525

(3) Allocation of expanded affiliated group’s § 199 deduction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525(4) Special rules for consolidated groups. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525

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(5) Identification of members of the expanded affiliated group. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525(6) Allocation of income and loss. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525

(a) In general. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525(i) Pro rata allocation method. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525(ii) Closing of the books method. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525(iii) Making the § 199 closing of the books election. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525

(b) Coordination with rules relating to the allocation of income under § 1.1502–76(b). . . . . . . . . . . . . . . . 525(7) Total § 199 deduction for a corporation that is a member of an expanded affiliated group for some or all ofits taxable year.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525(8) Computation of § 199 deduction for members of expanded affiliated group with different taxable years. . . . 526

.10 Trade or Business Requirement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526

.11 Coordination with Alternative Minimum Tax. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526

.12 Special rules. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526(1) Certain nonrecognition transactions.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526(2) Section 1031 exchanges.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526(3) Section 381 transactions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526(4) Taxpayers with a 52–53 week taxable year. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526

SECTION 5. EFFECTIVE DATE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526

SECTION 6. REQUEST FOR COMMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526.01 In General. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526.02 Addresses for Comments.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 527.03 Deadline for Submission of Comments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 527

SECTION 7. DRAFTING INFORMATION. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 527

SECTION 1. PURPOSE

The Internal Revenue Service andTreasury Department currently are de-veloping regulations under § 199 of theInternal Revenue Code, enacted as part ofthe American Jobs Creation Act of 2004,Pub. L. No. 108–357 (the Act), regardingthe deduction relating to income attrib-utable to domestic production activities.This notice provides interim guidance onwhich taxpayers may rely until the regula-tions are issued. The Service and TreasuryDepartment expect that the regulationswill incorporate the rules set forth in thisnotice and will be effective for taxableyears beginning after December 31, 2004,the effective date of § 199. See § 102(e)of the Act. This notice requests commentson the interim guidance provided hereinand any additional guidance that should beprovided in regulations. Comments mustbe received by March 31, 2005.

SECTION 2. OVERVIEW OF § 199

.01 In General. (1) Section 199(a)(1)allows a deduction equal to 9 percent(3 percent in the case of taxable years be-ginning in 2005 and 2006, and 6 percentin the case of taxable years beginning in

2007, 2008, or 2009) of the lesser of (a)the qualified production activities income(QPAI) of the taxpayer for the taxableyear, or (b) taxable income (determinedwithout regard to § 199) for the taxableyear (or, in the case of an individual, under§ 199(d)(2), adjusted gross income).

(2) Section 199(b)(1) limits the deduc-tion for a taxable year to 50 percent of theW–2 wages paid by the taxpayer duringthe calendar year that ends in such taxableyear. For this purpose, § 199(b)(2) definesthe term “W–2 wages” to mean the sumof the aggregate amounts the taxpayer isrequired under § 6051(a)(3) and (8) to in-clude on the Forms W–2 of the taxpayer’semployees during the calendar year endingduring the taxpayer’s taxable year. Sec-tion 199(b)(3) provides that the Secretaryshall prescribe rules for the application of§ 199(b) in the case of an acquisition ordisposition of a major portion of either atrade or business or a separate unit of atrade or business during the taxable year.

.02 Qualified Production Activities In-come. (1) Under § 199(c)(1), QPAI is theexcess of domestic production gross re-ceipts (DPGR) over the sum of: (a) the costof goods sold (CGS) allocable to such re-ceipts; (b) other deductions, expenses, or

losses directly allocable to such receipts;and (c) a ratable portion of deductions, ex-penses, and losses not directly allocable tosuch receipts or another class of income.

(2) Section 199(c)(2) provides thatthe Secretary shall prescribe rules for theproper allocation of items of income, de-duction, expense, and loss for purposes ofdetermining QPAI.

(3) Section 199(c)(3) provides specialrules for determining costs in computingQPAI. Under these special rules, any itemor service brought into the United Statesis treated as acquired by purchase, and itscost is treated as not less than its value im-mediately after it enters the United States.A similar rule applies in determining theadjusted basis of leased or rented prop-erty when the lease or rental gives riseto DPGR. If the property has been ex-ported by the taxpayer for further manu-facture, the increase in cost or adjusted ba-sis must not exceed the difference betweenthe value of the property when exportedand its value when brought back into theUnited States after further manufacture.

(4) Section 199(c)(4)(A) defines DPGRto mean the taxpayer’s gross receipts thatare derived from: (a) any lease, rental,license, sale, exchange, or other disposi-

2005–7 I.R.B. 502 February 14, 2005

tion of (i) qualifying production property(QPP) that was manufactured, produced,grown, or extracted (MPGE) by the tax-payer in whole or in significant part withinthe United States; (ii) any qualified filmproduced by the taxpayer; or (iii) elec-tricity, natural gas, or potable water pro-duced by the taxpayer in the United States;(b) construction performed in the UnitedStates; or (c) engineering or architecturalservices performed in the United States forconstruction projects in the United States.Section 199(c)(4)(B) excepts from DPGRgross receipts of the taxpayer that are de-rived from: (a) the sale of food and bev-erages prepared by the taxpayer at a retailestablishment; and (b) the transmission ordistribution of electricity, natural gas, orpotable water.

(5) Section 199(c)(5) defines QPP tomean: (a) tangible personal property; (b)any computer software; and (c) any prop-erty described in § 168(f)(4) (certain soundrecordings).

(6) Section 199(c)(6) defines a quali-fied film to mean any property describedin § 168(f)(3) if not less than 50 percent ofthe total compensation relating to produc-tion of the property is compensation forservices performed in the United Statesby actors, production personnel, directors,and producers. The term does not includeproperty with respect to which recordsare required to be maintained under 18U.S.C. § 2257 (generally, films, video-tapes, or other matter that depict actualsexually explicit conduct and are pro-duced in whole or in part with materialsthat have been mailed or shipped in inter-state or foreign commerce, or are shippedor transported or are intended for shipmentor transportation in interstate or foreigncommerce).

(7) Section 199(c)(7) provides thatDPGR does not include any gross receiptsof the taxpayer derived from propertyleased, licensed, or rented by the taxpayerfor use by any related person. A person istreated as related to another person if bothpersons are treated as a single employerunder either § 52(a) or (b) (without regardto § 1563(b)), or § 414(m) or (o).

.03 Pass-thru Entities. (1) Sec-tion 199(d)(1) provides that, in the caseof an S corporation, partnership, estateor trust, or other pass-thru entity, § 199generally is applied at the shareholder,

partner, or similar level, except as oth-erwise provided in rules applicable toindividuals and patrons of cooperatives.Section 199(d)(1) further provides that theSecretary shall prescribe rules for the ap-plication of § 199, including rules relatingto: (a) restrictions on the allocation of thededuction to taxpayers at the partner orsimilar level; and (b) additional reportingrequirements.

(2) Notwithstanding the general rulethat § 199 is applied at the shareholder,partner, or similar level, § 199(d)(1)(B)provides that, for purposes of applying thewage limitation of § 199(b), a shareholder,partner, or similar person that is allocatedQPAI from an S corporation, partnership,estate, trust, or other pass-thru entity isalso treated as having been allocated W–2wages from such entity in an amount equalto the lesser of: (i) such person’s allocableshare of such wages (without regard tothis rule) as determined under regulationsprescribed by the Secretary; or (ii) 2 times9 percent (3 percent in the case of taxableyears beginning in 2005 and 2006, and 6percent in the case of taxable years begin-ning in 2007, 2008, or 2009) of the QPAIallocated to such person for the taxableyear.

.04 Individuals. In the case of individ-uals, § 199(d)(2) provides that the deduc-tion is equal to the applicable percent of thelesser of the taxpayer’s (1) QPAI for thetaxable year, or (2) adjusted gross income(AGI) for the taxable year determined afterapplying §§ 86, 135, 137, 219, 221, 222,and 469, and without regard to § 199.

.05 Patrons of Certain Cooperatives.(1) Section 199(d)(3) provides specialrules under which a taxpayer receivingcertain patronage dividends or certainqualified per-unit retain allocations froma cooperative (to which subchapter T ap-plies) engaged in the MPGE, in whole orin significant part, or in the marketing, ofany agricultural or horticultural productis allowed a deduction under § 199 withrespect to the amount of the patronagedividends or qualified per-unit retain allo-cations that are: (a) allocable to the portionof the cooperative’s QPAI that would bedeductible by the cooperative; and (b)designated as such by the cooperative in awritten notice mailed to its patrons duringthe payment period described in § 1382.Such an amount, however, does not reduce

the taxable income of the cooperative un-der § 1382.

(2) In determining the portion of the co-operative’s QPAI that would be deductibleby the cooperative, the cooperative’s tax-able income is computed without takinginto account any deduction allowable un-der § 1382(b) or (c) (relating to patron-age dividends, per-unit retain allocations,and nonpatronage distributions) and, in thecase of a cooperative engaged in marketingagricultural and horticultural products, thecooperative is treated as having MPGE, inwhole or in significant part, any QPP mar-keted by the cooperative that its patronshave MPGE.

.06 Expanded Affiliated Groups. (1)Section 199(d)(4)(A) provides that allmembers of an expanded affiliated group(EAG) are treated as a single corpo-ration for purposes of § 199. Section199(d)(4)(B) provides that an EAG is anaffiliated group as defined in § 1504(a),determined by substituting “50 percent”for “80 percent” each place it appears, andwithout regard to § 1504(b)(2) and (4).

(2) Section 199(d)(4)(C) provides that,except as provided in regulations, the § 199deduction is allocated among the membersof the EAG in proportion to each mem-ber’s respective amount (if any) of QPAI.

.07 Trade or Business Requirement.Section 199(d)(5) provides that § 199 isapplied by taking into account only itemsthat are attributable to the actual conductof a trade or business.

.08 Alternative Minimum Tax. Sec-tion 199(d)(6) provides rules to coordinatethe deduction allowed under § 199 with thealternative minimum tax (AMT) imposedby § 55. The deduction is allowed forpurposes of the AMT, except that the de-duction is equal to the applicable percentof the lesser of the taxpayer’s: (1) QPAI,determined without regard to subchapterA, Part IV, of the Code; or (2) alternativeminimum taxable income (AMTI). Forpurposes of the preceding sentence, in thecase of an individual, AGI (determinedwithout regard to § 199) shall be substi-tuted for AMTI.

.09 Authority to Prescribe Regulations.Section 199(d)(7) authorizes the Secretaryto prescribe such regulations as are neces-sary to carry out the purposes of § 199.

February 14, 2005 503 2005–7 I.R.B.

SECTION 3. EXPLANATION OFINTERIM GUIDANCE

.01 In General. Section 199 provides adeduction from gross income for an appli-cable percentage of QPAI subject to cer-tain limits. Section 199 raises a num-ber of complex issues. In general, the in-terim guidance provided in this notice isintended to balance the goals of: (1) ensur-ing compliance with the intent and purposeof § 199; and (2) providing clear, admin-istrable rules that minimize, to the extentpossible, the administrative burden on tax-payers and the Service.

.02 Wage Limitation. (1) In general.Section 4.02(1) of this notice providesrules that are used in determining theamount of “W–2 wages” of a taxpayer.Section 4.02(1) provides that for purposesof § 199(b)(2), the term “taxpayer” means“employer.” Section 4.02(1) provides thatonly amounts from Forms W–2, “Wageand Tax Statement,” issued for employeesof the taxpayer for employment by thetaxpayer are included in calculating thisamount. For purposes of this calculation,employees of the taxpayer are limited toemployees as defined by § 3121(d)(1) and(d)(2) (that is, officers of a corporate tax-payer and employees of the taxpayer underthe common law rules). Section 4.02(1)(b)provides generally that any discussion ofthe term “wages” in this notice is solelyfor purposes of § 199 and has no appli-cation in determining whether amountsare wages for purposes of the FederalInsurance Contributions Act (FICA), theFederal Unemployment Tax Act (FUTA),federal income tax withholding, or anyother wage related determination.

(2) Wages paid by other entities. Sec-tion 4.02(1) of this notice provides thata taxpayer may take into account wagespaid and reported by other entities to em-ployees of that taxpayer for employmentby that taxpayer. Thus, a taxpayer maytake into account wages paid by agentsof the taxpayer on behalf of the taxpayerto employees of the taxpayer that are in-cluded on Forms W–2 issued by the agent.A taxpayer also may take into accountwages paid by a person defined as an em-ployer under § 3401(d)(1), to employeesof the taxpayer if the wages are includedon Forms W–2 issued by the § 3401(d)(1)employer.

(3) Acquisitions and dispositions of atrade or business (or major portion). Sec-tion 4.02(1)(d) of this notice provides thatif a taxpayer (the successor) acquires themajor portion of a trade or business or themajor portion of a separate unit of a tradeor business from another taxpayer (the pre-decessor), the successor may not take intoaccount wages paid to common law em-ployees of the predecessor employer in re-spect of services rendered to the prede-cessor employer, even if those wages arereported on Forms W–2 furnished by thesuccessor.

(4) Non-duplication rule. Section4.02(1)(e) of this notice includes anon-duplication rule, which provides thatamounts that are treated as W–2 wagesfor any taxable year may not be treatedas W–2 wages for any other taxable year.Thus, an amount of nonqualified deferredcompensation that is treated as W–2 wagesunder the Unmodified Box Method in sec-tion 4.02(2)(b)(i) for a taxable year maynot be treated as W–2 wages in any othertaxable year.

(5) Definition of W–2 wages. (a) Ingeneral. Section 4.02(2) of this no-tice provides rules for determining the“W–2 wages” of a taxpayer. The term“W–2 wages” includes amounts that arerequired to be included on statementsunder § 6051(a)(3) and (8) with respectto employees of the taxpayer. Because§ 6051(a)(3) and (8) include the totalamount of wages as defined in § 3401(a),the total amount of elective deferrals(within the meaning of § 402(g)(3)), thecompensation deferred under § 457, and(for tax years beginning after December31, 2005) the amount of designated Rothcontributions (as defined in § 402A), thereis no single box on the Form W–2 thatnecessarily includes all these items of in-formation without including other items.Therefore, no single box on the Form W–2meets the § 199(b)(2) definition of W–2wages.

(b) Methods for calculating W–2 wages.Because no single box on Form W–2 sat-isfies the definition of W–2 wages under§ 199(b)(2), section 4.02(2)(b) of this no-tice provides three alternative methods forcalculating W–2 wages only for purposesof § 199. The first option allows for a sim-plified calculation while the last two op-tions provide greater accuracy. Under thefirst option, a taxpayer may treat as the

taxpayer’s W–2 wages under § 199(b)(2)the lesser of (A) the total entries in Box1 of all Forms W–2 filed with the SocialSecurity Administration (SSA) by the tax-payer with respect to employees of the tax-payer or (B) the total entries in Box 5 ofall Forms W–2 filed with the SSA by thetaxpayer with respect to employees of thetaxpayer. Under the second option, theW–2 wages are calculated by subtractingfrom the total amounts reported in Box 1 ofForms W–2 with respect to employees ofthe taxpayer (1) amounts that are includedin Box 1 that are not wages under § 3401(a)and (2) items that are treated as wages un-der § 3402(o) (for example, supplemen-tal unemployment compensation benefits),and then adding those elective deferralsthat are reported in Box 12 of Forms W–2with Codes D, E, F, G, and S. Under thethird option, a taxpayer may track the ac-tual amount of wages subject to federalincome tax withholding, subtract supple-mental unemployment compensation ben-efits that were included in this amount, andthen add specific elective deferrals that arereported in Box 12 of Forms W–2 withCodes D, E, F, G, and S.

.03 Determining Qualified ProductionActivities Income. Section 4.03 of this no-tice provides rules for determining a tax-payer’s QPAI for the taxable year. Thisnotice provides that QPAI is determinedon an item-by-item basis (and not, for ex-ample, on a division-by-division, a prod-uct line-by-product line, or a transaction-by-transaction basis) and is the sum ofthe QPAI derived by the taxpayer fromeach item. For purposes of this determi-nation, QPAI from each item may be pos-itive or negative. Section 4.04 providesrules for determining a taxpayer’s DPGR,the definition of the terms “gross receipts,”“manufactured, produced, grown, or ex-tracted,” “by the taxpayer,” “in whole orin significant part,” and “derived from thelease, rental, license, sale, exchange, orother disposition of qualifying productionproperty,” as well as rules for determin-ing whether property qualifies as QPP (thatis, tangible personal property, computersoftware, and sound recordings). See sec-tion 3.04 for an explanation of these rules.Section 4.05 provides rules for determin-ing a taxpayer’s costs (including CGS) forpurposes of computing QPAI. See section3.05 for an explanation of the rules relat-ing to costs. Generally, if a taxpayer is

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engaged exclusively in the manufacture ofQPP within the United States and has noother sources of income, it is anticipatedthat QPAI will equal taxable income.

.04 Determining Domestic ProductionGross Receipts. (1) In general. Section4.04 of this notice generally provides rulesfor determining DPGR. A taxpayer mustdetermine the portion of its total grossreceipts that are DPGR. For example, ifa taxpayer manufactures QPP at a facilityinside the United States (that otherwisequalifies under § 199) and QPP at a facil-ity outside the United States, the taxpayergenerally must determine the portion of itsgross receipts that are attributable to QPPmanufactured inside the United States andthe portion of its gross receipts that areattributable to QPP manufactured outsidethe United States to determine the tax-payer’s DPGR. However, section 4.03(2)provides a safe harbor under which ataxpayer with less than 5 percent of totalgross receipts from items other than DPGRmay treat all gross receipts as DPGR andis therefore not required to allocate itsgross receipts. For example, interestand late fees relating to QPP manufac-tured in the United States by a taxpayerand sold by the taxpayer on credit arenot DPGR, but may be treated as DPGRif the taxpayer’s interest and late fees,when aggregated with other non-DPGR,are collectively less than 5 percent ofthe taxpayer’s total gross receipts. TheService and Treasury Department do notbelieve that the interim guidance shouldmandate a single method of determiningDPGR because the Service and TreasuryDepartment have not identified a singlemethod that would be appropriate for alltaxpayers. Accordingly, section 4.03(2)provides that a taxpayer’s method for de-termining DPGR and non-DPGR mustbe a reasonable method that accuratelyidentifies the gross receipts derived fromactivities described in § 199(c)(4) basedon all of the information available to thetaxpayer to substantiate the allocation.Among the factors that the Service willtake into consideration in determiningwhether a taxpayer’s method is reasonableis whether the taxpayer is using the mostaccurate information available to the tax-payer; the relationship between the grossreceipts and the base chosen; the accu-racy of the method chosen as comparedwith other possible methods; whether

the method is used by the taxpayer forinternal management or other businesspurposes; whether the method is used forother federal, state, or foreign income taxpurposes; the time, burden, and cost ofusing various methods; and whether thetaxpayer applies the method consistentlyfrom year to year. For example, a tax-payer that uses a specific identificationmethod (that is, a method that specificallyidentifies where the item was MPGE) forany other purpose is required to use thatmethod to determine DPGR. Similarly, ataxpayer that has the information readilyavailable to use a specific identificationmethod even if it does not use that methodfor any other purpose generally is requiredto use a specific identification method todetermine DPGR and the taxpayer’s useof a different, less accurate method to de-termine DPGR generally is not consideredreasonable. However, a taxpayer that doesnot currently use a specific identificationmethod for any other purpose and does nothave the information readily available touse the method generally is not required touse that method to determine DPGR. Seesection 3.05 for an explanation of rulesrelating to the allocation of costs.

(2) Definition of “gross receipts.” Forpurposes of § 199, section 4.04(2) of thisnotice defines the term “gross receipts” us-ing a definition that is derived from thedefinition under § 1.448–1T(f)(2)(iv)(A).In general, “gross receipts” for the taxableyear are those that are properly recognizedunder the taxpayer’s accounting methodfor federal income tax purposes.

(3) Definition of “manufactured, pro-duced, grown, or extracted.” (a) In general.In determining how this notice should de-fine MPGE under § 199(c)(4)(A)(i)(I), theService and Treasury Department consid-ered how those terms have been definedunder § 954 (see § 1.954–3(a)(4)(i) forthe definition of manufactured or pro-duced), and how the same or similar termshave been defined for purposes of § 38(see § 1.48–1(d)(2)) and § 263A (see§ 263A(g)(1) and § 1.263A–2(a)(1)(i)).Even though these and similar terms areused in other parts of the Code, the Ser-vice and Treasury Department believe thatfor this purpose the terms MPGE must beconstrued in light of the specific policiesunderlying § 199. Because the Serviceand Treasury Department believe thatCongress intended for the deduction under

§ 199 to be available to taxpayers for awide variety of production activities, sec-tion 4.04(3) of this notice defines MPGEbroadly to include all of the activitiesspecifically listed in §§ 199(c)(4)(A)(i)(I)and 263A(g)(1), and in §§ 1.48–1(d)(2)and 1.263A–2(a)(1)(i) (hereinafter re-ferred to as “MPGE activities”). Thisinterpretation is solely for purposes of§ 199, based on the authority provided tothe Secretary under § 199(d)(7), and doesnot affect the construction of these termsin other parts of the Code (for example,§ 954(a)(1)(A)).

(b) Consistency with § 263A. The Ser-vice and Treasury Department believethat the term “producer” has been inter-preted broadly under § 263A and includeswithin its scope all of the MPGE activities.Accordingly, the Service and Treasury De-partment believe that if a taxpayer claimsit has MPGE QPP for the taxable year forpurposes of § 199(c)(4)(A)(i)(I), it is fun-damentally inconsistent for the taxpayer toclaim it is not a “producer” under § 263Awith respect to the QPP for the taxableyear. Therefore, section 4.04(3)(b) of thisnotice provides that a taxpayer that hasMPGE QPP for the taxable year shouldalso consistently treat itself as a producerunder § 263A with respect to the QPPfor the taxable year unless the taxpayeris not subject to § 263A under the Code,regulations, or other published guidance.Taxpayers that currently are not properlyaccounting for their production activitiesunder § 263A, and that wish to changetheir method of accounting to complywith the producer requirements of § 263A,must follow the procedures of Rev. Proc.97–27, 1997–1 C.B. 680 (as modified andamplified by Rev. Proc. 2002–19, 2002–1C.B. 696, as amplified and clarified byRev. Proc. 2002–54, 2002–2 C.B. 432), orRev. Proc. 2002–9, 2002–1 C.B. 327 (asmodified and clarified by Announcement2002–17, 2002–1 C.B. 561, modified andamplified by Rev. Proc. 2002–19, 2002–1C.B. 696, and amplified, clarified, andmodified by Rev. Proc. 2002–54, 2002–2C.B. 432), whichever applies.

(4) Definition of “by the taxpayer.”With the exception of the rules applicableto an EAG, the Service and Treasury De-partment believe that the requirement of§ 199(c)(4)(A)(i) that property be MPGE“by the taxpayer” means that only onetaxpayer may claim the deduction under

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§ 199 with respect to the same functionperformed with respect to the same prop-erty. For example, if A enters into anagreement with an unrelated customer Bto manufacture 100 widgets for B, onlyone of the taxpayers is treated as hav-ing MPGE the widgets for purposes of§ 199(c)(4)(A)(i)(I). Section 4.04(4) ofthis notice provides that in contract man-ufacturing situations, if one taxpayer per-forms activities that constitute the MPGEof QPP or the production of a qualifiedfilm, electricity, natural gas, or potablewater (collectively “qualifying activity”)pursuant to a contract with an unrelatedparty, then only the taxpayer that hasthe benefits and burdens of ownershipof the property under federal income taxprinciples during the period the qualifyingactivity occurs is treated as engaging in thequalifying activity. This standard is basedon the principles under § 936 and § 263A.In considering which standard to apply incontract manufacturing situations, the Ser-vice and Treasury Department concludedthat it is not appropriate to treat propertyas being manufactured by the customerin a contract manufacturing situation ifthe customer does not have the benefitsand burdens of owning the property underfederal income tax principles during theperiod the qualifying activity occurs. Thisrule applies even if the customer exercisesdirect supervision and control over theactivities of the contractor or is treatedas a producer of the property pursuantto § 263A(g)(2) for other reasons. If acontractor does not have the benefits andburdens of owning the property underfederal income tax principles during theperiod the qualifying activity occurs, thecontractor is more appropriately viewedas performing a service for the customer.As a result, a contractor that does not sat-isfy the “by the taxpayer” requirementsof § 199(c)(4)(A)(i) is considered to bederiving gross receipts from the provi-sion of services and the receipts are notconsidered to be “derived from any lease,rental, license, sale, exchange, or otherdisposition of” the property within themeaning of § 199(c)(4)(A)(i) (see sec-tion 4.04(7)(a)). Thus, a taxpayer thatdoes not have the benefits and burdens ofownership of the property under federalincome tax principles during the periodthe qualifying activity occurs does notqualify under the contract manufacturing

rule for purposes of § 199. To illustratethis rule, if, in the example above, A ownsthe widgets during the period the quali-fying activity occurs (that is, A bears thebenefits and burdens of ownership underfederal income tax principles), the widgetswill be treated as manufactured by A andnot the unrelated customer B for purposesof § 199(c)(4)(A)(i)(I). Conversely, if B isthe owner of the widgets (that is, B bearsthe benefits and burdens under federalincome tax principles) during the periodthe qualifying activity occurs, the widgetswill be treated as manufactured by B, notA, for purposes of § 199(c)(4)(A)(i)(I).Under this rule, either A or B may qualifyfor the deduction, but both cannot obtainthe benefit of the deduction for the sameactivity. No inference is intended concern-ing the definition of “by the taxpayer” or“contract manufacturing” for purposes ofany other provision of the Code.

(5) Definition of “in whole or in sig-nificant part.” (a) In general. To qualifyfor the § 199 deduction, QPP must beMPGE “in whole or in significant part bythe taxpayer within the United States.”Under § 199, the gross receipts that areconsidered DPGR are not limited to thegross receipts attributable to QPP MPGEentirely by a taxpayer. For example, ifa taxpayer purchases partially manufac-tured QPP from another taxpayer andthe taxpayer satisfies the “in whole orin significant part” requirement with re-spect to the manufacture of the QPP, thetaxpayer’s gross receipts derived fromthe lease, rental, license, sale, exchange,or other disposition of that QPP will beconsidered DPGR (assuming all otherrequirements of § 199(c) are met). Like-wise, if a taxpayer imports QPP that itpartially manufactured outside the UnitedStates, and the taxpayer satisfies the “inwhole or in significant part” requirementwith respect to its United States manufac-turing activity associated with that QPP,the taxpayer’s gross receipts derived fromthe lease, rental, license, sale, exchange,or other disposition of that QPP will beconsidered DPGR (assuming all other re-quirements of § 199(c) are met). Similarly,if a taxpayer manufactures QPP in signifi-cant part in the United States and exportsthe goods for further manufacture outsidethe United States, the taxpayer’s grossreceipts derived from the lease, rental, li-cense, sale, exchange, or other disposition

of that QPP will be considered DPGR,regardless of whether the QPP is importedback into the United States prior to thelease, rental, license, sale, exchange, orother disposition of the QPP (and assum-ing all other requirements of § 199(c) aremet). See section 4.04(7) of this notice fora discussion of the definition of “derivedfrom the lease, rental, license, sale, ex-change, or other disposition of qualifyingproduction property.”

(b) Substantial in nature. Section4.04(5)(b) of this notice provides, gener-ally, that the “in whole or in significantpart” requirement is satisfied if the tax-payer’s MPGE activity within the UnitedStates with respect to the QPP is “sub-stantial in nature.” Whether a taxpayer’sMPGE activity is “substantial in nature”for purposes of § 199 generally dependsupon all of the facts and circumstances,including the relative value added by, andrelative cost of, the taxpayer’s MPGEactivity in the United States, the natureof the property, and the nature of theMPGE activity that the taxpayer per-forms in the United States. Although this“substantial in nature” requirement ap-plies on a facts and circumstances basislike the “substantial in nature” require-ment in § 1.954–3(a)(4)(iii), this “sub-stantial in nature” requirement is not thesame as the requirements underlying the“not the property which it purchased”standard in § 1.954–3(a)(4). In partic-ular, the substantial transformation testof § 1.954–3(a)(4)(ii) is not relevant tothe determination of “substantial in na-ture” for purposes of § 199(c)(4)(A)(i)(I).The Service and Treasury Departmentconsidered whether the general rule fordetermining whether the taxpayer satis-fies the “in whole or in significant part”requirement should be based upon a sin-gle, quantitative criterion, such as relativevalue, or relative cost, of the United Statesactivity. However, the Service and Trea-sury Department concluded that such ageneral rule would not be suitable in allcircumstances. For example, assume thata taxpayer purchases gemstones and pre-cious metal and then uses these materialsto produce jewelry in the United States(for example, by cutting and polishing thegemstones, melting and shaping the metal,and combining the finished materials).The Service and Treasury Departmentbelieve that the taxpayer is properly re-

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garded as manufacturing or producing theQPP in significant part within the UnitedStates. The value added by the taxpayer’sUnited States manufacturing, however,may not be substantial when comparedto the value of the final product becauseof the relatively high value of the pur-chased materials. Similarly, the cost of thetaxpayer’s United States manufacturingmay not be substantial when compared tothe total cost of the product (and there-fore also may not meet the safe harbordiscussed below). However, the natureof the product, and the nature of the tax-payer’s United States MPGE activity, issuch that the United States MPGE activityis “substantial in nature.” Accordingly, theService and Treasury Department believethat the “substantial in nature” test shouldbe applied by considering all of the factsand circumstances.

(c) Safe harbor. Section 4.04(5)(c) ofthis notice provides a safe harbor underwhich a taxpayer will be treated as MPGEproperty in whole or in significant partwithin the United States if, in connectionwith the property, conversion costs (directlabor and related factory burden) to MPGEthe property are incurred by the taxpayerwithin the United States and the costs ac-count for 20 percent or more of the totalCGS of the property. This rule would op-erate similarly to the safe harbor providedunder § 1.954–3(a)(4)(iii) for determiningwhether, for purposes of computing for-eign base company sales income, the saleof property is treated as the sale of a man-ufactured product rather than the sale of acomponent part, when purchased compo-nents constitute part of the property.

(d) Certain activities and costs disre-garded. The Service and Treasury De-partment believe that, in connection withthe MPGE of QPP, packaging, repackag-ing, labeling, and minor assembly opera-tions should not be considered in apply-ing the general “substantial in nature” test,and that the costs of those activities shouldnot be considered in applying the safe har-bor. This rule is similar to the test ap-plied in § 1.954–3(a)(4)(iii). For exam-ple, a taxpayer whose United States activ-ities consist solely of affixing a label to aplastic bottle otherwise manufactured en-tirely outside the United States will not beregarded as having met the “in whole orin significant part” requirement, regardlessof the value added to the bottle by the la-

bel or the relative cost incurred by the tax-payer with respect to the labeling activity.In addition, the Service and Treasury De-partment do not believe it is appropriate toregard a taxpayer as meeting the “in wholeor in significant part” requirement if thetaxpayer manufactures tangible personalproperty entirely outside the United States,even if the design and development activi-ties that lead to the tangible personal prop-erty occur entirely within the United Statesbecause the design and development activ-ities with respect to tangible personal prop-erty give rise to the creation of an intan-gible asset. Thus, with respect to tangiblepersonal property, design and developmentactivities also are disregarded for purposesof the general “substantial in nature” test,and the costs of those activities are dis-regarded for purposes of the safe harborin section 4.04(5)(c) of this notice. How-ever, with respect to computer softwareand sound recordings, intangible propertythat may constitute QPP under § 199, theService and Treasury Department believethat a significant portion of the “produc-tion” may be viewed as design and devel-opment (for example, writing the program-ming code in the case of computer soft-ware, and recording and editing the mastercopy in the case of sound recordings). Ac-cordingly, in the case of computer softwareand sound recordings, design and develop-ment activities are not disregarded for pur-poses of applying the “substantial in na-ture” test and the costs of those activitiesare not disregarded for purposes of the safeharbor in section 4.04(5)(c).

(6) Definition of “United States.”Section 7701(a)(9) generally providesthat, for purposes of the Code, the term“United States” when used in a geograph-ical sense includes only the 50 states andthe District of Columbia. For purposes of§ 199, the term United States follows the§ 7701(a)(9) definition and includes theterritorial waters of the United States andthe seabed and subsoil of those submarineareas that are adjacent to the territorial wa-ters of the United States and over whichthe United States has exclusive rights, inaccordance with international law, withrespect to the exploration and exploitationof natural resources. However, becauseneither § 199 nor the legislative historyexplicitly include possessions and territo-ries of the United States or the airspaceover the United States and these areas

within the definition of United States,the term “United States” does not in-clude possessions and territories of theUnited States or the airspace over theUnited States and these areas for purposesof § 199. See, for example, § 638 and§ 301.7701(b)–1(c)(2)(ii).

(7) Definition of “derived from thelease, rental, license, sale, exchange, orother disposition of qualifying productionproperty.” (a) In general. Section 4.04(7)of this notice provides that gross receipts“derived from” an activity described insection 4.04(3) are limited to the directproceeds from the lease, rental, license,sale, exchange, or other disposition ofthe QPP. Thus, for example, the “derivedfrom the sale of QPP” requirement ismet with respect to direct proceeds fromthe sale of QPP manufactured in wholeor in significant part within the UnitedStates by a taxpayer for sale (assuming allother requirements of § 199(c) are met),as well as for direct proceeds from thesale of self-constructed QPP manufac-tured in whole or in significant part in theUnited States by a taxpayer and used inthe taxpayer’s trade or business (assum-ing all other requirements of § 199(c) aremet) (see section 3.05 for a discussionof determining costs with respect to thedisposition of self-constructed assets). Inaddition, business interruption insuranceand payments not to produce are treatedas gross receipts “derived from the lease,rental, license, sale, exchange, or otherdisposition of” an activity described insection 4.04(7)(a) to the extent the pay-ments are substitutes for gross receiptsthat would be so treated (assuming allother requirements of § 199(c) are met).Except as provided in section 4.04(7)(c)with respect to certain advertising incomeand section 4.04(7)(e) with respect to cer-tain oil and gas partnerships, the Serviceand Treasury Department believe that noother receipts are within the language of§ 199(c)(4)(A)(i). For purposes of the“derived from the lease, rental, license,sale, exchange, or other disposition of”requirement of § 199(c)(4)(A)(i), existingfederal income tax law principles applyto determine whether a transaction is, insubstance, a lease, rental, license, sale,exchange or other disposition, or whetherit is a service. See for example, Rev.Rul 88–65, 1988–2 C.B. 32, which treatsa short-term rental as a service. For an

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explanation of the rules relating to de-termining gross receipts “derived from”construction performed in the UnitedStates, see section 3.04(11)(e).

(b) Allocation of gross receipts — em-bedded services. With certain exceptionsdiscussed below, gross receipts derivedfrom the performance of services do notqualify as DPGR. Accordingly, in thecase of the lease, rental, license, sale, ex-change, or other disposition of propertythat contains a service element (embeddedservice), section 4.04(7)(b) of this noticegenerally requires that the taxpayer allo-cate the gross receipts (as well as the costs— see section 4.05) between the propertyand the embedded service. The portionof the gross receipts that are considered“derived from the lease, rental, license,sale, exchange, or other disposition” ofthe property may not exceed the sellingprice of the property without the serviceelement. Section 4.04(7)(b) provides twoexceptions to the allocation requirement.First, a taxpayer may include in DPGRgross receipts from a qualified warranty(that is, a warranty that is provided in con-nection with the sale of QPP if (1) in thenormal course of its business, the chargefor the warranty is included in the pricecharged for the lease, rental, license, sale,exchange, or other disposition of the QPPand (2) the warranty is neither separatelyoffered by the taxpayer nor separately bar-gained for with the customer (that is, thecustomer cannot purchase the QPP withoutthe warranty)). This exception is consis-tent with a similar exception provided insection 3.07 of Rev. Proc. 71–21, 1971–2C.B. 549 (modified and superseded byRev. Proc. 2004–34, 2004–22 I.R.B.991), regarding the deferral of certain ad-vance payments for services. Second, ade minimis amount of gross receipts fromembedded services for each item of prop-erty may qualify as DPGR. A de minimisamount of gross receipts from embeddedservices is equal to less than 5 percent ofthe gross receipts of the property. If one ofthese exceptions is met, the gross receiptsderived from the lease, rental, license, sale,exchange, or other disposition of propertyand the gross receipts from the embeddedservices are treated as “derived from thelease, rental, license, sale, exchange, orother disposition” of the property and aretreated as DPGR (assuming all other re-quirements of § 199(c) are met). The 5

percent de minimis rule is consistent with§ 1.451–5(a)(3), which generally providesthat if less than 5 percent of an advancepayment for goods is allocable to the pro-vision of services, the portion so allocablewill be considered as an advance paymentfor goods. For purposes of applying thisde minimis rule, the gross receipts from aqualified warranty that are included in theprice charged for the lease, rental, license,sale, exchange, or other disposition ofproperty are not treated as gross receiptsfor services.

(c) Advertising income. The Serviceand Treasury Department believe that ad-vertising income attributable to the saleor other disposition of newspapers andmagazines should be considered “derivedfrom” the sale or other disposition of thenewspapers and magazines because theadvertising income is inextricably linkedto the gross receipts derived from the lease,rental, sale, exchange or other dispositionof the newspapers and magazines. Forexample, a newspaper manufacturer’s re-ceipts from an advertiser to publish displayadvertising or classified advertisements inits newspaper are treated as gross receiptsderived from the sale of the newspapersfor purposes of § 199 (assuming all otherrequirements of § 199(c) are met).

(d) Computer software. The determina-tion of whether a transfer of computer soft-ware is a sale or exchange of property, a li-cense generating royalty income, or a leasegenerating rental income is made takinginto account all facts and circumstances.The form adopted by the parties to a trans-action, the classification of the transac-tion under copyright law, and the physicalor electronic or other medium used to ef-fectuate the transfer of computer softwareare not determinative. See § 1.861–18.A service provided using computer soft-ware that does not involve a transfer of thecomputer software does not result in grossreceipts that are derived from the lease,rental, license, sale, exchange, or other dis-position of computer software. Thus, withrespect to computer software that is de-veloped in the United States and sold tocustomers who take delivery of the soft-ware by downloading the software fromthe Internet, the manufacturer’s gross re-ceipts from the sales are DPGR (assumingall other requirements of § 199(c) are met).Except as provided in the safe harbor de-scribed in section 3.04(7)(b) of this notice,

gross receipts derived by a taxpayer fromsoftware that is merely offered for use tocustomers online for a fee are not DPGR.In addition, gross receipts derived from thelease, rental, license, sale, exchange, orother disposition of computer software donot include gross receipts derived from: (i)providing customer support in connectionwith the sale of computer software; (ii) on-line services; or (iii) providing Internet ac-cess or telephone services over the Inter-net. These receipts are not DPGR becausethese receipts are attributable to the provi-sion of a service and are not derived fromthe lease, rental, license, sale, exchange, orother disposition of the software.

(8) Definition of “qualifying produc-tion property.” (a) In general. Section199(c)(5) provides that the term “qualify-ing production property” includes: (1) tan-gible personal property; (2) computer soft-ware; and (3) sound recordings.

(b) Tangible personal property. Thedefinition of “tangible personal prop-erty” provided in section 4.04(8)(b) ofthis notice is derived primarily from,and is generally consistent with, the def-inition of that term under § 1.48–1(c).Consistent with § 1.48–1(c), section4.04(8)(b) provides that local law isnot controlling for purposes of deter-mining whether property is tangible per-sonal property under § 199(c)(5)(A). Inaddition to many of the items specifi-cally referenced in § 1.48–1(c), section4.04(8)(b) includes in the term “tangiblepersonal property” videocassettes, com-puter diskettes, books, and similar items.See § 1.263A–2(a)(2)(ii). No inferenceis intended concerning whether theseitems are tangible or intangible propertyfor purposes of any other section of theCode (for example, § 197). Treating theseitems as tangible personal property is con-sistent with the definitions provided for“computer software,” “sound recordings,”and “qualified films,” that do not includethe tangible personal property (if any) inwhich computer software, a sound record-ing, or a qualified film is fixed. As a result,“tangible personal property” excludes anyproperty that falls within the definition ofcomputer software, a sound recording, ora qualified film. For example, a sale of acomputer game on a CD-ROM has botha tangible personal property element (thedisc) and a computer software element(the program fixed on the disc), but a sale

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of the same program effected instead byan internet download involves computersoftware only.

(c) Computer software. (i) In general.The definition of “computer software”provided in section 4.04(8)(c) of this no-tice is derived from the definition of thatterm under § 1.197–2(c)(4)(iv), but alsoincludes the machine-readable coding forvideo games and similar programs, regard-less of whether the program is designed tooperate on a “computer” (as defined under§ 168(i)(2)(B)). The term “computer soft-ware” includes all property described insection 4.04(8)(c). Thus, DPGR includesthe gross receipts from computer softwarethat was developed by the taxpayer, pro-vided the gross receipts are derived fromthe lease, rental, license, sale, exchange,or other disposition of computer softwareas required by § 199(c)(4)(A)(i).

(ii) Tangible personal property not in-cluded. “Computer software” does notinclude diskettes or other tangible prop-erty on which machine-readable codingis placed, as the property is consideredtangible personal property for purposesof § 199. For example, assume B, whois unrelated to A, develops software out-side the United States and licenses therights to manufacture and distribute thesoftware to A, and A manufactures inthe United States compact discs encodedwith the software. Assume further that Asells the compact discs encoded with thesoftware. A’s gross receipts from the saleof the compact discs are derived in partfrom the sale of tangible personal property(the compact discs), and in part from thesale of computer software. Therefore, Amust allocate its gross receipts betweenthose attributable to the software (whichare not DPGR) and those attributable tothe compact discs (which are DPGR, as-suming all other requirements of § 199(c)are met). Assume in the alternative thatA is an integrated software developer andproducer that designs the software outsidethe United States and manufactures thecompact discs within the United States.Assume further that A sells the compactdiscs encoded with the software. A’s grossreceipts from the sale of the compact discsare derived in part from the sale of tangi-ble personal property (the compact discs),and in part from the sale of computer soft-ware. Therefore, A must allocate its grossreceipts between those attributable to the

software (which are not DPGR becausethe software was developed outside theUnited States) and those attributable to thecompact discs (which are DPGR, assum-ing all other requirements of § 199(c) aremet).

(d) Sound recordings. Section 199(c)(5)(C) provides that QPP includes anyproperty described in § 168(f)(4). Sec-tion 4.04(8)(d) of this notice defines theterm “sound recording” consistent with§ 168(f)(4). Consistent with the defini-tions of computer software and qualifiedfilms, the definition of “sound recording”does not include tangible personal prop-erty in which the sound recording is fixed,such as a compact disc. This interpre-tation does not affect any other sectionof the Code (for example, § 168(f)(4)).Consequently, the results in the examplesprovided in section 3.04(8)(c)(ii) wouldbe the same if, instead of software, the ex-amples involved the production of soundrecordings and compact discs that containthe sound recordings.

(9) Definition of “qualified film.” (a)In general. Section 199(c)(6) providesthat the term “qualified film” means anyproperty described in § 168(f)(3). Ac-cordingly, section 4.04(9) of this noticedefines a “qualified film” to include anymotion picture film or video tape (otherthan certain sexually explicit visual depic-tions), as well as live or delayed televi-sion programming (see H.R. Conf. Rep.No. 755, 108th Cong., 2d Sess. 273(fn. 30) (2004) (Conference Report) (here-inafter referred to collectively as “film”)if not less than 50 percent of the totalcompensation relating to the production ofthe property is compensation for servicesperformed in the United States by actors,production personnel, directors, and pro-ducers. Qualified films include all prop-erty described in section 4.04(9). Consis-tent with the definitions of “computer soft-ware” and “sound recordings,” the defini-tion of “qualified film” is limited to themaster copy of the film (or other copyfrom which the holder is licensed to makeand produce copies), and does not includetangible personal property embodying thequalified film, such as DVDs or videocas-settes. This interpretation does not affectany other section of the Code (for exam-ple, § 168(f)(3)). In no event will ticketsales for viewing qualified films consti-tute DPGR. Thus, for example, if A pro-

duces a qualified film, fixes the film to atangible medium purchased from an unre-lated taxpayer, and leases or licenses thequalified film and medium containing thequalified film to unrelated commercial the-aters, A’s gross receipts from the lease orlicense of the qualified film are “derivedfrom” (i) the lease of tangible personalproperty (the tangible medium on whichthe copy is fixed), that are not DPGR, and(ii) the license of the qualified film (theright to publicly display the film), that areDPGR. If, instead, A licenses a qualifiedfilm to unrelated taxpayer B, and B re-produces the film on DVDs or videocas-settes manufactured by B in the UnitedStates, B’s gross receipts from the saleof the DVDs and videocassettes are “de-rived from” the sale of (i) tangible per-sonal property (the DVDs and videocas-settes), that are DPGR, and (ii) the quali-fied film (the motion picture fixed on theDVDs and cassettes), that are not DPGR.A taxpayer that merely writes a screenplayor other similar material is not consideredto have produced a qualified film under§ 199(c)(4)(A)(i)(II). Therefore, amountsthat a taxpayer receives from the sale of ascript or screenplay, even if it is developedinto a qualified film, are not gross receipts“derived from” a qualified film. In addi-tion, revenue from the sale of film-themedmerchandise is revenue from the sale oftangible personal property, and not grossreceipts “derived from” a qualified film.Finally, gross receipts derived from a li-cense of the right to use the film charac-ters are not gross receipts “derived from”a qualified film.

(b) Production personnel. For purposesof § 199(c)(6), the term “production per-sonnel” includes all personnel (other thanactors, directors, and producers) who aredirectly involved in the production of thefilm. Thus, “production personnel” un-der section 4.04(9)(a) of this notice in-clude writers, choreographers and com-posers providing services during the pro-duction of a film, casting agents, cameraoperators, set designers, lighting techni-cians, make-up artists, and others whoseactivities are directly related to the produc-tion of the film. “Production personnel” donot include, however, individuals whoseactivities are ancillary to the production,such as advertisers and promoters, distrib-utors, studio administrators and managers,

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studio security personnel, and personal as-sistants to actors.

(c) Compensation for services. Undersection 4.04(9)(b) of this notice, compen-sation for services includes all paymentsfor services performed by actors, produc-tion personnel, directors, and producers,including participations and residuals. SeeConference Report at 273 (fn. 31). In thecase of a taxpayer that uses the incomeforecast method of § 167(g) and capi-talizes participations and residuals intothe adjusted basis of the qualified film,the taxpayer must use the same estimateof participations and residuals for pur-poses of § 199 that it uses for purposes of§ 167(g). In the case of a taxpayer thatexcludes participations and residuals fromadjusted basis of the qualified film under§ 167(g)(7)(D)(i), the taxpayer must de-termine the compensation expected to bepaid as participations and residuals basedon the total forecasted income used indetermining income forecast depreciation.

(d) Determination of 50 percent. TheService and Treasury Department do notbelieve that a single method of allocatingcompensation between services performedwithin the United States and services per-formed outside the United States is ap-propriate for all taxpayers. Accordingly,section 4.04(9)(c) of this notice providesthat a taxpayer may use any reasonablemethod of making the allocation. Amongthe factors to be considered in determiningwhether a taxpayer’s method of allocatingcompensation is reasonable is whether thetaxpayer uses that method consistently.

(10) Electricity, natural gas, andpotable water. (a) In general. DPGRincludes gross receipts derived from anylease, rental, license, sale, exchange, orother disposition of electricity, natural gas,or potable water produced by the taxpayerin the United States (assuming all otherrequirements of § 199(c) are met). DPGRdoes not include, however, gross receiptsof the taxpayer derived from the transmis-sion or distribution of these items. TheConference Report at 272–3 (fn. 28) ex-plains that an integrated producer that bothproduces and delivers electricity, naturalgas, or potable water, must allocate itsgross receipts between: (i) production thatqualifies as DPGR; and (ii) distributionand transmission (that do not qualify asDPGR). Thus, section 4.04(10)(d) of thisnotice generally requires such allocation.

However, if less than 5 percent of a tax-payer’s gross receipts derived from a saleof electricity, natural gas, or potable waterare attributable to the transmission anddistribution of such electricity, natural gas,or potable water, then the gross receiptsderived from that sale that are attributableto the transmission and distribution ofsuch items will be treated for purposes of§ 199 as being DPGR.

(b) Natural gas. Section 4.04(10)(b) ofthis notice defines the term “natural gas”in a manner consistent with § 613A(e)(2)and generally includes only natural gasextracted from a natural deposit. Thus,natural gas would not include, for exam-ple, methane gas extracted from a land-fill. Consistent with the Conference Re-port at 272–3 (fn. 28), section 4.04(10)(b)provides that, in the case of natural gas,production activities include all activitiesinvolved in extracting natural gas fromthe ground and processing the gas intopipeline quality gas.

(c) Potable water. Section 4.04(10)(c)of this notice provides that, consistentwith the Conference Report at 272–3(fn. 28), production activities with respectto potable water include the acquisition,collection, and storage of raw water (un-treated water), transportation of raw waterto a water treatment facility, and treat-ment of raw water at such a facility. Thus,gross receipts derived from any of theseactivities performed in the United Statesare included in DPGR (assuming all otherrequirements of § 199(c) are met). DPGRdoes not include, however, gross receiptsderived from the storage of potable wa-ter after completion of treatment of thepotable water, or delivery of potable waterto customers. The Service and TreasuryDepartment believe that Congress in-tended for the provision relating to potablewater to apply to water utilities, not totaxpayers engaged in the trade or businessof producing bottled water. As a result,for purposes of § 199 the production ofbottled water will be treated as the produc-tion of tangible personal property under§ 199(c)(5)(A) and not the production ofpotable water under § 199(c)(4)(A)(i)(III).Accordingly, with respect to a taxpayerthat produces bottled water in the UnitedStates, the gross receipts from whichwould otherwise qualify as DPGR, DPGRalso includes the gross receipts attributableto the distribution of the bottled water and

no allocation between the production anddistribution of the bottled potable water isrequired.

(11) Definition of “construction per-formed in the United States.” (a) Construc-tion of real property. Section 4.04(11)(a)of this notice defines the term “construc-tion” under § 199(c)(4)(A)(ii) to mean theconstruction of real property (that is, resi-dential and commercial buildings (includ-ing items that are structural componentsof such buildings), inherently permanentstructures other than tangible property inthe nature of machinery, inherently perma-nent land improvements, and infrastruc-ture). Section 4.04(11)(a) makes clear thatlocal law is not controlling for purposesof determining whether or not property isreal property for purposes of “construc-tion” under § 199(c)(4)(A)(ii). See Con-ference Report at 271 (fn. 26). Tangiblepersonal property (as defined under sec-tion 4.04(8)(b)) (for example, appliances,furniture and fixtures) that is sold as partof a construction project is not consideredreal property for this purpose. Under sec-tion 4.04(11)(a), however, if more than 95percent of the total gross receipts derivedby a taxpayer from a construction projectare attributable to real property (as definedin § 1.263A–8(c)), the total gross receiptsderived by the taxpayer from the projectare DPGR from construction (assuming allother requirements of § 199 are met).

(b) Activities constituting construction.The Service and Treasury Departmentbelieve the term “construction” includesmost activities that are typically performedin connection with the erection or substan-tial renovation of real property, but doesnot include tangential services such ashauling trash and debris, and deliveringmaterials, even if the tangential servicesare essential for construction. However,if a taxpayer performing constructionalso, in connection with the constructionproject, provides tangential services suchas delivering materials to the construc-tion site and removing its constructiondebris, the gross receipts derived fromsuch tangential services are DPGR. Im-proving land (for example, grading andlandscaping) and painting are activitiesthat are considered “construction,” butonly if they are performed in connectionwith other activities (whether or not by thesame taxpayer) that constitute the erectionor substantial renovation of real property.

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The term “construction” does not includeany activity that is within the definition of“engineering and architectural services”(see section 4.04(11)(b) of this notice).

(c) Definition of “infrastructure.”The term “infrastructure,” for pur-poses of § 199, includes roads, powerlines, water systems, railroad spurs,and communications facilities. See§ 168(j)(4)(C)(ii). The term also includessewers, sidewalks, cable, and wiring. See§ 1.263A–12(e)(2)(iii). The term also in-cludes inherently permanent oil and gasplatforms.

(d) Definition of “substantial renova-tion.” The Service and Treasury Depart-ment believe that the standard to be appliedin determining whether there has been asubstantial renovation of real property isthe standard applied under § 263(a) to de-termine whether a taxpayer’s activities re-sult in permanent improvements or bet-terments of property, such that the costof the activities must be capitalized. Ac-cordingly, consistent with the rules under§ 263(a), section 4.04(11)(d) of this noticedefines the term “substantial renovation”to mean the renovation of a major com-ponent or substantial structural part of realproperty that materially increases the valueof the property, substantially prolongs theuseful life of the property, or adapts theproperty to a new or different use. See§ 263(a) and the regulations thereunder.

(e) “Derived from construction.” (i) Ingeneral. Section 199(c)(4)(A)(ii) does notprovide that DPGR “derived from con-struction” performed in the United Statesare gross receipts derived from “any lease,rental, license, sale, exchange, or otherdisposition of” property. The Service andTreasury Department believe that grossreceipts from the rental of real propertythat the taxpayer constructs are not de-rived from construction, but are insteadcompensation for the use or forbearanceof the property. Accordingly, in the caseof construction, DPGR does not includegross receipts from the lease or rentalof constructed real property. However,DPGR may include the proceeds of asale, exchange, or other disposition of realproperty constructed in the United States(whether or not the property is sold im-mediately after construction is completed)if all other requirements of § 199(c) aremet. DPGR also includes compensationreceived for construction services per-

formed in the United States (assuming allother requirements of § 199(c) are met).

(ii) Taxpayers deriving gross receiptsfrom construction. The Service and Trea-sury Department believe that it is appropri-ate, in certain situations, for more than onetaxpayer to be regarded as deriving grossreceipts from construction with respect tothe same activity and the same construc-tion project. For example, if X (who isnot in the trade or business of constructionand is the owner, under federal income taxprinciples, of a building within the UnitedStates) retains Y (a general contractor) tooversee a “substantial renovation” of thebuilding, and Y retains Z (a subcontrac-tor) to install a new electrical system in thebuilding as part of that substantial renova-tion, the amounts that Y receives from X,and amounts that Z receives from Y, qual-ify as DPGR. The proceeds that X receivesfrom the subsequent sale of the building donot qualify as DPGR because X did not en-gage in any activity constituting construc-tion.

(12) Definition of “engineering and ar-chitectural services.” (a) In general. Thedefinitions provided in section 4.04(12) ofthis notice of the terms “engineering ser-vices” and “architectural services” for pur-poses of § 199(c)(4)(A)(iii) are the sameas those provided in § 1.924(a)–1T(e)(5)and –1T(e)(6) without regard to the spe-cial rules of § 1.924(a)–1T(e)(2) and–1T(e)(3). Section 199(c)(4)(A)(iii) pro-vides that such services must be performedin the United States for a constructionproject in the United States. This noticerequires that: (1) the engineering or archi-tectural services relate to real property; (2)the services be performed in the UnitedStates; and (3) the taxpayer providingthese services be able to substantiate thatthe services relate to a construction projectwithin the United States.

(b) Performance of services in theUnited States. Section 4.04(12)(d) ofthis notice provides a safe harbor underwhich, if, in connection with a construc-tion project in the United States, the grossreceipts derived from engineering or ar-chitectural services (1) performed outsidethe United States or (2) related to prop-erty other than real property are less than5 percent of the total gross receipts de-rived from engineering or architecturalservices performed by the taxpayer withrespect to the same construction project,

the receipts will be treated as DPGR de-rived from engineering or architecturalservices performed in the United Statesfor a construction project in the UnitedStates (assuming all other requirements of§ 199(c) are met).

(c) Construction projects within theUnited States. Gross receipts from en-gineering or architectural services thatotherwise would qualify as DPGR willnot fail to qualify merely because the con-struction project planned for the UnitedStates ultimately is not undertaken or com-pleted.

(13) Exception for sales of certain foodand beverages. Under § 199(c)(4)(B),DPGR does not include gross receipts de-rived from the sale of food and beveragesprepared by the taxpayer at a retail estab-lishment. For purposes of this rule, section4.04(13) of this notice adopts a definitionof “retail establishment” that is similar tothe definition of “retail space” under § 110(regarding qualified lessee constructionallowances for short-term leases). Un-der this definition, a retail establishmentmeans real property leased, occupied, orotherwise used by the taxpayer in its tradeor business of selling food or beverages tothe public and at which the taxpayer makesretail sales. Thus, a taxpayer’s facility isnot a retail establishment if the taxpayeronly uses the facility to prepare food orbeverages for wholesale sale. However,under a safe harbor provided in section4.04(13), a facility at which food or bev-erages are prepared will not be treated as aretail establishment if less than 5 percentof the total gross receipts of the taxpayerfor the taxable year that are derived fromthe sale of food or beverages prepared atthe facility are attributable to retail salesat the facility. If a taxpayer’s facility isa retail establishment, then as a matterof administrative grace, the Service andTreasury Department will permit the tax-payer to allocate its gross receipts betweengross receipts derived from the retail saleof the food and beverages prepared andsold at the retail establishment (which arenon-DPGR) and gross receipts derivedfrom the wholesale sale of the food andbeverages prepared at the retail establish-ment (which are DPGR).

.05 Determining Costs. (1) In general.To determine its QPAI for the taxableyear, a taxpayer must reduce its DPGRby the amount of CGS directly allocable

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to DPGR, the amount of deductions, ex-penses, and losses (deductions) directlyallocable to DPGR and a ratable portionof other deductions not directly alloca-ble to DPGR, or another class of income.Section 199(c)(2) directs the Secretary toprescribe rules for the proper allocationof these items. The legislative history of§ 199 indicates that, when appropriate,these rules should be similar to, and con-sistent with, the relevant cost allocationrules provided by §§ 263A and 861. Ataxpayer’s costs must be determined us-ing the taxpayer’s accounting method forfederal income tax purposes. Section 4.05of this notice provides rules for determin-ing CGS directly allocable to DPGR andrules to determine deductions allocatedand apportioned to DPGR. Pursuant to theauthority granted by § 199(c)(2), the costdetermination rules provided in section4.05 do not differentiate between deduc-tions directly allocable to DPGR under§ 199(c)(1)(B)(ii) and other deductionsthat are not directly allocable to DPGRor another class of gross income under§ 199(c)(1)(B)(iii).

(2) Allocation of cost of goods sold.Section 4.05(2) of this notice providesrules for determining the CGS directlyallocable to DPGR. Generally, CGS mustbe specifically identified with, or directlytraced to, DPGR in accordance with thetaxpayer’s books and records. However,if the taxpayer’s books and records donot allow the taxpayer to identify theCGS directly allocable to DPGR, the tax-payer may use a reasonable method toallocate CGS between DPGR and othergross receipts. If a method is used to al-locate gross receipts between DPGR andnon-DPGR, the taxpayer may not use adifferent method for purposes of allocatingCGS. For purposes of § 199, CGS includesthe cost of inventoriable goods sold duringthe year as well as the adjusted basis ofnoninventory property sold or exchangedduring the year.

(3) Allocation and apportionment ofdeductions. (a) Three alternative meth-ods. Section 4.05 of this notice pro-vides three methods for allocating andapportioning deductions. Under the firstmethod (the § 861 method), which isavailable to all taxpayers, a taxpayer de-termines the deductions allocated andapportioned to DPGR by applying theallocation and apportionment rules pro-

vided by §§ 1.861–8 through 1.861–17and §§ 1.861–8T through 1.861–14T (the§ 861 regulations) subject to the provisionsof this notice. This notice provides specialrules for apportioning certain charitabledeductions and research and experimenta-tion deductions. The Service and TreasuryDepartment recognize that these allo-cation and apportionment rules may beburdensome to certain taxpayers that oth-erwise would not be required to use theserules, particularly for taxpayers that arenot currently using the section 861 costallocation regime. Accordingly, section4.05 provides two alternative apportion-ment methods for certain taxpayers, witha goal of minimizing the need for smallertaxpayers to devote additional resourcesto compliance. Any taxpayer with aver-age annual gross receipts of $25,000,000or less may use the simplified deductionmethod. Under the simplified deductionmethod, a taxpayer’s deductions gen-erally are ratably apportioned betweenDPGR and other receipts based on rel-ative gross receipts. The Service andTreasury Department invite comments onthe appropriateness of the gross receiptsthreshold for use of the simplified deduc-tion method. Alternatively, a qualifyingsmall taxpayer may use the small businesssimplified overall method to allocate CGSand deductions to DPGR. A qualifyingsmall taxpayer is a taxpayer that has av-erage annual gross receipts of $5,000,000or less or a taxpayer that is eligible to usethe cash method as provided in Rev. Proc.2002–28, 2002–1 C.B. 815. For purposesof the simplified deduction method and thesmall business simplified overall method,a taxpayer meets the applicable averageannual gross receipts test if the averageannual gross receipts of the taxpayer forthe 3 taxable years (or, if fewer, the taxableyears during which the taxpayer was in ex-istence) preceding the current taxable yeardo not exceed the applicable gross receiptsthreshold. Preceding taxable years are in-cluded even if one or more of such taxableyears began before the effective date of§ 199. In the case of any taxable year ofless than 12 months (a short taxable year),the gross receipts must be annualized by(a) multiplying the gross receipts for theshort period by 12 and (b) dividing the re-sult by the number of months in the shortperiod. Whether the members of an EAGmay use the simplified deduction method

or the small business simplified overallmethod is determined by reference to theaverage annual gross receipts of the EAG.To compute the average annual gross re-ceipts of an EAG, the gross receipts ofeach member of the EAG for its taxableyear that ends with or within the taxableyear of the member that is computing its§ 199 deduction are aggregated, regardlessof whether the computing member or thenon-computing member was a member ofthe EAG during its entire taxable year. Amember of an EAG that qualifies to usethe simplified deduction method or thesmall business simplified overall methodmay do so only if all members of the EAGagree to and use the same method.

(b) Treatment of certain deductions.Section 4.05(3)(b) of this notice clari-fies that certain deductions do not reduceDPGR or gross income attributable toDPGR under any of the three methods. Aloss generated by the sale of property re-duces DPGR or gross income attributableto DPGR only if the proceeds from the saleof the property are, or would have been,included in DPGR. A deduction allowedunder § 172 for a net operating loss isnot allocated or apportioned to DPGR orgross income attributable to DPGR. Under§ 199(d)(5), deductions not attributable tothe actual conduct of a trade or businessare not taken into account under § 199 and,therefore, are not allocated or apportionedto DPGR or gross income attributable toDPGR.

.06 Application of § 199 to Pass-thruEntities. (1) In general. In the case ofan S corporation, partnership, estate ortrust, or other pass-thru entity, § 199 is ap-plied at the partner, shareholder or simi-lar level. The Service and Treasury De-partment believe that Congress intended§ 199 to be applied in a manner consis-tent with the economic arrangement of theowners of a pass-thru entity. The Serviceand Treasury Department believe that thisobjective can be accomplished by allow-ing each owner to compute its § 199 de-duction by taking into account its distribu-tive or proportionate share of the items (in-cluding items of income, gain, loss, deduc-tion, cost of goods sold allocated to suchitems of income, and gross receipts thatare included in such items of income) al-located or attributable, in accordance withsection 4.06 of this notice, to the pass-thruentity’s activities described in § 199(c)(4)

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(qualified production activities), providedthe items are not otherwise disallowed bythe Code. For purposes of computing the§ 199(b) limitation, an owner’s share ofW–2 wages of a pass-thru entity is thelesser of the owner’s allocable share of thepass-thru entity’s W–2 wages or 2 timesthe applicable percentage of the owner’sQPAI computed taking into account onlythe items of the pass-thru entity allocatedto the owner for the taxable year. Theowner of the pass-thru entity will aggre-gate its items of income or expense (in-cluding W–2 wages) allocated or attrib-utable to the pass-thru entity’s qualifiedproduction activities, including those ex-penses incurred by the owner of the pass-thru entity directly that are allocated to thepass-thru entity’s qualified production ac-tivities, and the owner’s items of income orexpense (including W–2 wages) allocatedor attributable to its other qualified produc-tion activities.

(2) Gain or loss from the disposition ofan interest in a pass-thru entity. Becausethe sale of an interest in a pass-thru en-tity does not reflect the realization of QPAIby that entity, QPAI generally does not in-clude gain or loss recognized on the sale,exchange or other disposition of an interestin the entity. However, if § 751(a) or (b)applies, gain or loss allocated to assets ofthe partnership the sale, exchange, or otherdisposition of which would give rise to anitem of QPAI is taken into account in com-puting the partner’s § 199 deduction.

(3) Effective date of § 199 for pass-thruentities. Section 199(e) provides that § 199applies for taxable years beginning afterDecember 31, 2004. Accordingly, section4.06(3) of this notice provides that § 199only applies to taxable years of pass-thruentities that begin on or after January 1,2005. The Service and Treasury Depart-ment recognize that a pass-thru entity willneed to provide certain information to itsowners to allow those persons to com-pute the § 199 deduction. The Serviceand Treasury Department intend to providerules relating to information reporting bypass-thru entities in future guidance.

.07 Patrons of Agricultural and Horti-cultural Cooperatives. Section 4.07 of thisnotice provides rules for the application of§ 199 to agricultural and horticultural co-operatives and their patrons. The Serviceand Treasury Department recognize that acooperative will need to provide certain in-

formation to its patrons to allow the pa-trons to compute the § 199 deduction. TheService and Treasury Department intend toprovide rules relating to such informationreporting by cooperatives in future guid-ance.

.08 Expanded Affiliated Groups. (1)In general. All members of an EAG aretreated as a single corporation for purposesof § 199. An EAG is an affiliated groupas defined in § 1504(a), determined bysubstituting “50 percent” for “80 percent”each place it appears, and without regard to§ 1504(b)(2) and (4). Therefore, a single§ 199 deduction is computed for the EAGand then that deduction is allocated amongmembers of the EAG.

(2) Computation of expanded affiliatedgroup’s § 199 deduction. (a) In general.The Service and Treasury Departmentbelieve that the § 199 deduction of theEAG must be computed by aggregatingeach member’s taxable income or loss,QPAI, and W–2 wages. For this purpose,a member’s QPAI is the member’s DPGRless the sum of the CGS allocable to thereceipts and other costs required to beallocated under section 4.05 of this no-tice. For purposes of this determination, amember’s QPAI may be positive or nega-tive. A member’s taxable income or lossand QPAI shall be determined by referenceto the member’s methods of accounting.However, pursuant to § 199(c)(7)(A), amember’s DPGR shall not include anygross receipts of the member derived fromproperty leased, licensed, or rented by itfor use by any related person as defined in§ 199(c)(7)(B).

(b) Attribution of activities. For pur-poses of determining whether gross re-ceipts are DPGR, the Service and Trea-sury Department believe that each mem-ber of an EAG should be treated as con-ducting the activities conducted by eachother member of the EAG. Thus, if Corpo-ration X and Corporation Y are membersof the same EAG and X manufactures QPPin the United States and sells the QPP to Yand Y then sells the same item to an un-related party, X’s production activities areattributed to Y. Accordingly, the proceedsof X’s sale to Y and Y’s sale to the unre-lated party are DPGR for X and Y, respec-tively (assuming all other requirements of§ 199 are met).

(c) Anti-avoidance rule. Althoughtransactions between members of an EAG

are disregarded in computing the EAG’s§ 199 deduction only to the extent pro-vided in § 199(c)(7), if a transactionbetween members of an EAG is engagedin or structured with a principal purposeof qualifying for, or modifying the amountof, the § 199 deduction for one or moremembers of the EAG, adjustments must bemade to eliminate the effect of the trans-action on the computation of the § 199deduction.

(3) Allocation of expanded affiliatedgroup’s § 199 deduction. The EAG’s§ 199 deduction is allocated among mem-bers of the EAG in proportion to eachmember’s QPAI, if any, regardless ofwhether the EAG member has taxableincome or loss for the taxable year andregardless of whether the EAG memberhas W–2 wages for the taxable year. Forthis purpose, if a member has negativeQPAI, the QPAI of the member shall betreated as zero.

(4) Special rules for consolidatedgroups. The Service and Treasury Depart-ment believe that, for purposes of § 199,if an EAG includes members of a consoli-dated group (as defined in § 1.1502–1(h)),the members of the consolidated groupshould be treated as a single member ofthe EAG. Therefore, if an EAG includescorporations that are members of a con-solidated group and corporations that arenot members of a consolidated group, incomputing the taxable income limitationof the EAG, the consolidated taxable in-come of the consolidated group, not theseparate taxable income of the membersof the consolidated group, is taken intoaccount. If all of the members of an EAGare members of the same consolidatedgroup, the consolidated group’s § 199 de-duction is determined based on the group’sconsolidated taxable income or loss, notthe separate taxable income or loss of itsmembers. The § 199 deduction of a con-solidated group (or the § 199 deductionallocated to a consolidated group that isa member of an EAG) must be allocatedto the members of the consolidated groupin proportion to each consolidated groupmember’s QPAI, if any, regardless ofwhether the consolidated group memberhas separate taxable income or loss for thetaxable year and regardless of whether themember has W–2 wages for the taxableyear. For purposes of allocating the § 199deduction of a consolidated group among

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its members, if a consolidated group mem-ber has negative QPAI, the QPAI of themember shall be treated as zero.

(5) Identification of members of the ex-panded affiliated group. The Service andTreasury Department believe that whethera corporation is a member of an EAG mustbe determined on a daily basis. Therefore,a corporation may be a member of an EAGon January 1 but not a member of the EAGon January 2. If a corporation becomes orceases to be a member of an EAG, the cor-poration is treated as becoming or ceasingto be a member of the EAG at the end ofthe day on which its status as a memberchanges.

(6) Allocation of income and loss. Acorporation that is a member of an EAGfor only a portion of its taxable year mustallocate its taxable income or loss, QPAI,and W–2 wages between the portion of thetaxable year during which it is a memberof the EAG and the portion of the tax-able year during which it is not a mem-ber of the EAG. In general, this allocationof items must be made by using the prorata allocation method described in sec-tion 4.09(6)(a)(i) of this notice. However,the corporation may elect to use the clos-ing of the books method described in sec-tion 4.09(6)(a)(ii). Section 4.09(6)(a)(iii)prescribes rules for the time and mannerof making the election to use the closingof the books method.

(a) Pro rata allocation method. Underthe pro rata allocation method, an equalportion of each of the taxable income orloss, QPAI, and W–2 wages for the taxableyear is assigned to each day of the corpora-tion’s taxable year. Then, those items as-signed to those days during which the cor-poration was a member of the EAG are ag-gregated.

(b) Closing of the books method. Underthe closing of the books method, taxableincome or loss, QPAI, and W–2 wages forthe period during which the corporationwas a member of the EAG are computedby treating the corporation’s taxable yearas two separate taxable years, the first ofwhich ends at the close of the day on whichthe corporation’s status as a member ofthe EAG changes and the second of whichbegins at the beginning of the day afterthe corporation’s status as a member of theEAG changes.

(7) Total § 199 deduction for a corpo-ration that is a member of an expanded af-

filiated group for some or all of its taxableyear. If a corporation is a member of anEAG for its entire taxable year, the cor-poration’s § 199 deduction for the taxableyear is the amount of the § 199 deductionof the EAG allocated to the corporation bythe EAG. If a corporation is a member ofan EAG for a portion of its taxable year,and is either not a member of any EAG, oris a member of another EAG, or both, foranother portion of the taxable year, the cor-poration’s § 199 deduction for the taxableyear is the sum of its § 199 deductions foreach portion of the taxable year.

(8) Computation of § 199 deduction formembers of Expanded Affiliated Groupwith different taxable years. If membersof an EAG have different taxable years,in computing the § 199 deduction of amember (the “computing member”), withrespect to each member of the EAG, thecomputing member is required to takeinto account the taxable income or loss,QPAI, and W–2 wages that are both (1)attributable to the period during which themember of the EAG and the computingmember are both members of the EAG,and (2) taken into account in a taxable yearthat begins after the effective date of § 199and ends with or within the taxable yearof the computing member with respect towhich the § 199 deduction is computed.

SECTION 4. INTERIM GUIDANCE

.01 In General. Under § 199(a)(1), ataxpayer may deduct an amount equal to9 percent (3 percent in the case of tax-able years beginning in 2005 and 2006,and 6 percent in the case of taxable yearsbeginning in 2007, 2008, or 2009) of thelesser of the taxpayer’s QPAI (as definedin section 4.03 of this notice) for the tax-able year, or the taxpayer’s taxable income(determined without regard to § 199) forthe taxable year. For purposes of the pre-ceding sentence, the definition of taxableincome under § 63 shall apply.

.02 Wage Limitation. (1) Rules of ap-plication. (a) In general. Pursuant to§ 199(b)(1), the amount of the deductionallowable to the taxpayer under § 199(a)for any taxable year shall not exceed 50percent of the W–2 wages of the taxpayer.For this purpose, except as provided in sec-tion 4.02(1)(c) of this notice, the FormsW–2 used in determining the amount ofW–2 wages are those issued for the cal-

endar year ending during the taxpayer’staxable year for wages paid to employ-ees (or former employees) of the taxpayerfor employment by the taxpayer. For thispurpose and for purposes of section 4.02,employees of the taxpayer are limited toemployees of the taxpayer as defined in§ 3121(d)(1) and (d)(2) (that is, officersof a corporate taxpayer and employees ofthe taxpayer under the common law rules).For purposes of § 199(b)(2), the term “tax-payer” means “employer.” In determiningW–2 wages a taxpayer may take into ac-count any wages paid by another entity andreported by the other entity on Forms W–2with the other entity as the employer listedin Box c of the Forms W–2, provided thatthe wages were paid to employees of thetaxpayer for employment by the taxpayer.If the taxpayer is treated as an employerdescribed in § 3401(d)(1) because of con-trol of the payment of wages (that is, thetaxpayer is not the common law employerof the payee of the wages), the payment ofwages may not be included in determiningW–2 wages of the taxpayer. If the taxpayeris paying wages as an agent of another en-tity to individuals who are not employeesof the taxpayer, the wages may not be in-cluded in determining the W–2 wages ofthe taxpayer.

(b) No application in determiningwhether amounts are wages for employ-ment tax purposes. The discussion of“wages” in this notice is for purposes of§ 199 only and has no application in deter-mining whether amounts are wages under§ 3121(a) for purposes of the FICA, under§ 3306(b) for purposes of the FUTA, under§ 3401(a) for purposes of the Collectionof Income Tax at Source on Wages (fed-eral income tax withholding), or any otherwage related determination.

(c) Application in case of taxpayer withshort taxable year. In the case of a tax-payer with a short taxable year, subject tothe rules of section 4.02(1)(a) of this no-tice, the W–2 wages of the taxpayer forthe short taxable year shall include thosewages paid during the short taxable year toemployees of the taxpayer as determinedunder the tracking wages method. Underthe tracking wages method described insection 4.02(2)(b)(iii), the taxpayer mustcalculate W–2 wages by tracking wagesactually paid during the short taxable yearto employees, subject to the modificationsthat in step (B) only the supplemental un-

2005–7 I.R.B. 514 February 14, 2005

employment compensation benefits paidduring the short taxable year are requiredto be deducted and that in step (C) of suchmethod only the portions of the amountsreported in Box 12, Codes D, E, F, G, andS actually deferred or contributed duringthe short taxable year may be included inthe W–2 wages.

(d) Acquisition or disposition of a tradeor business (or major portion). If a tax-payer (a successor) acquires the major por-tion of a trade or business or the major por-tion of a separate unit of a trade or businessfrom another taxpayer (a predecessor), theW–2 wages of each of the successor andpredecessor for purposes of computing the§ 199 deduction shall be computed pur-suant to the rules of this notice, includingsections 4.02(1) and 4.02(2) of this notice,regardless of whether the W–2 wages arereported on Forms W–2 furnished by thesuccessor or Forms W–2 furnished by thepredecessor.

(e) Non-duplication rule. Amounts thatare treated as W–2 wages for a taxable yearunder any method may not be treated asW–2 wages of any other taxable year.

(2) Definition of “W–2 wages.” (a) Ingeneral. Section 199(b)(2) defines W–2wages for purposes of § 199(b)(1) as thesum of the amounts required to be includedon statements under § 6051(a)(3) and (8)with respect to employment of employeesof the taxpayer for the calendar year. Thus,the term W–2 wages includes: (i) the totalamount of wages as defined in § 3401(a);(ii) the total amount of elective deferrals(within the meaning of § 402(g)(3)); (iii)the compensation deferred under § 457;and (iv) for tax years beginning after De-cember 31, 2005, the amount of designatedRoth contributions (as defined in § 402A).Under the 2004 and 2005 Form W–2, theelective deferrals under § 402(g)(3) andthe amounts deferred under § 457 directlycorrelate to coded items reported in Box12 on Form W–2. Box 12, Code D is forelective deferrals to a § 401(k) cash or de-ferred arrangement; Box 12, Code E is forelective deferrals under a § 403(b) salaryreduction agreement; Box 12, Code F isfor elective deferrals under a § 408(k)(6)salary reduction Simplified EmployeePension (SEP); Box 12, Code G is forelective deferrals under a § 457(b) plan;and Box 12, Code S is for employee salaryreduction contributions under a § 408(p)SIMPLE (simple retirement account).

(b) Methods for calculating W–2 wages.Taxpayers may use one of three methodsin calculating W–2 wages. These threemethods are subject to the non-duplica-tion rule provided in section 4.02(1)(e) ofthis notice, and the tracking wages methodis subject to the rule provided in section4.02(1)(c), if applicable.

(i) Unmodified box method. Under thismethod, W–2 wages are calculated by tak-ing, without modification, the lesser of:

(A) The total entries in Box 1 of allForms W–2 filed with the SSA by the tax-payer with respect to employees of the tax-payer for employment by the taxpayer; or

(B) The total entries in Box 5 of allForms W–2 filed with the SSA by the tax-payer with respect to employees of the tax-payer for employment by the taxpayer.

(ii) Modified Box 1 method. Under thismethod, the taxpayer makes modificationsto the total entries in Box 1 of Forms W–2filed with respect to employees of the tax-payer. W–2 wages under this method arecalculated as follows:

(A) Total the amounts in Box 1 ofForms W–2 with respect to employeesof the taxpayer for employment by thetaxpayer;

(B) Subtract from the total in Step (A)amounts included in Box 1 of Forms W–2that are not wages for federal income taxwithholding purposes and amounts in-cluded in Box 1 of Forms W–2 that aretreated as wages under § 3402(o) (forexample, supplemental unemploymentcompensation benefits); and

(C) Add to the amount obtained afterStep (B) amounts that are reported in Box12 of Forms W–2 with respect to employ-ees of the taxpayer for employment by thetaxpayer and that are properly coded D, E,F, G, or S.

(iii) Tracking wages method. Under thismethod, the taxpayer actually tracks totalwages subject to federal income tax with-holding and makes appropriate modifica-tions. W–2 wages under this method arecalculated as follows:

(A) Total the amounts of wages sub-ject to federal income tax withholding thatare paid to employees of the taxpayer foremployment by the taxpayer and that arereported on Forms W–2 for the calendaryear;

(B) Subtract from the total in Step(A) the supplemental unemploymentcompensation benefits (as defined in

§ 3402(o)(2)(A)) that were included inthe total in Step A; and

(C) Add to the amount obtained afterStep (B) amounts that are reported in Box12 of Forms W–2 with respect to employ-ees of the taxpayer for employment by thetaxpayer and that are properly coded D, E,F, G or S.

.03 Determining Qualified Produc-tion Activities Income. (1) In general.Section 199(c)(1) defines QPAI for anytaxable year as an amount equal to the ex-cess (if any) of (A) the taxpayer’s DPGR(as defined in section 4.04 of this notice),over (B) the sum of (i) the CGS that areallocable to such receipts (see section4.05), (ii) other deductions, expenses, orlosses directly allocable to such receipts(see section 4.05), and (iii) a ratable por-tion of other deductions, expenses, andlosses that are not directly allocable tosuch receipts or another class of income(see section 4.05). For purposes of § 199,QPAI is determined on an item-by-itembasis (and not, for example, on a divi-sion-by-division, product line-by-productline, or transaction-by-transaction basis)and is the sum of QPAI derived by thetaxpayer from each item. For purposes ofthis determination, QPAI from each itemmay be positive or negative. For example,if a taxpayer manufactures a shirt and a hatin the United States, and the QPAI derivedfrom the manufacture of the shirt is $3 andthe QPAI derived from the manufacture ofthe hat is ($1), the taxpayer’s QPAI is $2.

(2) Allocation of gross receipts. A tax-payer must determine the portion of itsgross receipts that are DPGR and the por-tion of its gross receipts that are not DPGR.For example, if a taxpayer leases, rents, li-censes, sells, exchanges, or otherwise dis-poses of QPP, the gross receipts of whichconstitute DPGR, and engages in trans-actions with respect to similar property,the gross receipts of which do not con-stitute DPGR, the taxpayer must allocateits gross receipts from all the transactionsbased on a reasonable method that is sat-isfactory to the Secretary and that accu-rately identifies the gross receipts that con-stitute DPGR. Factors taken into consider-ation in determining whether the methodis reasonable include whether the taxpayeruses the most accurate information avail-able; the relationship between the grossreceipts and the apportionment base cho-sen; the accuracy of the method chosen

February 14, 2005 515 2005–7 I.R.B.

as compared with other possible methods;whether the method is used by the taxpayerfor internal management or other businesspurposes; whether the method is used forother federal, state, or foreign income taxpurposes; the time, burden, and cost ofusing various methods; and whether thetaxpayer applies the method consistentlyfrom year to year. All of a taxpayer’sgross receipts are treated as DPGR if lessthan 5 percent of the taxpayer’s total grossreceipts are non-DPGR (after applicationof other de minimis safe harbors providedin section 4 of this notice that result ingross receipts being treated as DPGR). Ifthe amount of the taxpayer’s gross receiptsthat do not qualify as DPGR equals or ex-ceeds 5 percent of the total gross receipts,the taxpayer is required to allocate all grossreceipts between DPGR and non-DPGR.For example, if a taxpayer only derivesgross receipts from the sale of gasoline re-fined by the taxpayer in the United Statesand the sale of gasoline the taxpayer ac-quired (either by purchase or in exchangefor gasoline refined by the taxpayer in theUnited States) from an unrelated party, thetaxpayer must allocate its gross receiptsbetween the gross receipts attributable tothe gasoline refined by the taxpayer in theUnited States (that qualify as DPGR as-suming all other requirements of § 199are met) and the taxpayer’s gross receiptsderived from the resale of the acquiredgasoline (that do not qualify as DPGR) if5 percent or more of the taxpayer’s totalgross receipts are not from the sale of gaso-line refined by the taxpayer in the UnitedStates. Similarly, a taxpayer that manu-factures the same type of QPP at facili-ties within the United States and outsidethe United States must allocate its gross re-ceipts between the receipts from the QPPmanufactured in the United States and re-ceipts from the QPP not manufactured inthe United States if 5 percent or more ofits total gross receipts are non-DPGR.

(3) Treatment of advance payments. Ifa taxpayer recognizes an advance paymentfor goods, services, use of property, etc.,in gross receipts in a taxable year ear-lier than the taxable year the goods, ser-vices, use of property, etc., to which the ad-vance payment relates are delivered, per-formed, provided, etc., the taxpayer mustaccurately identify based on a reasonablemethod that is satisfactory to the Secre-tary whether the receipts (and correspond-

ing CGS and expenses) qualify as DPGR.See section 4.03(2) of this notice for thefactors taken into consideration in deter-mining whether the taxpayer’s method isreasonable.

.04 Determining Domestic Produc-tion Gross Receipts. (1) In general.Section 199(c)(4)(A) defines DPGR asthe gross receipts (as defined in section4.04(2) of this notice) of the taxpayer thatare derived from (as defined in section4.04(7)):

(a) Any lease, rental, license, sale, ex-change, or other disposition of:

(i) QPP (as defined in section 4.04(8))that is MPGE (as defined in section4.04(3)) by the taxpayer (as defined insection 4.04(4)) in whole or in significantpart (as defined in section 4.04(5)) withinthe United States (as defined in section of4.04(6)),

(ii) Any qualified film (as defined insection 4.04(9)) produced by the taxpayer(in accordance with section 4.04(9)), or

(iii) Electricity, natural gas, or potablewater (as defined in section 4.04(10)) pro-duced by the taxpayer in the United States(in accordance with section 4.04(10)),

(b) Construction (as defined in section4.04(11)) performed in the United States(in accordance with section 4.04(11)), or

(c) Engineering or architectural ser-vices (as defined in section 4.04(12))performed in the United States for con-struction projects in the United States (inaccordance with 4.04(12)).

(2) Definition of “gross receipts.” Theterm “gross receipts” means the taxpayer’sreceipts for the taxable year that are rec-ognized under the taxpayer’s method ofaccounting used in that taxable year forfederal income tax purposes. For thispurpose, gross receipts include total sales(net of returns and allowances) and allamounts received for services. In addi-tion, gross receipts include any incomefrom investments, and from incidental oroutside sources. For example, gross re-ceipts include interest (including originalissue discount and tax-exempt interestwithin the meaning of § 103), dividends,rents, royalties, and annuities, regard-less of whether the amounts are derivedin the ordinary course of the taxpayer’strade of business. Gross receipts are notreduced by CGS or by the cost of prop-erty sold if such property is described in§ 1221(a)(1), (2), (3), (4) or (5). Gross

receipts do not include the repayment ofa loan or similar instrument (for example,a repayment of the principal amount of aloan held by a commercial lender) and,except to the extent of gain recognized,do not include gross receipts derived froma non-recognition transaction such as a§ 1031 exchange. Finally, gross receiptsdo not include amounts received by thetaxpayer with respect to sales tax or othersimilar state and local taxes if, under theapplicable state or local law, the tax islegally imposed on the purchaser of thegood or service, and the taxpayer merelycollects and remits the tax to the taxing au-thority. If, in contrast, the tax is imposedon the taxpayer under the applicable law,then gross receipts include the amountsreceived that are allocable to the paymentof such tax.

(3) Definition of “manufactured, pro-duced, grown, or extracted.” (a) In gen-eral. The terms MPGE in § 199(c)(4)(A)(i)(I) include activities relatingto manufacturing, producing, growing,extracting, installing, developing, improv-ing, and creating QPP; making QPP out ofscrap, salvage, or junk material as well asfrom new or raw material by processing,manipulating, refining, or changing theform of an article, or by combining or as-sembling two or more articles; cultivatingsoil, raising livestock, fishing, and miningminerals. The terms also include storage,handling or other processing activities(other than transportation activities) withinthe United States related to the sale, ex-change or other disposition of agriculturalproducts, provided the products are con-sumed in connection with, or incorporatedinto, the MPGE of QPP whether or not bythe taxpayer. For example, assume A, B,and C are unrelated taxpayers. A ownsgrain storage bins in the United States inwhich it stores for a fee B’s corn that wasgrown in the United States. B sells its cornto C. C processes B’s corn into corn syrupin the United States. The gross receiptsfrom A’s, B’s, and C’s activities are DPGRfrom the MPGE of QPP.

(b) Consistency with § 263A. A tax-payer that has MPGE QPP for the taxableyear should treat itself as a producer un-der § 263A with respect to the QPP forthe taxable year unless the taxpayer is notsubject to § 263A under the Code, regu-lations, or other published guidance. Ataxpayer that currently is not properly ac-

2005–7 I.R.B. 516 February 14, 2005

counting for its production activities under§ 263A, and wishes to change its methodof accounting to comply with the producerrequirements of § 263A, must follow theprocedures of Rev. Proc. 97–27 or Rev.Proc. 2002–9, whichever applies.

(4) Definition of “by the taxpayer.”With the exception of the rules provided insection 4.09(2)(b) of this notice applicableto an EAG, if one taxpayer performs aqualifying activity under § 199(c)(4)(A)(i)pursuant to a contract with another party,then only the taxpayer that has the benefitsand burdens of ownership of the propertyunder federal income tax principles duringthe period the qualifying activity occursis treated as engaging in the qualifyingactivity.

(5) Definition of “in whole or in signif-icant part.” (a) In general. QPP describedin § 199(c)(4)(A)(i)(I) must be MPGE inwhole or in significant part by the tax-payer within the United States. Except inthe case of a related person transaction un-der § 199(c)(7), DPGR includes all of thetaxpayer’s gross receipts derived from thelease, rental, license, sale, exchange, orother disposition of QPP for which the tax-payer MPGE the QPP in whole or in sig-nificant part in the United States. For ex-ample, if a taxpayer imports QPP that ispartially manufactured, the taxpayer com-pletes the manufacture of the QPP in theUnited States, and the taxpayer’s comple-tion of the manufacturing of the QPP inthe United States satisfies the “in signifi-cant part” requirement, then the taxpayer’sgross receipts from the sale of the QPPqualify as DPGR (assuming all other re-quirements of § 199(c) are met). In ad-dition, if a taxpayer manufactures QPP insignificant part in the United States and ex-ports the QPP for further manufacture out-side the United States, the taxpayer’s grossreceipts derived from the lease, rental, li-cense, sale, exchange, or other dispositionof that QPP will be considered DPGR, re-gardless of whether the QPP is importedback into the United States prior to thelease, rental, license, sale, exchange, orother disposition of the QPP (assuming allother requirements of § 199(c) are met). Ifa taxpayer enters into a contract with an-other party and the taxpayer has the bene-fits and burdens of ownership of the QPPunder federal income tax principles duringthe period the MPGE activity occurs andthe taxpayer is considered to MPGE the

QPP under § 199, then the taxpayer mustdetermine whether the MPGE performedby the other party on behalf of the taxpayeris performed in whole or in significant partwithin the United States.

(b) Substantial in nature. QPP willbe treated as MPGE in significant part bythe taxpayer within the United States ifthe MPGE of the QPP performed by thetaxpayer within the United States is sub-stantial in nature taking into account allthe facts and circumstances, including therelative value added by, and relative costof, the taxpayer’s MPGE activity in theUnited States, the nature of the property,and the nature of the MPGE activity thatthe taxpayer performs in the United States.For example, if property is MPGE by thetaxpayer outside the United States or byan unrelated party within the United Statesand the property is used as a componentpart of the QPP produced by the taxpayerwithin the United States, the QPP (includ-ing the component part) will be treatedas MPGE in significant part by the tax-payer within the United States if the pro-duction of the QPP performed by the tax-payer within the United States is substan-tial in nature. In addition, if a taxpayerpurchases unrefined oil extracted outsidethe United States by an unrelated party andthe taxpayer refines the oil in the UnitedStates, the refining of the oil by the tax-payer in the United States will be treated asMPGE that is substantial in nature withinthe United States. However, packaging,repackaging, labeling, and minor assemblyoperations do not qualify as substantial innature. In addition, development activitiesand the creation or licensing of intangiblesdo not qualify as substantial in nature forany QPP other than computer software andsound recordings.

(c) Safe harbor. A taxpayer will betreated as having MPGE property in wholeor in significant part within the UnitedStates if, in connection with the property,conversion costs (direct labor and relatedfactory burden) to MPGE the property areincurred by the taxpayer within the UnitedStates and the costs account for 20 percentor more of the total CGS of the property.For purposes of this safe harbor, devel-opment costs and the cost of any intangi-bles do not qualify as conversion costs forany QPP other than computer software andsound recordings. In addition, the costs ofpackaging, repackaging, labeling, and mi-

nor assembly operations do not qualify asconversion costs.

(6) Definition of “United States.” Forpurposes of § 199, the term “United States”includes the 50 states, the District of Co-lumbia, the territorial waters of the UnitedStates, and the seabed and subsoil of thosesubmarine areas that are adjacent to theterritorial waters of the United States andover which the United States has exclu-sive rights, in accordance with interna-tional law, with respect to the explorationand exploitation of natural resources. Theterm “United States” does not include pos-sessions and territories of the United Statesor the airspace over the United States andthese areas.

(7) Definition of “derived from thelease, rental, license, sale, exchange, orother disposition of qualifying productionproperty.” (a) In general. The term “de-rived from the lease, rental, license, sale,exchange, or other disposition of qualify-ing production property” is defined as, andlimited to, the gross receipts directly fromthe lease, rental, license, sale, exchange,or other disposition of QPP. For example,“derived from the sale of QPP” includesgross receipts from the sale of QPP manu-factured in whole or in significant part inthe United States by a taxpayer for sale,as well as gross receipts from the saleof self-constructed QPP manufactured inwhole or in significant part in the UnitedStates by a taxpayer and used in the tax-payer’s trade or business before beingsold. In addition, the proceeds from busi-ness interruption insurance and paymentsnot to produce are treated as gross receipts“derived from the lease, rental, license,sale, exchange, or other disposition ofQPP” to the extent that they are substitutesfor gross receipts that would qualify asDPGR. The value of property receivedin an exchange of QPP that was MPGEby the taxpayer for QPP that was MPGEby an unrelated taxpayer is DPGR for thetaxpayer. The value of property acquiredby a taxpayer in exchange for QPP is grossreceipts derived from an exchange of theQPP, and is DPGR if the QPP was MPGEby the taxpayer in whole or in significantpart within the United States. However,any gross receipts from the subsequentsale by the taxpayer of the property thatthe taxpayer acquired in the exchange arenot DPGR, because the taxpayer did notMPGE the property acquired in the ex-

February 14, 2005 517 2005–7 I.R.B.

change, even if that property is QPP thathad been MPGE within the United Statesby the other party to the exchange.

(b) Allocation of gross receipts — em-bedded services. Except with respect toconstruction or engineering or architec-tural services described in § 199(c)(4)(ii)and (iii), gross receipts “derived from” theperformance of services do not qualify asDPGR. In the case of an embedded service,that is, a service the price of which is in-cluded in the amount charged for the lease,rental, license, sale, exchange, or other dis-position of property, DPGR includes onlythe receipts from the lease, rental, license,sale, exchange, or other disposition of theproperty and not any receipts attributableto the embedded service (assuming allother requirements of § 199(c) are met).There are two exceptions to this generalrule regarding embedded services. First, ataxpayer may include in DPGR (assumingall other requirements of § 199(c) are met)gross receipts from a qualified warranty(that is, a warranty that is provided in con-nection with the sale of QPP if (1) in thenormal course of its business, the chargefor the warranty is included in the pricecharged for the lease, rental, license, sale,exchange, or other disposition of the QPPand (2) the warranty is neither separatelyoffered by the taxpayer nor separately bar-gained for with the customer (that is, thecustomer cannot purchase the QPP with-out the warranty)). Second, a de minimisamount of gross receipts from embeddedservices for each item of property mayqualify as DPGR. A de minimis amountof gross receipts from embedded servicesis less than 5 percent of the gross receiptsderived from the lease, rental, license,sale, exchange, or other disposition of theproperty. For purposes of applying this deminimis test, gross receipts from qualifiedwarranties are not treated as gross receiptsfor services.

(c) Advertising income. Gross receiptsthat are “derived from” the sale or otherdisposition of newspapers and magazinesinclude advertising income. For example,a newspaper manufacturer’s gross receiptsfrom an advertiser to publish display ad-vertising or classified advertisements in itsnewspaper are treated as gross receipts de-rived from the sale of the newspapers (as-suming all other requirements of § 199 aremet).

(d) Computer software. Gross receiptsderived from computer software (as de-fined in section 4.04(8)(c)) do not includegross receipts derived from Internet ac-cess services, online services, customersupport, telephone services, games playedthrough a website, provider-controlledsoftware online access services, and otherservices that do not constitute the lease,rental, license, sale, exchange, or otherdisposition of computer software that wasdeveloped by the taxpayer.

(e) Exception for certain oil and gaspartnerships. If a partnership is engagedsolely in the extraction, refining, process-ing, etc., of oil or gas and distributes theoil or gas or products derived from the oilor gas (products) to its partners who thensell the oil or gas or products, then, for pur-poses of § 199, the gross receipts derivedby the partners from the sale of the oil orgas or products are treated as gross receiptsderived by the partnership from the MPGEof QPP. The partnership must follow therules provided in section 4.06 of this no-tice regarding the application of § 199 topass-thru entities to ensure that the costsattributable to oil or gas or products areproperly taken into account.

(8) Definition of “qualifying produc-tion property.” (a) In general. Qualifyingproduction property includes: (1) tan-gible personal property, as defined insection 4.04(8)(b); (2) computer software,as defined in section 4.04(8)(c); and (3)sound recordings, as defined in section4.04(8)(d).

(b) Tangible personal property. Theterm “tangible personal property” isany tangible property other than land,buildings, (including items that arestructural components of such build-ings) and any property described un-der § 199(c)(4)(A)(i)(II) and (III), or§ 199(c)(5)(B) and (C). Thus, qualifiedfilms, computer software, and soundrecordings are not tangible personal prop-erty regardless of whether they are fixedon a tangible medium. However, the tangi-ble medium on which the property is fixed(for example, a videocassette, a computerdiskette, or other similar tangible item) istangible personal property. In determin-ing whether property is “tangible personalproperty,” the fact that property is personalproperty or tangible property under locallaw is not controlling. Conversely, prop-erty may be tangible personal property for

purposes of § 199(c)(5)(A) even thoughunder local law the property is considereda fixture and therefore real property. Thus,property such as production machinery,printing presses, transportation and officeequipment, refrigerators, grocery coun-ters, testing equipment, display racks andshelves, and neon and other signs that iscontained in or attached to a building con-stitutes tangible personal property for pur-poses of § 199(c)(5)(A). Further, propertythat is in the nature of machinery (otherthan structural components of a building)is tangible personal property even thoughlocated outside a building. Thus, for ex-ample, a gasoline pump, hydraulic car lift,or automatic vending machine, althoughannexed to the ground, is considered tan-gible personal property. A structure thatis property in the nature of machineryor is essentially an item of machinery orequipment is not an inherently permanentstructure and is tangible personal property.In the case, however, of a building or in-herently permanent structure that includesproperty in the nature of machinery as astructural component, the property in thenature of machinery is real property. Theterm “tangible personal property” doesnot include the creation of copyrightedmaterial such as a manuscript in a formother than in a tangible medium.

(c) Computer software. The term “com-puter software” means any program or rou-tine or any sequence of machine-readablecode that is designed to cause a computerto perform a desired function or set offunctions, and the documentation requiredto describe and maintain that program orroutine. Computer software also includesthe machine-readable coding for videogames and similar programs, regardlessof whether the program is designed tooperate on a “computer” (as defined in§ 168(i)(2)(B)). If the medium in whichthe software is contained, whether writ-ten, magnetic, or otherwise, is tangible,then such medium is considered tangiblepersonal property for purposes of § 199.Therefore, if a taxpayer develops a soft-ware program that it reproduces and sellson diskettes, the program fixed on thediskette is treated as computer software,and the diskette is treated as tangible per-sonal property. Computer programs of allclasses, for example, operating systems,executive systems, monitors, compilersand translators, assembly routines, and

2005–7 I.R.B. 518 February 14, 2005

utility programs as well as applicationprograms, are included. Computer soft-ware also includes any incidental andancillary rights that are necessary to effectthe acquisition of the title to, the owner-ship of, or the right to use the computersoftware, and that are used only in connec-tion with that specific computer software.Such incidental and ancillary rights arenot included in the definition of trademarkor trade name under § 1.197–2(b)(10)(i).For example, a trademark or trade namethat is ancillary to the ownership or useof a specific computer software programin the taxpayer’s trade or business and isnot acquired for the purpose of marketingthe computer software is included in thedefinition of computer software and is notincluded in the definition of trademarkor trade name. Computer software doesnot include any data or information baseunless the data base or item is in the publicdomain and is incidental to a computerprogram. For this purpose, a copyrightedor proprietary data or information base istreated as in the public domain if its avail-ability through the computer program doesnot contribute significantly to the cost ofthe program. For example, if a word-pro-cessing program includes a dictionaryfeature that may be used to spell-checka document or any portion thereof, theentire program (including the dictionaryfeature) is computer software regardlessof the form in which the dictionary featureis maintained or stored.

(d) Sound recordings. The term “soundrecordings” means any works that resultfrom the fixation of a series of musical,spoken, or other sounds. If the medium(such as compact discs, tapes, or otherphonorecordings) in which the sounds areembodied is tangible, the medium is con-sidered tangible personal property for pur-poses of § 199. Therefore, the sale ofan audio cassette involves both a soundrecording (the sounds fixed on the tape)and tangible personal property (the cas-sette itself). See section 4.04(8)(c) of thisnotice. The term “sound recordings” doesnot include the creation of copyrighted ma-terial in a form other than a sound record-ing, such as lyrics or music written on pa-per or other similar material.

(9) Definition of “qualified film.” (a) Ingeneral. The term “qualified film” meansany motion picture film, video tape, orlive or delayed television programming if

not less than 50 percent of the total com-pensation relating to the production of theproperty is compensation for services per-formed in the United States by actors, pro-duction personnel, directors, and produc-ers. The term “production personnel” in-cludes writers, choreographers and com-posers providing services during the pro-duction of a film, casting agents, cameraoperators, set designers, lighting techni-cians, make-up artists, and others whoseactivities are directly related to the produc-tion of the film. “Production personnel” donot include, however, individuals whoseactivities are ancillary to the production,such as advertisers and promoters, distrib-utors, studio administrators and managers,studio security personnel, and personal as-sistants to actors. If the medium on whicha qualified film is fixed is tangible (such asa DVD), such medium is treated as tangi-ble personal property. Therefore, a DVDcopy of a motion picture consists of botha qualified film (the motion picture con-tent embodied in the disc) and tangible per-sonal property (the disc itself).

(b) Compensation for services. Theterm “compensation for services” meansall payments for services performed byactors, production personnel, directors,and producers, including participationsand residuals. In the case of a taxpayerthat uses the income forecast method of§ 167(g) and capitalizes participationsand residuals into the adjusted basis ofthe qualified film, the taxpayer must usethe same estimate of participations andresiduals for purposes of § 199 that it usesfor purposes of § 167(g). In the case ofa taxpayer that excludes participationsand residuals from adjusted basis of thequalified film under § 167(g)(7)(D)(i), thetaxpayer must determine the compensa-tion expected to be paid as participationsand residuals based on the total forecastedincome used in determining income fore-cast depreciation.

(c) Determination of 50 percent. A tax-payer may use any reasonable method ofmaking the allocation. Among the factorsto be considered in determining whether ataxpayer’s method of allocating compen-sation is reasonable is whether the tax-payer uses that method consistently.

(d) Exception. A “qualified film” doesnot include property with respect to whichrecords are required to be maintained un-der 18 U.S.C. § 2257. Section 2257 of

Title 18 requires maintenance of certainrecords with respect to any book, maga-zine, periodical, film, videotape, or othermatter that (1) contains one or more visualdepictions made after November 1, 1990,of actual sexually explicit conduct and (2)is produced in whole or in part with materi-als that have been mailed or shipped in in-terstate or foreign commerce, or is shippedor transported or is intended for shipmentor transportation in interstate or foreigncommerce.

(10) Electricity, natural gas, andpotable water. (a) In general. DPGRincludes gross receipts derived from anylease, rental, license, sale, exchange, orother disposition of electricity, natural gas,or potable water produced by the taxpayerin the United States (assuming all otherrequirements of § 199(c) are met). DPGRdoes not include gross receipts of the tax-payer derived from the transmission ordistribution of these items.

(b) Natural gas. The term “naturalgas” includes only natural gas extractedfrom a natural deposit and does not in-clude, for example, methane gas extractedfrom a landfill. In the case of natural gas,production activities include all activitiesinvolved in extracting natural gas fromthe ground and processing the gas intopipeline quality gas.

(c) Potable water. The term “potablewater” means unbottled drinking water. Inthe case of potable water, production ac-tivities include the acquisition, collection,and storage of raw water (untreated water),transportation of raw water to a water treat-ment facility, and treatment of raw water atsuch a facility. Gross receipts attributableto any of these activities are included inDPGR (assuming all other requirements of§ 199(c) are met). DPGR does not include,however, gross receipts derived from thestorage of potable water after completionof treatment of the potable water, or deliv-ery of potable water to customers.

(d) Exceptions. In the case of anintegrated producer that both producesand delivers electricity, natural gas, orpotable water, the taxpayer must allo-cate its gross receipts between production(DPGR) and distribution and transmis-sion (non-DPGR). However, if less than5 percent of a taxpayer’s gross receiptsderived from a sale of electricity, naturalgas, or potable water are attributable to thetransmission or distribution of the elec-

February 14, 2005 519 2005–7 I.R.B.

tricity, natural gas, or potable water, thenthe gross receipts derived from that salethat are attributable to the transmissionand distribution of the electricity, naturalgas, or potable water will be treated forpurposes of § 199 as being DPGR (assum-ing all other requirements of § 199(c) aremet).

(i) Electricity. Gross receipts attribut-able to the transmission of electricity fromthe generating facility to a point of localdistribution and gross receipts attributableto the distribution of electricity to finalcustomers are not DPGR.

(ii) Natural gas. Gross receipts attribut-able to the transmission of pipeline qualitygas from a natural gas field (or from a natu-ral gas processing plant) to a local distribu-tion company’s citygate (or to another cus-tomer) are not DPGR. Likewise, gross re-ceipts of a local gas distribution companyattributable to distribution from the city-gate to the local customers are not DPGR.

(iii) Potable water. Gross receipts at-tributable to the storage of potable wa-ter after completion of treatment of thepotable water, as well as gross receipts at-tributable to the transmission and distribu-tion of potable water, are not DPGR.

(11) Definition of “construction per-formed in the United States.” (a) Construc-tion of real property. The term “construc-tion” means the construction or erection ofreal property (that is, residential and com-mercial buildings (including items that arestructural components of such buildings),inherently permanent structures other thantangible personal property in the natureof machinery (see section 4.04(8)(b) ofthis notice), inherently permanent land im-provements, and infrastructure) by a tax-payer that is in a trade or business thatis considered construction for purposes ofthe North American Industry Classifica-tion System (NAICS codes). Tangible per-sonal property (as defined under section4.04(8)(b)) (for example, appliances, fur-niture and fixtures) that is sold as partof a construction project is not consid-ered real property for this purpose. How-ever, if more than 95 percent of the totalgross receipts derived by a taxpayer froma construction project are derived from realproperty (as defined in § 1.263A–8(c)),then the total gross receipts derived by thetaxpayer from the project are DPGR fromconstruction (assuming all other require-ments of § 199(c) are met). In determin-

ing whether property is “real property,” thefact that property is real property underlocal law is not controlling. Conversely,property may be real property for purposesof § 199(c)(4)(A)(ii) even though under lo-cal law the property is considered tangiblepersonal property.

(b) Activities constituting construction.Activities constituting construction in-clude activities performed in connectionwith a project to erect or substantiallyrenovate real property, but do not includetangential services such as hauling trashand debris, and delivering materials, evenif the tangential services are essentialfor construction. However, if the tax-payer performing construction also, inconnection with the construction project,provides tangential services such as de-livering materials to the construction siteand removing its construction debris, thegross receipts derived from the tangen-tial services are DPGR. Improving land(for example, grading and landscaping)and painting are activities constitutingconstruction only if these activities areperformed in connection with other activi-ties (whether or not by the same taxpayer)that constitute the erection or substantialrenovation of real property. The taxpayerengaged in these activities must make areasonable inquiry to determine whetherthe activity relates to the erection or sub-stantial renovation of real property. Theterm “construction” does not include anyactivity that is within the definition of“engineering and architectural services”(see section 4.04(12) of this notice).

(c) Definition of “infrastructure.” Theterm “infrastructure” includes roads,power lines, water systems, railroad spurs,communications facilities, sewers, side-walks, cable, and wiring. The term alsoincludes inherently permanent oil and gasplatforms.

(d) Definition of “substantial renova-tion.” The term “substantial renovation”means the renovation of a major compo-nent or substantial structural part of realproperty that materially increases the valueof the property, substantially prolongs theuseful life of the property, or adapts theproperty to a new or different use.

(e) “Derived from construction.” As-suming all other requirements of § 199(c)are met, DPGR derived from the con-struction of real property performed inthe United States includes the proceeds

from the sale, exchange, or other dispo-sition of real property constructed by thetaxpayer in the United States (whetheror not the property is sold immediatelyafter construction is completed). DPGRderived from the construction of real prop-erty also includes compensation for theperformance of construction services bythe taxpayer in the United States. How-ever, DPGR derived from the constructionof real property does not include grossreceipts from the lease or rental of realproperty constructed by the taxpayer orgross receipts attributable to the sale orother disposition of land.

(12) Definition of “Engineering andarchitectural services.” (a) In general.DPGR includes gross receipts derivedfrom engineering or architectural servicesperformed in the United States for con-struction projects in the United States (as-suming all other requirements of § 199(c)are met). The engineering or architecturalservices must relate to real property, mustbe performed in the United States, and thetaxpayer providing these services mustbe able to substantiate that the servicesrelate to a construction project withinthe United States. DPGR includes grossreceipts derived from engineering or ar-chitectural services even if the plannedconstruction project is not undertaken oris not completed (subject to the taxpayersubstantiating that the services relate toa construction project that would havebeen within the United States if it hadbeen undertaken and assuming all otherrequirements of § 199(c) are met).

(b) Engineering services. Engineeringservices in connection with any con-struction project include any professionalservices requiring engineering educa-tion, training, and experience and theapplication of special knowledge of themathematical, physical, or engineeringsciences to those professional servicessuch as consultation, investigation, eval-uation, planning, design, or responsiblesupervision of construction for the pur-pose of assuring compliance with plans,specifications, and design.

(c) Architectural services. Architec-tural services in connection with anyconstruction project include the offeringor furnishing of any professional servicessuch as consultation, planning, aestheticand structural design, drawings and spec-ifications, or responsible supervision of

2005–7 I.R.B. 520 February 14, 2005

construction (for the purpose of assuringcompliance with plans, specifications, anddesign) or erection, in connection with anyconstruction project.

(d) De minimis exception for perfor-mance of services in the United States.If gross receipts derived from engineer-ing or architectural services (1) performedoutside the United States or (2) relatedto property other than real property fora construction project inside the UnitedStates total less than 5 percent of the totalgross receipts of the taxpayer derived fromengineering or architectural services per-formed by the taxpayer with regard to thesame construction project, such receiptswill be treated as DPGR.

(13) Exception for sales of certain foodand beverages. DPGR does not includegross receipts of the taxpayer that are de-rived from the sale of food or beveragesprepared by the taxpayer at a retail estab-lishment. A “retail establishment” is de-fined as real property leased, occupied, orotherwise used by the taxpayer in its tradeor business of selling food or beverages tothe public at which retail sales are made. Afacility at which food or beverages are pre-pared will not be treated as a retail estab-lishment if less than 5 percent of the foodor beverages that are sold at that facilityduring the taxable year are retail sales. If ataxpayer’s facility is a retail establishment,then, as a matter of administrative grace,the taxpayer may allocate its gross receiptsbetween gross receipts derived from the re-tail sale of the food and beverages preparedand sold at the retail establishment (whichare non-DPGR) and gross receipts derivedfrom the wholesale sale of the food andbeverages prepared at the retail establish-ment (which are DPGR). The exception forsales of certain food and beverages also ap-plies to food and beverages for non-humanconsumption.

(14) Related persons. Section 199(c)(7)provides that DPGR does not include anygross receipts of the taxpayer derived fromproperty leased, licensed, or rented by thetaxpayer for use by any related person. Aperson is treated as related to another per-son if both persons are treated as a singleemployer under either § 52(a) or (b) (with-out regard to § 1563(b)), or § 414 (m) or(o).

.05 Determining Costs. (1) In gen-eral. To determine its QPAI for the taxableyear, a taxpayer must reduce its DPGR

by the amount of CGS directly allocableto DPGR, the amount of deductions di-rectly allocable to DPGR and a ratable por-tion of other deductions not directly al-locable to DPGR, or another class of in-come. Section 4.05(2) of this notice pro-vides rules for determining CGS directlyallocable to DPGR. Section 4.05(3) pro-vides rules for determining the deductionsallocated and apportioned to DPGR and aratable portion of deductions not directlyallocable to DPGR or another class of in-come. Section 4.05(3) generally providesthat a taxpayer must determine deductionsallocated and apportioned to DPGR usingthe rules of the regulations under § 861of the Code. Section 4.05(3) provides,however, that a taxpayer with average an-nual gross receipts of $25,000,000 or lessmay determine deductions apportionableto DPGR using the simplified deductionmethod. Section 4.05(4) provides a simpli-fied overall method that a qualifying smalltaxpayer may use to allocate and apportionCGS and deductions to DPGR. Consistentwith the rule in section 4.09(1) that treatsall members of an EAG as a single corpo-ration for purposes of § 199, whether themembers of an EAG may use the simpli-fied deduction method or the small busi-ness simplified overall method is deter-mined at the EAG level. In addition, amember of an EAG that may use the sim-plified deduction method or the small busi-ness simplified overall method may do soonly if all members of the EAG agree toand use the same method.

(2) Cost of goods sold allocable to do-mestic production gross receipts. (a) Ingeneral. Section 199(c)(1)(B)(i) requires ataxpayer to reduce DPGR by the CGS di-rectly allocable to DPGR. A taxpayer mustallocate CGS in accordance with this sec-tion 4.05(2) of this notice or, if applica-ble, section 4.05(4). CGS is equal to be-ginning inventory plus purchases and pro-duction costs incurred during the taxableyear less ending inventory. For purposesof § 199, CGS allocable to DPGR includesthe costs that would have been included inending inventory under the principles of§§ 263A, 471, and 472 if the goods soldduring the taxable year were on hand atthe end of the taxable year. CGS alloca-ble to DPGR includes inventory valuationadjustments such as writedowns under thelower of cost or market method. For pur-poses of § 199, CGS also includes the ad-

justed basis of noninventory property, thegross receipts from the sale or other dispo-sition of which are included in DPGR.

(b) Allocating cost of goods sold. If ataxpayer can identify from its books andrecords CGS allocable to DPGR, CGSallocable to DPGR is that amount. How-ever, if a taxpayer’s books and recordsdo not allow the taxpayer to identifyCGS allocable to DPGR, the taxpayermust use a reasonable method to allocateCGS between DPGR and other gross re-ceipts. If a taxpayer uses a method toallocate gross receipts between DPGR andnon-DPGR, the taxpayer may not use adifferent method for purposes of allocatingCGS. In other cases, whether an alloca-tion method is reasonable is based on allof the facts and circumstances includingthe relationship between CGS and the basechosen; the accuracy of the method chosenas compared with other possible methods;whether the method is used by the tax-payer for internal management and otherbusiness purposes; whether the method isused for other federal or state income taxpurposes; the availability of costing infor-mation; and the time, burden, and cost ofusing various methods. Depending on thefacts and circumstances, reasonable meth-ods may include methods based on grossreceipts, number of units sold, number ofunits produced, or total production costs.

(c) Special rules for imported itemsor services. Under § 199(c)(3), the costof any item or service brought into theUnited States is treated as not less thanits value immediately after it entered theUnited States for purposes of determiningthe CGS to be used in the computationof QPAI. When an item or service isbrought into the United States that hadbeen exported by the taxpayer for furthermanufacture, the increase in cost may notexceed the difference between the valueof the property when exported and thevalue of the property when brought backinto the United States after further man-ufacture. For this purpose, the value ofproperty is its customs value as defined in§ 1059A(b)(1).

(3) Other deductions allocable orapportionable to domestic productiongross receipts. (a) In general. Section199(c)(1)(B)(ii) and (iii) requires a tax-payer to reduce DPGR by deductions thatare directly allocable to DPGR, and aratable portion of deductions that are not

February 14, 2005 521 2005–7 I.R.B.

directly allocable to DPGR or anotherclass of income. Any cost that may not betaken into account in computing taxableincome for the taxable year is not treatedas a deduction for purposes of this sec-tion. A taxpayer generally must allocateand apportion these deductions using therules provided in the § 861 regulations,subject to the rules provided in this section4.05(3) (the § 861 method). In lieu of the§ 861 method, a taxpayer with average an-nual gross receipts of $25,000,000 or lessmay apportion these deductions using thesimplified deduction method. A taxpayerelecting the simplified deduction methodmust use that method for all deductions.See also section 4.05(4) for the small busi-ness simplified overall method availableto a qualified small taxpayer.

(b) Rules that apply to all alloca-tion and apportionment methods. (i) Ingeneral. The rules provided in section4.05(3)(b)(ii) through (v) apply to losses,net operating losses, and certain otherdeductions when allocating and appor-tioning deductions to DPGR or grossincome attributable to DPGR under the§ 861 method (section 4.05(3)(c)), thesimplified deduction method (section4.05(3)(d)), or the small business simpli-fied overall method (section 4.05(4)).

(ii) Losses. A deduction under § 165for a loss related to property (includingtheft, casualty, or abandonment losses) isallocated or apportioned to DPGR or grossincome attributable to DPGR only if theproceeds from the sale of the property are,or would have been, included in DPGR.

(iii) Net operating losses. A deduc-tion allowed under § 172 for a net oper-ating loss is not allocated or apportionedto DPGR or gross income attributable toDPGR.

(iv) Deductions not attributable to theactual conduct of a trade or business. De-ductions not attributable to the actual con-duct of a trade or business are not allocatedor apportioned to DPGR or gross incomeattributable to DPGR. See § 199(d)(5). Forexample, the standard deduction providedby § 63(c) and the deduction for personalexemptions provided by § 151 are not al-located or apportioned to DPGR or grossincome attributable to DPGR.

(v) Deductions related to de minimisgross receipts and embedded servicesincluded in domestic production gross re-ceipts. If a taxpayer is permitted to treat

non-DPGR as DPGR pursuant to a safeharbor or de minimis rule provided in thisnotice (e.g., section 4.03(2) or section4.04(10)(d) of this notice), deductions re-lated to such non-DPGR treated as DPGRmust be allocated or apportioned to DPGRor gross income attributable to DPGR.If the gross receipts related to embed-ded services are included in DPGR undersection 4.04(7), the deductions related toproviding such services must be allocatedor apportioned to DPGR or gross incomeattributable to DPGR.

(c) Section 861 method. (i) In gen-eral. A taxpayer must allocate and ap-portion its deductions using the allocationand apportionment rules provided by the§ 861 regulations, subject to the modifi-cations provided in section 4.05(3)(b)(ii)through (v) and section 4.05(3)(c)(ii) and(iii) of this notice. Under this method,§ 199 is treated as an “operative section”described in § 1.861–8(f). Accordingly,the taxpayer applies the rules of the § 861regulations to allocate and apportion de-ductions (including its distributive sharesof deductions) to gross income attributableto DPGR. Generally, the taxpayer allocatesdeductions to the relevant class of gross in-come and apportions (if necessary) suchdeductions within the class of gross in-come between gross income attributable toDPGR (the statutory grouping) and otherincome (the residual grouping). The § 861regulations generally are applied on a sin-gle entity basis, although the rules are ap-plied on the basis of the affiliated group (asdetermined under the § 861 regulations)for certain expenses such as interest ex-pense and research and experimental ex-penses. Consistent with these rules, alloca-tion and apportionment of deductions gen-erally are determined on an aggregate basisby the owner of the pass-thru entity. Seefor example, §§ 1.861–9T(e) and –17(f).If the taxpayer uses the allocation and ap-portionment rules of the § 861 regulationsfor another operative section of the Code,it must use the same method of allocationand the same principles for apportionmentfor purposes of all operative sections (sub-ject to, in the case of the § 861 method,the rules provided in section 4.05(3)(b)(ii)through (v) and section 4.05(3)(c)(ii) and(iii) of this notice). See § 1.861–8(f)(2)(i).

(ii) Deductions for charitable contribu-tions. Deductions for charitable contribu-tions (as allowed under §§ 170, 873(b)(2),

and 882(c)(1)(B)) must be ratably appor-tioned between gross income attributableto DPGR and other gross income based onthe relative amounts of gross income. Forindividuals, this provision applies solelyto deductions for charitable contributionsthat are attributable to the actual conductof a trade or business.

(iii) Research and experimental expen-ditures. Research and experimental expen-ditures must be allocated and apportionedin accordance with § 1.861–17. Becausean apportionment based on geographicsources is not required for purposes of§ 199, the exclusive apportionment rule of§ 1.861–17(b) does not apply for purposesof the § 861 method.

(d) Simplified deduction method. Ataxpayer with average annual gross re-ceipts (as defined in section 4.05(5) ofthis notice) of $25,000,000 or less mayuse the simplified deduction method.Under the simplified deduction method,except as provided in section 4.05(3)(b)of this notice, a taxpayer’s deductionsare ratably apportioned between DPGRand non-DPGR based on relative grossreceipts. Accordingly, the amount of de-ductions apportioned to DPGR is equalto the same proportion of the deductionsthat the amount of DPGR bears to totalgross receipts. In the case of an owner of apass-thru entity, the simplified deductionmethod (including whether the methodmay be used) is applied at the level ofthe owner of the pass-thru entity takinginto account the owner’s DPGR, receipts,and other items from all sources includingits distributive or allocable share of thoseitems of the pass-thru entity.

(4) Small business simplified overallmethod. (a) In general. A qualifyingsmall taxpayer may use the small businesssimplified overall method to allocate andapportion CGS and deductions betweenDPGR and non-DPGR. Under the smallbusiness simplified overall method, a tax-payer’s total CGS and deductions (exceptas provided in section 4.05(3)(b) of thisnotice) are ratably apportioned betweenDPGR and other receipts based on relativegross receipts. Accordingly, the amountof CGS and deductions apportioned toDPGR is equal to the same proportion ofCGS and deductions that the amount ofDPGR bears to total gross receipts.

(b) Qualifying small taxpayer. For pur-poses of section 4.05(4)(a) of this notice,

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a qualifying small taxpayer is a taxpayerthat has average annual gross receipts (asdescribed in section 4.05(5) of this notice)of $5,000,000 or less or a taxpayer that iseligible to use the cash method as providedin Rev. Proc. 2002–28, 2002–1 C.B. 815.(That is, any taxpayer with average annualgross receipts of $10,000,000 or less that isnot prohibited from using the cash methodunder § 448, including a partnership, an Scorporation, a C corporation, or an individ-ual.)

(5) Average annual gross receipts.For purposes of the simplified deductionmethod in section 4.05(3)(d) of this noticeand the small business simplified overallmethod in section 4.05(4), average annualgross receipts means the average annualgross receipts of the taxpayer for the 3taxable years (or, if fewer, the taxableyears during which the taxpayer was inexistence) preceding the current taxableyear, even if one or more of such taxableyears began before the effective date of§ 199. In the case of any taxable year ofless than 12 months (a short taxable year),the gross receipts shall be annualized by(a) multiplying the gross receipts for theshort period by 12 and (b) dividing theresult by the number of months in theshort period. Whether the members of anEAG may use the simplified deductionmethod or the small business simplifiedoverall method is determined by referenceto the average annual gross receipts ofthe EAG. To compute the average annualgross receipts of an EAG, the gross re-ceipts of each member of the EAG for itstaxable year that ends with or within thetaxable year of the computing member (asdefined in section 4.09(8) of this notice)are aggregated, regardless of whether thecomputing member or the non-computingmember was a member of the EAG duringits entire taxable year. A member of anEAG that qualifies to use the simplifieddeduction method or the small businesssimplified overall method may do so onlyif all members of the EAG agree to anduse the same method.

.06 Application of § 199 to Pass-thruEntities. (1) Allocations to partners,shareholders, and similar interest hold-ers. (a) Partnerships. (i) Determination atpartner level. The § 199 deduction is de-termined at the partner level. As a result,each partner must compute its deduc-tion separately. Each partner is allocated,

in accordance with §§ 702 and 704, itsshare of items (including items of income,gain, loss, deduction, cost of goods soldallocated to such items of income, andgross receipts that are included in suchitems of income) allocated or attributableto the partnership’s activities describedin § 199(c)(4) (qualified production ac-tivities), along with any other items ofincome, gain, loss, deduction or credit ofthe partnership. To determine its § 199deduction for the taxable year, a partneraggregates its share of the items allocatedor attributable to the partnership’s qual-ified production activities, any expensesincurred by the partner directly that areallocated to the partnership’s qualifiedproduction activities, and those items ofthe partner that are allocated or attrib-utable to qualified production activitiesfrom sources other than the partnership. Apartnership may specially allocate itemsof income, gain, loss, or deduction allo-cated or attributable to the partnership’squalified production activities, subject tothe rules of § 1.704–1(b), including therules for determining substantial economiceffect under § 1.704–1(b)(2)(iii).

(ii) Expenses. Each partner must takeinto account the partner’s distributiveshare of expenses allocated to the quali-fied production activities of the partner-ship, regardless of whether the partnershipotherwise has taxable income. However,expenses of a partnership that otherwisewould be taken into account for purposesof computing the partner’s § 199 deduc-tion shall only be taken into account ifand to the extent the partner’s distributiveshare of the losses and deductions fromall of the partnership’s activities is notdisallowed by §§ 465, 469, 704(d), or anyother provision of the Code. In the eventthat only a portion of the partner’s dis-tributive share of the losses or deductionsare allowed for a taxable year, a propor-tionate share of the losses or deductionsthat reflect expenses allocated to the part-nership’s qualified production activities,determined in a manner consistent with§§ 465, 469 and 704(d), shall be taken intoaccount for purposes of computing the§ 199 deduction for that taxable year. Tothe extent that any of the disallowed lossesor deductions are allowed in a later taxableyear, the partner shall take into accounta proportionate share of the expenses re-flected in those losses or deductions in

computing its QPAI for that later taxableyear.

(iii) W–2 wages. Under § 199(d)(1)(B),a partner’s share of W–2 wages of the part-nership for purposes of determining thepartner’s § 199(b) limitation is the lesser ofthe partner’s allocable share of the wages(without regard to § 199(d)(1)(B)) as de-termined under regulations prescribed bythe Secretary, or 2 times 9 percent (3 per-cent in the case of taxable years beginningin 2005 and 2006, and 6 percent in thecase of taxable years beginning in 2007,2008, or 2009) of the QPAI computed tak-ing into account only the items of the part-nership allocated to the partner for the tax-able year of the partnership. In determin-ing a partner’s share of the W–2 wages ofa partnership, allocations by the partner-ship of W–2 wages, otherwise meeting therequirements of § 704(b), shall be takeninto account by the partner for purposes of§ 199(d)(1)(B). Thus, a partner’s share ofW–2 wages of the partnership is the lesserof the amount of W–2 wages allocated tothe partner under § 704, or 2 times theapplicable percentage of the QPAI com-puted taking into account only the items ofthe partnership allocated to the partner forthe taxable year of the partnership, deter-mined at the partner level, in accordancewith section 4.06(1)(a)(i) and (ii), by ref-erence to the partner’s distributive or al-locable share of the partnership’s items ofincome, gain, loss or deduction (includinggross receipts and costs of goods sold), al-located or attributable to qualified produc-tion activities, and expenses incurred di-rectly by the partner which are allocated tothe partnership’s qualified production ac-tivities, for the taxable year. Each partnermust aggregate the W–2 wages allocatedfrom the partnership with its W–2 wagesfrom other sources for purposes of com-puting the partner’s § 199(b) limitation forthe taxable year. However, if QPAI com-puted taking into account only the items ofthe partnership allocated to the partner forthe taxable year is not greater than zero,the partner may not take into account anyW–2 wages of the partnership for purposesof computing the wage limitation under§ 199(b) for the taxable year.

(b) S corporations. (i) Determinationat S corporation shareholder level. The§ 199 deduction is determined at the share-holder level. As a result, each shareholdermust compute its deduction separately.

February 14, 2005 523 2005–7 I.R.B.

Each shareholder is allocated, in accor-dance with § 1366, its pro rata share ofitems (including items of income, gain,loss, and deduction) allocated or attribut-able to the qualified production activitiesof the S corporation. To the extent thatsuch items represent items relevant tothe computation of the § 199 deduction(for example, DPGR, CGS, other itemsallocable to DPGR, or W–2 wages of theS corporation), the shareholder will takesuch items into account in computing its§ 199 deduction. To compute its § 199deduction for the taxable year, the share-holder will aggregate its pro rata share ofitems allocated or attributable to the S cor-poration’s qualified production activities,and those items of the shareholder thatare allocated or attributable to qualifiedproduction activities from sources otherthan the S corporation.

(ii) Expenses. Each shareholder musttake into account its pro rata share of ex-penses allocated to the qualified produc-tion activities of the S corporation, regard-less of whether the S corporation other-wise has taxable income. However, ex-penses of the S corporation that otherwisewould be taken into account for purposesof computing the shareholder’s § 199 de-duction shall only be taken into account ifand to the extent the shareholder’s pro ratashare of the losses or deductions from all ofthe S corporation’s activities are not dis-allowed by §§ 465, 469, 1366(d), or anyother provision of the Code. In the eventthat only a portion of the shareholder’spro rata share of the losses or deductionsis allowed for a taxable year, a propor-tionate share of the losses or deductionsthat reflect expenses allocated to the S cor-poration’s qualified production activities,determined in a manner consistent with§§ 465, 469, and 1366(d), shall be takeninto account for purposes of computing the§ 199 deduction for that taxable year. Tothe extent that any of the disallowed lossesor deductions are allowed in a later tax-able year, the shareholder shall take intoaccount a proportionate share of the ex-penses reflected in those losses or deduc-tions in computing its QPAI for that latertaxable year.

(iii) W–2 wages. Under § 199(d)(1)(B),an S corporation shareholder’s share ofW–2 wages of the S corporation for pur-poses of determining the shareholder’s§ 199(b) limitation is the lesser of the

shareholder’s allocable share of the wages(without regard to § 199(d)(1)(B)) as de-termined under regulations prescribed bythe Secretary, or 2 times 9 percent (3 per-cent in the case of taxable years beginningin 2005 and 2006, and 6 percent in the caseof taxable years beginning in 2007, 2008,or 2009) of the QPAI computed takinginto account only the items of the S cor-poration allocated to the shareholder forthe taxable year. Each shareholder mustaggregate the W–2 wages allocated fromthe S corporation with its W–2 wages fromother sources for purposes of computingits § 199(b) limitation for the taxable year.However, if the shareholder is not allo-cated positive QPAI computed taking intoaccount only the items of the S corporationallocated to the shareholder for the taxableyear, the shareholder may not take intoaccount any W–2 wages of the S corpora-tion for purposes of computing the wagelimitation under § 199(b) for the taxableyear.

(2) Gain or loss from the disposition ofan interest in a pass-thru entity. QPAI gen-erally does not include gain or loss recog-nized on the sale, exchange, or other dis-position of an interest in the entity. How-ever, if § 751(a) or (b) applies, gain orloss allocable to assets of the partnershipthe sale, exchange, or other disposition ofwhich would give rise to QPAI is taken intoaccount in computing the partner’s § 199deduction.

(3) Effective date of § 199 for pass-thruentities. Section 199(e) provides that § 199applies for taxable years beginning on orafter January 1, 2005. Accordingly, § 199does not apply to taxable years of pass-thruentities that begin before January 1, 2005.For example, assume a pass-thru entity hasa taxable year beginning July 1, 2004, andending June 30, 2005, and the owners ofthe pass-thru entity have taxable years be-ginning January 1, 2005, and ending De-cember 31, 2005. The provisions of § 199do not apply to the pass-thru entity untilthe first date of its first taxable year begin-ning on or after January 1, 2005. Thus,§ 199 applies to the pass-thru entity forits taxable year beginning July 1, 2005.The owners of the pass-thru entity includetheir allocable or pro rata share of itemsallocated or attributable to the qualifiedproduction activities of the pass-thru en-tity, for purposes of determining their re-

spective § 199 deductions for their taxableyears ending December 31, 2006.

.07 Patrons of Agricultural and Horti-cultural Cooperatives. Section 199(d)(3)and this section 4.07 apply in the case of acooperative (to which Part I of SubchapterT applies), that is engaged in (1) the MPGEin whole or in significant part of any agri-cultural or horticultural product, or (2) themarketing of agricultural or horticulturalproducts. Under § 199(d)(3) and this sec-tion, if any amount of a patronage dividendor qualified per-unit retain allocation paidin qualified per-unit retain certificates de-scribed in § 1385 is received by a patronfrom such a cooperative, and such amountis allocable to QPAI of the cooperative thatis deductible under § 199(a) and section4.01 of this notice by the cooperative, thenthe amount is deductible from the gross in-come of the patron. Such an amount, how-ever, does not reduce the taxable income ofthe cooperative under § 1382. In order forthe member to qualify for the deduction,§ 199(d)(3)(A)(ii) requires the cooperativeto designate the patron’s portion of the in-come allocable to QPAI of the organizationin a written notice mailed by the coopera-tive to its patron during the payment perioddescribed in § 1382(d) (that is, no later thanthe 15th day of the ninth month followingthe close of the taxable year). In determin-ing the portion of the cooperative’s QPAIthat would be deductible by the coopera-tive under § 199(a) and section 4.01, thecooperative’s taxable income is computedwithout taking into account any deductionallowable under § 1382(b) or (c) relatingto patronage dividends, per-unit retain al-locations, and nonpatronage distributionsand, in the case of a cooperative engagedin the marketing of agricultural and horti-cultural products, the cooperative is treatedas having MPGE in whole or in significantpart any QPP marketed by the cooperativethat its patrons have MPGE. For purposesof § 199, agricultural or horticultural prod-ucts also include fertilizer, diesel fuel andother supplies used in agricultural or horti-cultural production that are MPGE by thecooperative.

.08 Individuals. In the case of individ-uals, § 199(d)(2) provides that the deduc-tion is equal to the applicable percent of thelesser of the taxpayer’s (1) QPAI for thetaxable year, or (2) adjusted gross income(AGI) for the taxable year determined after

2005–7 I.R.B. 524 February 14, 2005

applying §§ 86, 135, 137, 219, 221, 222,and 469, and without regard to § 199.

.09 Expanded Affiliated Groups. (1)In general. All members of an EAG aretreated as a single corporation for purposesof § 199. An EAG is an affiliated groupas defined in § 1504(a), determined bysubstituting “50 percent” for “80 percent”each place it appears, and without regardto § 1504(b)(2) and (4).

(2) Computation of expanded affiliatedgroup’s § 199 deduction. (a) In general.The § 199 deduction for an EAG is de-termined by aggregating each member’staxable income or loss, QPAI, and W–2wages. For this purpose, a member’s QPAIis the member’s DPGR less the sum of theCGS allocable to such receipts and othercosts required to be allocated under sec-tion 4.05 of this notice. For purposes ofthis determination, a member’s QPAI maybe positive or negative. A member’s tax-able income or loss and QPAI shall bedetermined by reference to the member’smethod of accounting.

(b) Attribution of activities. Each mem-ber of an EAG is treated as conducting theactivities conducted by each other mem-ber of the EAG. For example, Corpora-tion A and Corporation B are members ofthe same EAG but do not file a consoli-dated return. A is engaged solely in thetrade or business of manufacturing QPP inthe United States. B is a reseller of theQPP manufactured by A. Without regardto the activities conducted by A, B wouldnot qualify for the § 199 deduction. How-ever, because B is a member of the EAGthat includes A, B is treated as conductingA’s manufacturing activities. Accordingly,B’s gross receipts attributable to its sale ofthe QPP it purchases from A are DPGR(assuming all other requirements of § 199are met).

(c) Anti-avoidance rule. If a transactionbetween members of an EAG is engagedin or structured with a principle purposeof qualifying for, or modifying the amountof, the § 199 deduction for one or moremembers of the EAG, adjustments must bemade to eliminate the effect of the transac-tion on the computation of the § 199 de-duction.

(3) Allocation of expanded affiliatedgroup’s § 199 deduction. The EAG’s§ 199 deduction is allocated among mem-bers of the EAG in proportion to eachmember’s QPAI, if any, regardless of

whether the EAG member has taxableincome or loss for the taxable year andregardless of whether the EAG memberhas W–2 wages. For this purpose, if amember has negative QPAI, the QPAI ofthe member shall be treated as zero.

(4) Special rules for consolidatedgroups. For purposes of § 199, a con-solidated group is treated as a single mem-ber of the EAG. Therefore, if an EAGincludes corporations that are membersof a consolidated group and corporationsthat are not members of a consolidatedgroup, in computing the taxable incomelimitation of the EAG, the consolidatedtaxable income of the consolidated group,not the separate taxable income of themembers of the consolidated group, istaken into account. If all of the membersof an EAG are members of the same con-solidated group, the consolidated group’s§ 199 deduction is determined based onthe group’s consolidated taxable incomeor loss, not the separate taxable income orloss of its members. The § 199 deductionof a consolidated group (or the § 199 de-duction allocated to a consolidated groupthat is a member of an EAG) must be allo-cated to the members of the consolidatedgroup in proportion to each consolidatedgroup member’s QPAI, if any, regardlessof whether the consolidated group memberhas separate taxable income or loss for thetaxable year and regardless of whether themember has W–2 wages for the taxableyear. For purposes of allocating the § 199deduction of a consolidated group amongits members, if a consolidated group mem-ber has negative QPAI, the QPAI of themember shall be treated as zero.

(5) Identification of members of the ex-panded affiliated group. A corporationmust determine whether it is a member ofan EAG on a daily basis. If a corporationbecomes or ceases to be a member of anEAG, the corporation is treated as becom-ing or ceasing to be a member of the EAGat the end of the day on which its status asa member changes.

(6) Allocation of income and loss. (a)In general. A corporation that is a mem-ber of an EAG for only a portion of its tax-able year must allocate its taxable incomeor loss, QPAI, and W–2 wages between theportion of the taxable year during which itis a member of the EAG and the portionof the taxable year during which it is nota member of the EAG. In general, this al-

location of items must be made by usingthe pro rata allocation method described insection 4.09(6)(a)(i) of this notice. How-ever, the corporation may elect to use theclosing of the books method described insection 4.09(6)(a)(ii).

(i) Pro rata allocation method. Underthe pro rata allocation method, an equalportion of each of the taxable income orloss, QPAI, and W–2 wages for the taxableyear is assigned to each day of the corpora-tion’s taxable year. Then, those items as-signed to those days during which the cor-poration was a member of the EAG are ag-gregated.

(ii) Closing of the books method. Underthe closing of the books method, taxableincome or loss, QPAI, and W–2 wages forthe period during which the corporationwas a member of the EAG are computedby treating the corporation’s taxable yearas two separate taxable years, the first ofwhich ends at the close of the day on whichthe corporation’s status as a member ofthe EAG changes and the second of whichbegins at the beginning of the day afterthe corporation’s status as a member of theEAG changes.

(iii) Making the § 199 closing of thebooks election. A corporation makes the§ 199 closing of the books election bymaking the following statement: “The§ 199 closing of the books election ishereby made with respect to [insert nameof corporation and its employer identifica-tion number] with respect to the followingperiods [insert dates of two periods be-tween which items are allocated pursuantto the closing of the books method].” Thestatement must be filed with the corpora-tion’s timely filed (including extensions)federal income tax return for the taxableyear that includes the periods that aresubject to the election. Once made, anelection under this section 4.09(6)(a)(iii)is irrevocable.

(b) Coordination with rules relat-ing to the allocation of income under§ 1.1502–76(b). If § 1.1502–76 (relatingto the taxable year of members of a consol-idated group) applies to a corporation thatis a member of an EAG, any allocation ofitems required under this section 4.09(6) ismade only after the allocation of the cor-poration’s items pursuant to § 1.1502–76.

(7) Total § 199 deduction for a corpo-ration that is a member of an expanded af-filiated group for some or all of its taxable

February 14, 2005 525 2005–7 I.R.B.

year. If a corporation is a member of anEAG for its entire taxable year, the cor-poration’s § 199 deduction for the taxableyear is the amount of the § 199 deductionallocated to the corporation by the EAG. Ifa corporation is a member of an EAG for aportion of its taxable year, and is either nota member of any EAG, or is a member ofanother EAG, or both, for another portionof the taxable year, the corporation’s § 199deduction for the taxable year is the sumof its § 199 deductions for each portion ofthe taxable year. For example, Corpora-tions X and Y, calendar year corporations,are members of the same EAG for the en-tire 2005 taxable year. Corporation Z, alsoa calendar year corporation, is a member ofthe EAG, of which X and Y are members,for the first half of 2005 and not a memberof any EAG for the second half of 2005.During the 2005 taxable year, Z does notjoin in the filing of a consolidated return.Z makes a § 199 closing of the books elec-tion. As a result, Z has $100 of QPAI and$80 of taxable income that is allocated tothe first half of the taxable year, and ($200)of QPAI and a $150 taxable loss that is al-located to the second half of the taxableyear. Taking into account Z’s QPAI andtaxable income allocated to the first halfof the taxable year pursuant to the § 199closing of the books election, the EAG haspositive QPAI and taxable income for thetaxable year and W–2 wages in excess ofthe § 199(b) wage limitation. Because theEAG has both positive QPAI and taxableincome and sufficient W–2 wages, and be-cause Z has positive QPAI for the first halfof the year, a portion of the EAG’s § 199deduction is allocated to Z. Z is allowed no§ 199 deduction for the second half of thetaxable year. Thus, despite the fact that Zhas ($100) of QPAI and a $70 taxable lossfor the entire 2005 taxable year, Z is stillentitled to a § 199 deduction for the taxableyear equal to the § 199 deduction allocatedto Z as a member of the EAG.

(8) Computation of § 199 deduction formembers of expanded affiliated group withdifferent taxable years. If members of anEAG have different taxable years, in de-termining the § 199 deduction of a member(the “computing member”), with respect toeach group member, the computing mem-ber is required to take into account the tax-able income or loss, QPAI, and W–2 wagesthat are both (1) attributable to the periodduring which the member of the EAG and

the computing member are both membersof the EAG and (2) taken into account ina taxable year that begins after the effec-tive date of § 199 and ends with or withinthe taxable year of the computing memberwith respect to which the § 199 deductionis computed.

.10 Trade or Business Requirement.Section 199(d)(5) provides that § 199 isapplied by taking into account only itemsthat are attributable to the actual conductof a trade or business.

.11 Coordination with Alternative Mini-mum Tax. Section 199(d)(6) provides rulesto coordinate the deduction allowed under§ 199 with the AMT imposed by § 55. Thededuction is allowed for purposes of theAMT, except that the deduction is equal tothe applicable percent of the lesser of thetaxpayer’s: (1) QPAI, determined with-out regard to subchapter A, Part IV, ofthe Code; or (2) AMTI (determined with-out regard to § 199), for the taxable year.For purposes of the preceding sentence, inthe case of an individual, AGI (determinedwithout regard to § 199) shall be substi-tuted for AMTI.

.12 Special rules. (1) Certain non-recognition transactions. Except as pro-vided in section 4.09 of the notice (therules applicable to EAGs), if property istransferred by the taxpayer to an entity in atransaction to which § 351 or 721 applies,then whether the gross receipts derivedby the entity are DPGR shall be deter-mined based on the activities performedby the entity without regard to the activi-ties performed by the taxpayer prior to thecontribution of the property to the entity.

(2) Section 1031 exchanges. If a tax-payer exchanges property for replacementproperty in a transaction to which § 1031applies, then whether the gross receipts de-rived from the lease, rental, license, sale,exchange, or other disposition of the re-placement property are DPGR shall be de-termined based solely on the activities per-formed by the taxpayer.

(3) Section 381 transactions. If a corpo-ration (the acquiring corporation) acquiresthe assets of another corporation (the tar-get corporation) in a transaction to which§ 381(a) applies, the acquiring corporationshall be treated as performing those ac-tivities of the target corporation with re-spect to the acquired assets of the targetcorporation. Therefore, to the extent thatthe acquired assets of the target corpora-

tion would have given rise to DPGR ifleased, rented, licensed, sold, exchanged,or otherwise disposed of by the target cor-poration, then the assets will give rise toDPGR if leased, rented, licensed, sold, ex-changed, or otherwise disposed of by theacquiring corporation (assuming all otherrequirements of § 199(c) are met).

(4) Taxpayers with a 52–53 week tax-able year. For purposes of applying§ 1.441–2(c)(1) in the case of a taxpayerusing a 52–53 week taxable year, any ref-erence in § 199(a)(2) (the phase-in rule)to a taxable year “beginning after” a par-ticular calendar year means a taxable yearbeginning after December 31st of thatyear. Similarly, any reference to a taxableyear “beginning in” a particular calendaryear means a taxable year beginning afterDecember 31st of the preceding calendaryear. For example, a 52–53 week taxableyear that begins on December 26, 2004, isdeemed to begin on January 1, 2005, andthe transition percentage for that taxableyear is 3 percent.

SECTION 5. EFFECTIVE DATE

This notice applies to taxable years be-ginning after December 31, 2004.

SECTION 6. REQUEST FORCOMMENTS

.01 In General. The Service and Trea-sury Department invite taxpayers to sub-mit written comments on issues relating to§ 199 and this notice. In particular, the Ser-vice and Treasury Department encouragetaxpayers to submit written comments onthe following issues:

(1) The Service and Treasury Depart-ment are aware that several provisions ofthe Code and regulations require computa-tions based upon taxable income, and thatthere is confusion concerning the order inwhich these provisions are to be applied.Taxpayers are invited to submit a list ofall provisions of the Code, regulations, andother administrative guidance (if any) thatrequire computations based upon taxableincome, and the order in which taxpayersbelieve they should be applied;

(2) The Service and Treasury Depart-ment are concerned that there may be situ-ations in which a contractor does not bearthe benefits and burdens of ownership withrespect to property (for example, for se-curity reasons), but nevertheless should

2005–7 I.R.B. 526 February 14, 2005

be regarded as satisfying the “by the tax-payer” requirement of § 199(c)(4)(A)(i).Taxpayers are invited to submit commentson such situations;

(3) The Service and Treasury Depart-ment request comments on the applicationof §199 to trusts and estates. In partic-ular, comments are requested on whetherthe apportionment of distributable net in-come between the trust and estate and itsbeneficiaries should govern the determina-tion of the §199 deduction for the taxableyear, what rules should apply if there isno distributable net income for the taxableyear, how these rules should be appliedto split-interest trusts, and the informationreporting requirements that should be im-posed on the trust or estate and its ben-eficiaries. Comments are also requestedon the application of §199 to pass-thru en-tities other than partnerships, S corpora-tions, trusts and estates;

(4) The Service and Treasury Depart-ment request comments on whether tax-payers should be able to change any allo-cation or apportionment method of grossreceipts or deductions on an amended re-turn and whether there should be restric-tions on a taxpayer’s ability to change fromone method to another;

(5) The Service and Treasury Depart-ment request comments on whether addi-tional modifications or clarifications to the§ 861 method would be appropriate, in-cluding modifications relating to the deter-mination of the “affiliated group” for pur-poses of allocating and apportioning ex-penses that are allocated and apportionedon an affiliated group basis;

(6) The Service and Treasury Depart-ment request comments regarding whethermembers of an EAG should be requiredto use the same method of allocatingand apportioning deductions to DPGR. Ifmembers of an EAG were to be able touse different methods of allocating andapportioning deductions, the Service andTreasury Department request commentsregarding whether a member’s ability touse the simplified deduction method or thesmall business simplified overall methodshould depend on the average annual grossreceipts of that member alone or the ag-gregate average annual gross receipts ofall members of the EAG;

(7) The Service and Treasury Depart-ment request comments related to the ap-plication of § 199 to computer software;and

(8) The Service and Treasury Depart-ment invite comments on the appropri-ateness of the $25,000,000 gross receiptsthreshold for use of the simplified deduc-tion method.

.02 Addresses for Comments. Sendsubmissions to: CC:PA:LPD:PR (Notice2005–14), room 5203, Internal RevenueService, PO Box 7604, Ben FranklinStation, Washington, DC 20044. Sub-missions may be hand-delivered Mondaythrough Friday between the hours of8 a.m. and 4 p.m. to CC:PA:LPD:PR (No-tice 2005–14), Courier’s Desk, InternalRevenue Service, 1111 Constitution Av-enue, NW, Washington, DC. Submissionsmay also be sent electronically via theInternet to the following e-mail address:Notice.comments@irscounsel.treas.gov.Include the notice number (Notice2005–14) in the subject line.

.03 Deadline for Submission of Com-ments. Comments must be received on orbefore March 31, 2005.

SECTION 7. DRAFTINGINFORMATION

The principal authors of this notice arePaul Handleman and Lauren Ross Taylorof the Office of Associate Chief Counsel(Passthroughs and Special Industries). Forfurther information regarding this notice,contact Mr. Handleman or Ms. Taylor at(202) 622–3040 (not a toll-free call). Forfurther information regarding the applica-tion of § 199 to pass-through entities, con-tact James Quinn of the Office of AssociateChief Counsel (Passthroughs and SpecialIndustries) at (202) 622–3080; regard-ing the determination of costs generally,contact Scott Rabinowitz of the Office ofAssociate Chief Counsel (Income Tax andAccounting) at (202) 622–4970; regard-ing the cost allocation rules under § 861,contact Bethany Ingwalson of the Officeof Associate Chief Counsel (International)at (202) 622–3850; regarding expandedaffiliated groups, contact Lisa Fuller ofthe Office of Associate Chief Counsel(Corporate) at (202) 622–7750; or regard-ing the definition of W–2 wages, contactAlfred Kelley of the Office of Associate

Chief Counsel (Tax Exempt and Gov-ernment Entities) at (202) 622–6040 (nottoll-free calls).

Partnership Anti-Mixing BowlRegulations

Notice 2005–15

The Internal Revenue Service intends topromulgate regulations under §§ 704 and737 of the Internal Revenue Code to ad-dress the income tax consequences of dis-tributions of property following partner-ship mergers.

BACKGROUND

Rev. Rul. 2004–43, 2004–18 I.R.B.842, holds that new § 704(c) gain or lossis created when assets are contributed bythe transferor partnership to the con-tinuing partnership in an assets-overmerger. Rev. Rul. 2004–43 also holdsthat § 704(c)(1)(B) applies to the newlycreated § 704(c) gain or loss in propertycontributed by the transferor partnershipto the continuing partnership in an as-sets-over partnership merger, but does notapply to reverse § 704(c) gain or loss re-sulting from a revaluation of property inthe continuing partnership. In addition,Rev. Rul. 2004–43 holds that for purposesof § 737(b), net precontribution gain in-cludes the newly created § 704(c) gain orloss in property contributed by the trans-feror partnership to the continuing partner-ship in an assets-over partnership merger,but does not include reverse § 704(c) gainor loss resulting from a revaluation ofproperty in the continuing partnership.

Some commentators have arguedthat Rev. Rul. 2004–43 is not consis-tent with the current regulations under§§ 704(c)(1)(B) and 737, and that the con-clusions in the ruling should not be appliedretroactively. In response to these com-ments, the Treasury Department and theService intend to issue regulations under§§ 704(c)(1)(B) and 737 implementing theprinciples of the ruling. The regulationswill be effective for distributions occur-ring after January 19, 2005. Rev. Rul.2005–10, published in this issue of theInternal Revenue Bulletin, revokes Rev.Rul. 2004–43.

February 14, 2005 527 2005–7 I.R.B.

DESCRIPTION OF REGULATIONS

The regulations will apply the princi-ples of Rev. Rul. 2004–43 to distributionsof property following assets-over partner-ship mergers. The regulations will ap-ply to distributions of property with newlycreated § 704(c) gain or loss whether ornot that gain or loss is treated as reverse§ 704(c) gain or loss as the result of arevaluation by the transferor partnership.The regulations also will apply to distri-butions of property with original § 704(c)gain or loss that existed upon contributionto the transferor partnership. However, theregulations will provide that if the trans-feror partnership in an assets-over mergerholds contributed property with original§ 704(c) gain or loss, the seven year pe-riods in §§ 704(c)(1)(B) and 737 do notrestart with respect to that gain or loss asa result of the merger.

The regulations will provide that§ 704(c)(1)(B) does not apply to newlycreated § 704(c) gain or loss in propertycontributed by the transferor partnershipto the continuing partnership in an as-sets-over partnership merger involvingpartnerships owned by the same ownersin the same proportions. In addition, theregulations will provide that for purposesof § 737, net precontribution gain does notinclude newly created § 704(c) gain or lossin property contributed by the transferorpartnership to the continuing partnershipin an assets-over partnership merger in-volving partnerships owned by the sameowners in the same proportions. In orderfor merging partnerships to qualify for theexceptions described in this paragraph,each partner’s percentage interest in thetransferor partnership’s capital, profits,losses, distributions, liabilities, and allother items must be the same as the part-ner’s percentage interest in those items ofthe continuing partnership.

EFFECTIVE DATES

The regulations will be effective fordistributions from partnerships made afterJanuary 19, 2005.

REQUEST FOR COMMENTS

Comments are requested regardingwhether there are any other commonlyowned partnerships that should be ex-cepted from the principles of Rev. Rul.

2004–43, and, if so, under what circum-stances the exceptions should apply. Com-ments are specifically requested regardingthe application of §§ 704(c)(1)(B) and737, including the previously contributedproperty exception of § 737(d)(1), to a dis-tribution of property, after an assets-overpartnership merger, to a partner who hadbeen a partner in the transferor partner-ship, where the distributed property washeld by the transferor partnership prior tothe merger. Comments are also requestedregarding whether the continuing partner-ship may apply a § 704(c) method to orig-inal § 704(c) gain or loss that is differentthan the method applied by the transferorpartnership, and whether the continuingpartnership may apply a § 704(c) methodto newly created § 704(c) gain or loss thatis different than the method that it appliesto original § 704(c) gain or loss.

Comments are also requested regard-ing whether there are any additional issuesthat should be addressed in the regulations.For example, comments are requested re-garding whether the regulations shouldapply the principles of §§ 704(c)(1)(B)and 737 to reverse section 704(c) gain orloss. Comments are also requested regard-ing whether the tiered partnership rule of§ 1.704–3(a)(9) of the Income Tax Regu-lations should be modified or expanded toprovide rules, similar to those applicableto assets-over partnership mergers, for theapplication of §§ 704(c)(1)(B) and 737, aswell as § 704(c)(1)(A), to tiered partner-ship arrangements.

Comments may be submitted on orbefore July 19, 2005, to Internal RevenueService, PO Box 7604, Washington, DC20044, Attn: CC:PA:LPD:PR (Notice2005–15), Room 5203. Submissions mayalso be hand-delivered Monday throughFriday between the hours of 8 a.m. and4 p.m. to the Courier’s Desk at 1111Constitution Avenue, NW, WashingtonDC 20224, Attn: CC:PA:LPD:PR (No-tice 2005–15), Room 5203. Submissionsmay also be sent electronically via theinternet to the following email address:Notice.comments@irscounsel.treas.gov.Include the notice number (Notice2005–15) in the subject line.

The principal author of this notice isLaura Fields of the Office of AssociateChief Counsel (Passthroughs & Special In-dustries). For further information regard-

ing this notice, contact Ms. Fields at (202)622–3050 (not a toll-free call).

26 CFR 601.105: Examination of returns and claimsfor refund, credit, or abatement; determination ofcorrect tax liability.(Also Part 1, §§ 121, 1031; 1.121–1, 1.1031(a)–1.)

Rev. Proc. 2005–14

SECTION 1. PURPOSE

This revenue procedure provides guid-ance on the application of §§ 121 and 1031of the Internal Revenue Code to a singleexchange of property.

SECTION 2. BACKGROUND

.01 Section 121(a) provides that a tax-payer may exclude gain realized on thesale or exchange of property if the propertywas owned and used as the taxpayer’s prin-cipal residence for at least 2 years duringthe 5-year period ending on the date of thesale or exchange. Section 121(b) providesgenerally that the amount of the exclu-sion is limited to $250,000 ($500,000 forcertain joint returns). Under § 121(d)(6),any gain attributable to depreciation ad-justments (as defined in § 1250(b)(3)) forperiods after May 6, 1997, is not eligiblefor the exclusion. This limitation appliesonly to depreciation allocable to the por-tion of the property to which the § 121 ex-clusion applies. See § 121–1(d)(1).

.02 Section 121(d), as amended by§ 840 of the American Jobs Creation Actof 2004, Pub. L. 108–357, provides that,if a taxpayer acquired property in an ex-change to which § 1031 applied, the § 121exclusion will not apply if the sale or ex-change of the property occurs during the5-year period beginning on the date of theacquisition of the property. This provisionis effective for sales or exchanges afterOctober 22, 2004.

.03 Under § 1.121–1(e) of the IncomeTax Regulations, a taxpayer who uses aportion of a property for residential pur-poses and a portion of the property forbusiness purposes is treated as using theentire property as the taxpayer’s princi-pal residence for purposes of satisfying the2-year use requirement if the residentialand business portions of the property arewithin the same dwelling unit. The term“dwelling unit” has the same meaning as

2005–7 I.R.B. 528 February 14, 2005

in § 280A(f)(1), but does not include ap-purtenant structures or other property. If,however, the business portion of the prop-erty is separate from the dwelling unit usedfor residential purposes, the gain alloca-ble to the business portion of the propertyis not excludable unless the taxpayer hasalso met the 2-year use requirement for thebusiness portion of the property.

.04 Section 1.121–1(e)(3) providesthat, for purposes of determining theamount of gain allocable to the residentialand business portions of the property, thetaxpayer must allocate the basis and theamount realized using the same methodof allocation the taxpayer used to deter-mine depreciation adjustments (as definedin § 1250(b)(3)). Allocation based onthe square footage of the residential andbusiness portions of the property is anappropriate method of allocating the basisand the amount realized. Poague v. UnitedStates, 66 A.F.T.R.2d (RIA) 5825 (E.D.Va. 1990), aff’d, 947 F.2d 942 (4th Cir.1991).

.05 Section 1031(a) provides that nogain or loss is recognized on the exchangeof property held for productive use in atrade or business or for investment (re-linquished property) if the property is ex-changed solely for property of like kind(replacement property) that is to be held ei-ther for productive use in a trade or busi-ness or for investment. Under § 1031(b),if a taxpayer also receives cash or prop-erty that is not like-kind property (boot) inan exchange that otherwise qualifies un-der § 1031(a), the taxpayer must recog-nize gain to the extent of the boot. Section1031 does not apply to property that is usedsolely as a personal residence.

.06 Section 1012 provides that the ba-sis of property is its cost. The basis ofproperty acquired in an exchange is its fairmarket value, unless otherwise providedin the Code or regulations (for example,§ 1031(d)). See Philadelphia Park Amuse-ment Co. v. United States, 126 F. Supp.184 (Ct. Cl. 1954).

.07 Under § 1031(d), the basis of the re-placement property is the same as the basisof the relinquished property, decreased bythe amount of cash received and increasedby the amount of gain recognized by thetaxpayer in the exchange.

.08 Neither § 121 nor § 1031 addressesthe application of both provisions to asingle exchange of property. Section

121(d)(5)(B), however, provides rules forapplying § 121 and another nonrecognitionprovision, § 1033, to a single replacementof property. Under § 1033, in general, gainis recognized only to the extent the amountrealized from a compulsory or involuntaryconversion of property exceeds the costof qualifying replacement property, andthe basis of the replacement property is itscost reduced by the amount of the gain notrecognized.

.09 Section 121(d)(5)(B) provides that,in applying § 1033, the amount realizedfrom the sale or exchange of property istreated as the amount determined withoutregard to § 121, reduced by the amountof gain excluded under § 121. Under§ 121(d)(5)(B), the amount realized froman exchange of a taxpayer’s principal res-idence for purposes of applying § 1033 isthe fair market value of the relinquishedproperty reduced by the amount of thegain excluded from gross income under§ 121. Thus, Congress concluded thatfor exchanges meeting the requirementsof both § 121 and § 1033, (1) the § 121exclusion should be applied to gain fromthe exchange before the application of§ 1033, (2) for purposes of determininggain that may be deferred under § 1033,the § 121 exclusion should be applied firstagainst amounts received by the taxpayerthat are not reinvested in the replacementproperty (amounts equivalent to boot thatwould result in gain recognition absentthe application of § 121), and (3) the gainexcluded under § 121 should be added inthe calculation of the taxpayer’s basis inthe replacement property. See S. Rep. No.830, 88th Cong., 2d Sess. 52–53, 1964–1C.B. (Part 2) 505, 556–7 (“the basis of thetaxpayer in the newly acquired residencewill be his basis for the old residence in-creased by any exclusion of gain obtainedby him under the provision which is rein-vested in the new residence”); H.R. Rep.No. 749, 88th Cong., 1st Sess. 47, 1964–1C.B. (Part 2) 125, 171.

SECTION 3. SCOPE

This revenue procedure applies to tax-payers who exchange property that satis-fies the requirements for both the exclu-sion of gain from the exchange of a prin-cipal residence under § 121 and the non-recognition of gain on the exchange oflike-kind properties under § 1031. Thus,

this revenue procedure applies only to tax-payers who satisfy the held for productiveuse in a trade or business or for investmentrequirement of § 1031(a)(1) with respect tothe relinquished business property and thereplacement business property (as definedbelow).

SECTION 4. APPLICATION

.01 In general. Taxpayers within thescope of this revenue procedure may ap-ply both the exclusion of gain from theexchange of a principal residence under§ 121 and the nonrecognition of gain fromthe exchange of like-kind properties under§ 1031 to an exchange of property by ap-plying the procedures set forth in this sec-tion 4.

.02 Computation of gain.(1) Application of § 121 before § 1031.

Section 121 must be applied to gain real-ized before applying § 1031.

(2) Application of § 1031 to gain attrib-utable to depreciation. Under § 121(d)(6),the § 121 exclusion does not apply to gainattributable to depreciation deductions forperiods after May 6, 1997, claimed with re-spect to the business or investment portionof a residence. However, § 1031 may ap-ply to such gain.

(3) Treatment of boot. In apply-ing § 1031, cash or other non-like kindproperty (boot) received in exchange forproperty used in the taxpayer’s trade orbusiness or held for investment (the relin-quished business property), is taken intoaccount only to the extent the boot exceedsthe gain excluded under § 121 with respectto the relinquished business property.

.03 Computation of basis. In determin-ing the basis of the property received inthe exchange to be used in the taxpayer’strade or business or held for investment(the replacement business property), anygain excluded under § 121 is treated asgain recognized by the taxpayer. Thus,under § 1031(d), the basis of the replace-ment business property is increased by anygain attributable to the relinquished busi-ness property that is excluded under § 121.

SECTION 5. EXAMPLES

In each example below, the taxpayeris an unmarried individual and the prop-erty or a portion of the property has beenused in the taxpayer’s trade or business or

February 14, 2005 529 2005–7 I.R.B.

held for investment within the meaning of§ 1031(a) as well as used as a principal res-idence as required under § 121.

Example 1. (i) Taxpayer A buys a house for$210,000 that A uses as A’s principal residence from2000 to 2004. From 2004 until 2006, A rents thehouse to tenants and claims depreciation deductionsof $20,000. In 2006, A exchanges the house for$10,000 of cash and a townhouse with a fair marketvalue of $460,000 that A intends to rent to tenants.A realizes gain of $280,000 on the exchange.

(ii) A’s exchange of a principal residence that Arents for less than 3 years for a townhouse intended

for rental and cash satisfies the requirements of both§§ 121 and 1031. Section 121 does not require theproperty to be the taxpayer’s principal residence onthe sale or exchange date. Because A owns and usesthe house as A’s principal residence for at least 2 yearsduring the 5-year period prior to the exchange, A mayexclude gain under § 121. Because the house is in-vestment property at the time of the exchange, A maydefer gain under § 1031.

(iii) Under section 4.02(1) of this revenue pro-cedure, A applies § 121 to exclude $250,000 of the$280,000 gain before applying the nonrecognitionrules of § 1031. A may defer the remaining gain

of $30,000, including the $20,000 gain attributableto depreciation, under § 1031. See section 4.02(2)of this revenue procedure. Although A receives$10,000 of cash (boot) in the exchange, A is notrequired to recognize gain because the boot is takeninto account for purposes of § 1031(b) only to theextent the boot exceeds the amount of excluded gain.See section 4.02(3) of this revenue procedure.

These results are illustrated as follows.

Amount realized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $470,000Less: Adjusted basis . . . . . . . . . . . . . . . . . . . . $190,000

Realized gain . . . . . . . . . . . . . . . . . . . . . $280,000Less: Gain excluded under § 121 . . . . . . . . . . $250,000

Gain to be deferred . . . . . . . . . . . . . . . . . $30,000

(iv) A’s basis in the replacement property is$430,000, which is equal to the basis of the re-linquished property at the time of the exchange($190,000) increased by the gain excluded under§ 121 ($250,000), and reduced by the cash A re-ceives ($10,000)). See section 4.03 of this revenueprocedure.

Example 2. (i) Taxpayer B buys a prop-erty for $210,000. The property consists of twoseparate dwelling units (within the meaning of§ 1.121–1(e)(2)), a house and a guesthouse. From2001 until 2006, B uses the house as B’s principalresidence and uses the guesthouse as an office in B’strade or business. Based on the square footage of therespective parts of the property, B allocates 2/3 ofthe basis of the property to the house and 1/3 to the

guesthouse. In 2006, B exchanges the entire propertyfor a residence and a separate property that B intendsto use as an office. The total fair market value of B’sreplacement properties is $360,000. The fair marketvalue of the replacement residence is $240,000 andthe fair market value of the replacement businessproperty is $120,000, which is equal to the fair mar-ket value of the relinquished business property. From2001 to 2006, B claims depreciation deductions of$30,000 for the business use. B realizes gain of$180,000 on the exchange.

(ii) Under § 121, B may exclude gain of $100,000allocable to the residential portion of the house (2/3of $360,000 amount realized, or $240,000, minus2/3 of $210,000 basis, or $140,000) because B meetsthe ownership and use requirements for that portion

of the property. Because the guesthouse is businessproperty separate from the dwelling unit and B hasnot met the use requirements for the guesthouse,B may not exclude the gain allocable to the guest-house under § 1.121–1(e). However, because the fairmarket value of the replacement business propertyis equal to the fair market value of the relinquishedbusiness property and B receives no boot, B maydefer the remaining gain of $80,000 (1/3 of $360,000amount realized, or $120,000, minus $40,000 ad-justed basis, which is 1/3 of $210,000 basis, or$70,000, adjusted by $30,000 depreciation) under§ 1031.

These results are illustrated as follows:

Total property 2/3 residential property 1/3 business property

Amount realized $360,000 $240,000 $120,000

Basis $210,000 $140,000 $ 70,000

Depreciation adjustment $ 30,000 $ 30,000

Adjusted basis $180,000 $140,000 $ 40,000

Realized gain $180,000 $100,000 $ 80,000

Gain excluded under § 121 $100,000 $100,000

Gain deferred under § 1031 $ 80,000 $ 80,000

(iii) Because no portion of the gain attributableto the relinquished business property is excluded un-der § 121 and B receives no boot and recognizes nogain or loss in the exchange, B’s basis in the replace-ment business property is equal to B’s basis in therelinquished business property at the time of the ex-change ($40,000). B’s basis in the replacement res-idential property is the fair market value of the re-placement residential property at the time of the ex-change ($240,000).

Example 3. (i) Taxpayer C buys a property for$210,000. The property consists of a house that con-stitutes a single dwelling unit under § 1.121–1(e)(2).From 2001 until 2006, C uses 2/3 of the house (bysquare footage) as C’s principal residence and uses

1/3 of the house as an office in C’s trade or business.In 2006, C exchanges the entire property for a resi-dence and a separate property that C intends to use asan office in C’s trade or business. The total fair mar-ket value of C’s replacement properties is $360,000.The fair market value of the replacement residenceis $240,000 and the fair market value of the replace-ment business property is $120,000, which is equalto the fair market value of the business portion of therelinquished property. From 2001 to 2006, C claimsdepreciation deductions of $30,000 for the businessuse. C realizes gain of $180,000 on the exchange.

(ii) Under § 121, C may exclude the gain of$100,000 allocable to the residential portion of thehouse (2/3 of $360,000 amount realized, or $240,000,

minus 2/3 of $210,000 basis, or $140,000) becauseC meets the ownership and use requirements for thatportion of the property.

(iii) The remaining gain of $80,000 (1/3 of$360,000 amount realized, or $120,000, minus$40,000 adjusted basis, which is 1/3 of $210,000basis, or $70,000, adjusted by $30,000 depreciation)is allocable to the business portion of the house(the office). Under section 4.02(1) of this revenueprocedure, C applies § 121 before applying the non-recognition rules of § 1031. Under § 1.121–1(e),C may exclude $50,000 of the gain allocable to theoffice because the office and residence are part of asingle dwelling unit. C may not exclude that portionof the gain ($30,000) attributable to depreciation

2005–7 I.R.B. 530 February 14, 2005

deductions, but may defer the remaining gain of$30,000 under § 1031.

These results are illustrated as follows:

Total property 2/3 residential property 1/3 business property

Amount realized $360,000 $240,000 $120,000

Basis $210,000 $140,000 $ 70,000

Depreciation adjustment $ 30,000 $ 30,000

Adjusted basis $180,000 $140,000 $ 40,000

Realized gain $180,000 $100,000 $ 80,000

Gain excluded under § 121 $150,000 $100,000 $ 50,000

Gain deferred under § 1031 $ 30,000 $ 30,000

(iv) C’s basis in the replacement residentialproperty is the fair market value of the replacementresidential property at the time of the exchange($240,000). C’s basis in the replacement businessproperty is $90,000, which is equal to C’s basis inthe relinquished business property at the time of theexchange ($40,000), increased by the gain excludedunder § 121 attributable to the relinquished businessproperty ($50,000). See section 4.03 of this revenueprocedure.

Example 4. (i) The facts are the same as in Exam-ple 3 except that C also receives $10,000 of cash inthe exchange and the fair market value of the replace-

ment business property is $110,000, which is $10,000less than the fair market value of the business portionof the relinquished property ($120,000).

(ii) Under § 121, C may exclude the gain of$100,000 allocable to the residential portion of thehouse (2/3 of $360,000 amount realized, or $240,000,minus 2/3 of $210,000 basis, or $140,000).

(iii) The remaining gain of $80,000 (1/3 of$360,000 amount realized, or $120,000, minus$40,000 adjusted basis) is allocable to the businessportion of the house. Under section 4.02(1) of thisrevenue procedure, C applies § 121 to exclude gainbefore applying the nonrecognition rules of § 1031.

Under § 1.121–1(e), C may exclude $50,000 of thegain allocable to the business portion of the housebut may not exclude the $30,000 of gain attributableto depreciation deductions. Under section 4.02(2)of this revenue procedure, C may defer the $30,000of gain under § 1031. Although C receives $10,000of cash (boot) in the exchange, C is not required torecognize gain because the boot is taken into accountfor purposes of § 1031(b) only to the extent the bootexceeds the amount of excluded gain attributable tothe relinquished business property. See 4.02(3) ofthis revenue procedure.

These results are illustrated as follows:

Total property 2/3 residential property 1/3 business property

Amount realized $360,000 $240,000 $110,000 + 10,000

Basis $210,000 $140,000 $ 70,000

Depreciation adjustment $ 30,000 $ 30,000

Adjusted basis $180,000 $140,000 $ 40,000

Realized gain $180,000 $100,000 $ 80,000

Gain excluded under § 121 $150,000 $100,000 $ 50,000

Gain deferred under § 1031 $ 30,000 $ 30,000

(iv) C’s basis in the replacement residentialproperty is the fair market value of the replacementresidential property at the time of the exchange($240,000). C’s basis in the replacement businessproperty is $80,000, which is equal to C’s basis in therelinquished business property ($40,000), increasedby the gain excluded under § 121 ($50,000), andreduced by the cash ($10,000) received. See section4.03 of this revenue procedure.

Example 5. (i) The facts are the same as in Ex-ample 3 except that the total fair market value of thereplacement properties is $540,000. The fair market

value of the replacement residence is $360,000, thefair market value of the replacement business prop-erty is $180,000, and C realizes gain of $360,000 onthe exchange.

(ii) Under § 121, C may exclude the gain of$220,000 allocable to the residential portion of thehouse (2/3 of $540,000 amount realized, or $360,000,minus 2/3 of $210,000 basis, or $140,000).

(iii) The remaining gain of $140,000 (1/3 of$540,000 amount realized, or $180,000, minus$40,000 adjusted basis) is allocable to the businessportion of the house. Under section 4.02(1) of this

revenue procedure, C excludes the gain before ap-plying the nonrecognition rules of § 1031. Under§ 1.121–1(e), C may exclude $30,000 of the gainallocable to the business portion, at which point Cwill have excluded the maximum limitation amountof $250,000. C may defer the remaining gain of$110,000 ($140,000 realized gain minus the $30,000gain excluded under § 121), including the $30,000gain attributable to depreciation, under § 1031.

These results are illustrated as follows:

February 14, 2005 531 2005–7 I.R.B.

Total property 2/3 residential property 1/3 business property

Amount realized $540,000 $360,000 $180,000

Basis $210,000 $140,000 $ 70,000

Depreciation adjustment $ 30,000 $ 30,000

Adjusted basis $180,000 $140,000 $ 40,000

Realized gain $360,000 $220,000 $140,000

Gain excluded under § 121 $250,000 $220,000 $ 30,000

Gain deferred under § 1031 $110,000 $110,000

(iv) C’s basis in the replacement residentialproperty is the fair market value of the replacementresidential property at the time of the exchange($360,000). C’s basis in the replacement businessproperty is $70,000, which is equal to C’s basis inthe relinquished business property ($40,000), in-creased by the amount of the gain excluded under§ 121 ($30,000). See section 4.03 of this revenueprocedure.

Example 6. (i) The facts are the same as in Ex-ample 3 except that the total fair market value of the

replacement properties is $750,000. The fair marketvalue of the replacement residence is $500,000, thefair market value of the replacement business prop-erty is $250,000, and C realizes gain of $570,000 onthe exchange.

(ii) The gain allocable to the residential portionis $360,000 (2/3 of $750,000 amount realized, or$500,000, minus 2/3 of $210,000 basis, or $140,000).C may exclude gain of $250,000 from gross incomeunder § 121. C must include in income the gain

of $110,000 allocable to the residential portion thatexceeds the § 121(b) exclusion limitation amount.

(iii) The remaining gain of $210,000 (1/3 of$750,000 amount realized, or $250,000, minus$40,000 adjusted basis) is allocable to the businessportion of the house. C may defer the $210,000of gain, including the $30,000 gain attributable todepreciation, under § 1031.

These results are illustrated as follows:

Total property 2/3 residential property 1/3 business property

Amount realized $750,000 $500,000 $250,000

Basis $210,000 $140,000 $ 70,000

Depreciation adjustment $ 30,000 $ 30,000

Adjusted basis $180,000 $140,000 $ 40,000

Realized gain $570,000 $360,000 $210,000

Gain excluded under § 121 $250,000 $250,000

Gain deferred under § 1031 $210,000 $210,000

Gain recognized $110,000 $110,000

(iv) C’s basis in the replacement residentialproperty is the fair market value of the replacementresidential property at the time of the exchange($500,000). C’s basis in the replacement businessproperty is $40,000, which is equal to C’s basis inthe relinquished business property at the time of theexchange.

SECTION 6. EFFECTIVE DATE

This revenue procedure is effective Jan-uary 27, 2005. However, taxpayers may

apply this revenue procedure in taxableyears for which the period of limitation onrefund or credit under § 6511 has not ex-pired.

DRAFTING INFORMATION

The principal author of this revenueprocedure is Sara Paige Shepherd of theOffice of Associate Chief Counsel (In-come Tax & Accounting). For further

information regarding this revenue pro-cedure, contact Ms. Shepherd at (202)622–4960 (not a toll-free call).

2005–7 I.R.B. 532 February 14, 2005

Part IV. Items of General InterestAmendment of PreviouslyProposed Regulations andNotice of Public Hearing

Statutory Mergers andConsolidations

REG–117969–00

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Amendment of previously pro-posed regulations and notice of publichearing.

SUMMARY: This document amends pre-viously proposed regulations published inthe Federal Register on January 24, 2003(REG–126485–01, 2003–1 C.B. 542, 68FR 3477) by cross-reference to temporaryregulations. Those regulations define theterm statutory merger or consolidation asthat term is used in section 368(a)(1)(A).This notice of proposed rulemaking affectscorporations engaging in mergers and con-solidations and their shareholders. It is be-ing issued concurrently with proposed reg-ulations under sections 358, 367, and 884.(See REG–125628–01 in this issue of theBulletin).

DATES: Written and electronic commentsand requests to speak and outlines of top-ics to be discussed at the public hearingscheduled for May 19, 2005, to be held inthe IRS Auditorium (7th Floor) must be re-ceived by April 28, 2005.

ADDRESSES: Send submissions toCC:PA:LPD:PR (REG–117969–00),Room 5203, Internal Revenue Ser-vice, POB 7604, Ben Franklin Sta-tion, Washington, DC 20044. Submis-sions may be hand delivered Mondaythrough Friday between the hours of8 a.m. and 4 p.m. to: CC:PA:LPD:PR(REG–117969–00), Courier’s Desk, In-ternal Revenue Service, 1111 ConstitutionAvenue, NW, Washington, DC, or sentelectronically, via the IRS Internet site atwww.irs.gov/regs or via the Federal eRule-making Portal at www.regulations.gov(IRS-REG–117969–00). The public hear-ing will be held in the IRS Auditorium (7th

Floor), Internal Revenue Building, 1111

Constitution Avenue, NW, Washington,DC.

FOR FURTHER INFORMATIONCONTACT: Concerning the proposed reg-ulations, Vincent Daly, (202) 622–7770;concerning submissions, the hearing, orplacement on the building access list toattend the hearing, Robin Jones, (202)622–7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background and Explanation ofProvisions

Before 1934, the term merger, as usedin the reorganization provisions, includedstatutory mergers as well as other combi-nations of corporate entities. In 1934, Con-gress amended the definition of a reorga-nization to provide separately for statutorymergers or consolidations and for the othertypes of transactions previously includedin the definition of a merger. There is noindication in the legislative history of the1934 changes to the definition of a reorga-nization that Congress intended to excludetransactions effected under foreign law.

In 1935, Treasury regulations inter-preted the term statutory merger underthe revised provision to mean a mergeror consolidation effected pursuant to thecorporation laws of a State or Territoryor the District of Columbia. The require-ment that the transaction be effected underdomestic law remains in place, with mi-nor variations. The Treasury Departmentand IRS believe that this interpretationis reasonable; nevertheless, the TreasuryDepartment and IRS believe that a re-examination is warranted in light of thepurposes of the statute and changes indomestic and foreign law since 1935.

The states have revised their laws to of-fer a greater variety of business entitiesand greater flexibility in effecting busi-ness combinations. Accordingly, the Trea-sury Department and IRS thought it ad-visable to define a merger or consolida-tion functionally, to supplement the refer-ence to state law. Accordingly, the Trea-sury Department and IRS developed andproposed such a functional definition in2003. See Notice of Proposed Rulemak-ing (REG–126485–01, 2003–1 C.B. 542

[68 FR 3477]), cross-referencing tempo-rary regulations (T.D. 9038, 2003–1, C.B.524 [68 FR 3384]) (January 24, 2003).

Many foreign jurisdictions now havemerger or consolidation statutes that op-erate in material respects like those of thestates, i.e., all assets and liabilities moveby operation of law. The Treasury De-partment and IRS believe that transactionseffected pursuant to these statutes shouldbe treated as reorganizations if they satisfythe functional criteria applicable to trans-actions under domestic statutes.

This document proposes a revised def-inition of a statutory merger or consolida-tion. The previously proposed definitionof a statutory merger required that it be atransaction effected “pursuant to the lawsof the United States or a State or the Dis-trict of Columbia.” See REG–126485–01(2003–1 C.B. 542 [68 FR 3477]). Thenew proposed definition contained in thisdocument replaces the quoted languagewith “pursuant to the statute or statutesnecessary to effect the merger or con-solidation.” This proposed change wouldallow a transaction effected pursuant tothe statutes of a foreign jurisdiction or ofa United States possession to qualify asa statutory merger or consolidation undersection 368(a)(1)(A), provided it other-wise qualifies as a reorganization. Thephrase statute or statutes is not intendedto prevent transactions effected pursuantto legislation from qualifying as mergersor consolidations where such legislationis supplemented by administrative or caselaw.

This notice of proposed rule-making also proposes to remove§1.368–2(b)(1)(iii) of the previously pro-posed regulations. That section imposeslimitations on the use of disregarded enti-ties in statutory mergers or consolidationswhen certain entities are not organizedunder the laws of the United States or aState or the District of Columbia.

Although this document revises theterms of the proposed definition of a statu-tory merger or consolidation for purposesof section 368, the provisions of the tem-porary regulations will remain in effectuntil this proposal is incorporated in tem-porary or final regulations after notice andcomment.

February 14, 2005 533 2005–7 I.R.B.

Section 1.368–2(b)(1)(B)(iv), Exam-ples 1 and 2 in the previously proposedregulations each specified that one ofthe parties to the transaction describedin the example “is not treated as own-ing any assets of an entity that is dis-regarded as an entity separate from itsowner for Federal tax purposes.” Theresults in those examples would be thesame in each case whether or not a partyto the transaction held such assets. See§1.368–2(b)(1)(B)(iv), Example 3 in thepreviously proposed regulations. To avoidany possible implication to the contrary,the Treasury Department and IRS proposeremoval of the sentence specifying thatcondition from each example. The Trea-sury Department and IRS are continuingto study other comments received on theearlier proposed regulations.

A notice of proposed rulemakingproposing amendments to the regulationsunder sections 358, 367, and 884 (includ-ing special rules for determining basis andholding period in certain transactions in-volving one or more foreign corporations)is being published simultaneously withthe publication of this notice of proposedrulemaking. See REG–125628–01 in thisissue of the Bulletin.

Proposed Effective Date

These regulations are proposed to applyto transactions occurring after the date fi-nal regulations are published in the Fed-eral Register.

Special Analyses

It has been determined that this noticeof proposed rulemaking is not a significantregulatory action as defined in ExecutiveOrder 12866. Therefore, a regulatory as-sessment is not required. It also has beendetermined that section 553(b) of the Ad-ministrative Procedure Act (5 U.S.C. chap-ter 5) does not apply to these regulations.Because the regulations do not impose acollection of information on small entities,the Regulatory Flexibility Act (5 U.S.C.chapter 6) does not apply. Pursuant to sec-tion 7805(f) of the Internal Revenue Code,this notice of proposed rulemaking will besubmitted to the Chief Counsel for Advo-cacy of the Small Business Administrationfor comment on its impact on small busi-ness.

Comments and Public Hearing

Before these proposed regulations areadopted as final regulations, considerationwill be given to any written comments(a signed original and eight (8) copies)or electronic comments that are submittedtimely to the IRS. The IRS and TreasuryDepartment specifically request commentson the clarity of the proposed regulationsand on how they can be made easier to un-derstand. All comments will be availablefor public inspection and copying.

A public hearing has been scheduled forMay 19, 2005, beginning at 10 a.m. in theIRS Auditorium (7th Floor), Internal Rev-enue Building, 1111 Constitution Avenue,NW, Washington, DC. Due to building se-curity procedures, visitors must enter at theConstitution Avenue entrance. In addition,all visitors must present photo identifica-tion to enter the building. Because of ac-cess restrictions, visitors will not be ad-mitted beyond the immediate entrance areamore than 30 minutes before the hearingstarts. For information about having yourname placed on the building access listto attend the hearing, see the FOR FUR-THER INFORMATION CONTACT por-tion of this preamble.

The rules of 26 CFR 601.601(a)(3) ap-ply to the hearing. Persons who wish topresent oral comments must submit writ-ten or electronic comments and an out-line of the topics to be discussed and thetime to be devoted to each topic (a signedoriginal and eight (8) copies) by April 28,2005. A period of 10 minutes will beallotted to each person for making com-ments. An agenda showing the schedulingof the speakers will be prepared after thedeadline for receiving outlines has passed.Copies of the agenda will be available freeof charge at the hearing.

Drafting Information

The principal author of these regula-tions is Vincent Daly, Office of the As-sociate Chief Counsel (Corporate). How-ever, other personnel from the IRS andTreasury Department participated in theirdevelopment.

* * * * *

Proposed Amendments to theRegulations

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

PART 1—INCOME TAXES

Paragraph 1. The authority citation forpart 1 continues to read, in part, as follows:

Authority: 26 U.S.C. 7805 * * *Par. 2. Paragraph (b)(1) of §1.368–2

as proposed on January 24, 2003, at 68 FR3477, is proposed to be revised to read asfollows:

§1.368–2 Definition of terms.

* * * * *(b)(1)(i) Definitions. The following

definitions apply for purposes of this para-graph (b)(1):

(A) Disregarded entity. A disregardedentity is a business entity (as defined in§301.7701–2(a) of this chapter) that isdisregarded as an entity separate from itsowner for Federal tax purposes. Examplesof disregarded entities include a domesticsingle member limited liability companythat does not elect to be classified as acorporation for Federal tax purposes, acorporation (as defined in §301.7701–2(b)of this chapter) that is a qualified REITsubsidiary (within the meaning of section856(i)(2)), and a corporation that is a qual-ified subchapter S subsidiary (within themeaning of section 1361(b)(3)(B)).

(B) Combining entity. A combining en-tity is a business entity that is a corporation(as defined in §301.7701–2(b) of this chap-ter) that is not a disregarded entity.

(C) Combining unit. A combining unitis composed solely of a combining entityand all disregarded entities, if any, the as-sets of which are treated as owned by suchcombining entity for Federal tax purposes.

(ii) Statutory merger or consolida-tion generally. For purposes of section368(a)(1)(A), a statutory merger or consol-idation is a transaction effected pursuantto the statute or statutes necessary to ef-fect the merger or consolidation, in whichtransaction, as a result of the operationof such statute or statutes, the followingevents occur simultaneously at the effec-tive time of the transaction—

(A) All of the assets (other than thosedistributed in the transaction) and liabili-ties (except to the extent satisfied or dis-

2005–7 I.R.B. 534 February 14, 2005

charged in the transaction) of each mem-ber of one or more combining units (eacha transferor unit) become the assets and li-abilities of one or more members of oneother combining unit (the transferee unit);and

(B) The combining entity of each trans-feror unit ceases its separate legal exis-tence for all purposes; provided, however,that this requirement will be satisfied evenif, under applicable law, after the effectivetime of the transaction, the combining en-tity of the transferor unit (or its officers,directors, or agents) may act or be actedagainst, or a member of the transferee unit(or its officers, directors, or agents) mayact or be acted against in the name ofthe combining entity of the transferor unit,provided that such actions relate to assetsor obligations of the combining entity ofthe transferor unit that arose, or relate toactivities engaged in by such entity, priorto the effective time of the transaction, andsuch actions are not inconsistent with therequirements of paragraph (b)(1)(ii)(A) ofthis section.

(iii) Examples. The following examplesillustrate the rules of paragraph (b)(1) ofthis section. In each of the examples, ex-cept as otherwise provided, each of V, Y,and Z is a C corporation. X is a limited li-ability company. Except as otherwise pro-vided, X is wholly owned by Y and is dis-regarded as an entity separate from Y forFederal tax purposes. The examples are asfollows:

Example 1. Divisive transaction pursuant to amerger statute. (i) Under State W law, Z transferssome of its assets and liabilities to Y, retains the re-mainder of its assets and liabilities, and remains inexistence following the transaction. The transactionqualifies as a merger under State W corporate law.

(ii) The transaction does not satisfy the require-ments of paragraph (b)(1)(ii)(A) of this section be-cause all of the assets and liabilities of Z, the com-bining entity of the transferor unit, do not become theassets and liabilities of Y, the combining entity andsole member of the transferee unit. In addition, thetransaction does not satisfy the requirements of para-graph (b)(1)(ii)(B) of this section because the sepa-rate legal existence of Z does not cease for all pur-poses. Accordingly, the transaction does not qualifyas a statutory merger or consolidation under section368(a)(1)(A).

Example 2. Merger of a target corporation into adisregarded entity in exchange for stock of the owner.(i) Under State W law, Z merges into X. Pursuant tosuch law, the following events occur simultaneouslyat the effective time of the transaction: all of the as-sets and liabilities of Z become the assets and liabil-ities of X and Z’s separate legal existence ceases for

all purposes. In the merger, the Z shareholders ex-change their stock of Z for stock of Y.

(ii) The transaction satisfies the requirements ofparagraph (b)(1)(ii) of this section because the trans-action is effected pursuant to State W law and thefollowing events occur simultaneously at the effec-tive time of the transaction: all of the assets and li-abilities of Z, the combining entity and sole memberof the transferor unit, become the assets and liabil-ities of one or more members of the transferee unitthat is comprised of Y, the combining entity of thetransferee unit, and X, a disregarded entity the assetsof which Y is treated as owning for Federal tax pur-poses, and Z ceases its separate legal existence for allpurposes. Accordingly, the transaction qualifies as astatutory merger or consolidation for purposes of sec-tion 368(a)(1)(A).

Example 3. Merger of a target S corporation thatowns a QSub into a disregarded entity. (i) The factsare the same as in Example 2, except that Z is an Scorporation and owns all of the stock of U, a QSub.

(ii) The deemed formation by Z of U pursuantto §1.1361–5(b)(1) (as a consequence of the termi-nation of U’s QSub election) is disregarded for Fed-eral income tax purposes. The transaction is treatedas a transfer of the assets of U to X, followed by X’stransfer of these assets to U in exchange for stockof U. See §1.1361–5(b)(3), Example 9. The transac-tion will, therefore, satisfy the requirements of para-graph (b)(1)(ii) of this section because the transac-tion is effected pursuant to State W law and the fol-lowing events occur simultaneously at the effectivetime of the transaction: all of the assets and liabili-ties of Z and U, the sole members of the transferorunit, become the assets and liabilities of one or moremembers of the transferee unit that is comprised of Y,the combining entity of the transferee unit, and X, adisregarded entity the assets of which Y is treated asowning for Federal tax purposes, and Z ceases its sep-arate legal existence for all purposes. Moreover, thedeemed transfer of the assets of U in exchange for Ustock does not cause the transaction to fail to qualifyas a statutory merger or consolidation. See section368(a)(2)(C). Accordingly, the transaction qualifiesas a statutory merger or consolidation for purposes ofsection 368(a)(1)(A).

Example 4. Triangular merger of a target corpo-ration into a disregarded entity. (i) The facts are thesame as in Example 2, except that V owns 100 per-cent of the outstanding stock of Y and, in the mergerof Z into X, the Z shareholders exchange their stockof Z for stock of V. In the transaction, Z transfers sub-stantially all of its properties to X.

(ii) The transaction is not prevented from qualify-ing as a statutory merger or consolidation under sec-tion 368(a)(1)(A), provided the requirements of sec-tion 368(a)(2)(D) are satisfied. Because the assets ofX are treated for Federal tax purposes as the assets ofY, Y will be treated as acquiring substantially all ofthe properties of Z in the merger for purposes of deter-mining whether the merger satisfies the requirementsof section 368(a)(2)(D). As a result, the Z sharehold-ers that receive stock of V will be treated as receivingstock of a corporation that is in control of Y, the com-bining entity of the transferee unit that is the acquir-ing corporation for purposes of section 368(a)(2)(D).Accordingly, the merger will satisfy the requirementsof section 368(a)(2)(D).

Example 5. Merger of a target corporation into adisregarded entity owned by a partnership. (i) Thefacts are the same as in Example 2, except that Yis organized as a partnership under the laws of StateW and is classified as a partnership for Federal taxpurposes.

(ii) The transaction does not satisfy the require-ments of paragraph (b)(1)(ii)(A) of this section. Allof the assets and liabilities of Z, the combining entityand sole member of the transferor unit, do not becomethe assets and liabilities of one or more members ofa transferee unit because neither X nor Y qualifies asa combining entity. Accordingly, the transaction can-not qualify as a statutory merger or consolidation forpurposes of section 368(a)(1)(A).

Example 6. Merger of a disregarded entity into acorporation. (i) Under State W law, X merges into Z.Pursuant to such law, the following events occur si-multaneously at the effective time of the transaction:all of the assets and liabilities of X (but not the assetsand liabilities of Y other than those of X) become theassets and liabilities of Z and X’s separate legal exis-tence ceases for all purposes.

(ii) The transaction does not satisfy the require-ments of paragraph (b)(1)(ii)(A) of this section be-cause all of the assets and liabilities of a transferorunit do not become the assets and liabilities of one ormore members of the transferee unit. The transactionalso does not satisfy the requirements of paragraph(b)(1)(ii)(B) of this section because X does not qual-ify as a combining entity. Accordingly, the transac-tion cannot qualify as a statutory merger or consoli-dation for purposes of section 368(a)(1)(A).

Example 7. Merger of a corporation into a dis-regarded entity in exchange for interests in the disre-garded entity. (i) Under State W law, Z merges intoX. Pursuant to such law, the following events occursimultaneously at the effective time of the transac-tion: all of the assets and liabilities of Z become theassets and liabilities of X and Z’s separate legal exis-tence ceases for all purposes. In the merger of Z intoX, the Z shareholders exchange their stock of Z for in-terests in X so that, immediately after the merger, X isnot disregarded as an entity separate from Y for Fed-eral tax purposes. Following the merger, pursuant to§301.7701–3(b)(1)(i) of this chapter, X is classifiedas a partnership for Federal tax purposes.

(ii) The transaction does not satisfy the require-ments of paragraph (b)(1)(ii)(A) of this sectionbecause immediately after the merger X is notdisregarded as an entity separate from Y and, con-sequently, all of the assets and liabilities of Z, thecombining entity of the transferor unit, do not becomethe assets and liabilities of one or more members of atransferee unit. Accordingly, the transaction cannotqualify as a statutory merger or consolidation forpurposes of section 368(a)(1)(A).

Example 8. Merger transaction preceded by dis-tribution. (i) Z operates two unrelated businesses,Business P and Business Q, each of which represents50 percent of the value of the assets of Z. Y desires toacquire and continue operating Business P, but doesnot want to acquire Business Q. Pursuant to a sin-gle plan, Z sells Business Q for cash to parties unre-lated to Z and Y in a taxable transaction, and then dis-tributes the proceeds of the sale pro rata to its share-holders. Then, pursuant to State W law, Z merges intoY. Pursuant to such law, the following events occur si-multaneously at the effective time of the transaction:

February 14, 2005 535 2005–7 I.R.B.

all of the assets and liabilities of Z related to BusinessP become the assets and liabilities of Y and Z’s sep-arate legal existence ceases for all purposes. In themerger, the Z shareholders exchange their Z stock forY stock.

(ii) The transaction satisfies the requirements ofparagraph (b)(1)(ii) of this section because the trans-action is effected pursuant to State W law and the fol-lowing events occur simultaneously at the effectivetime of the transaction: all of the assets and liabil-ities of Z, the combining entity and sole member ofthe transferor unit, become the assets and liabilities ofY, the combining entity and sole member of the trans-feree unit, and Z ceases its separate legal existence forall purposes. Accordingly, the transaction qualifiesas a statutory merger or consolidation for purposes ofsection 368(a)(1)(A).

Example 9. Transaction effected pursuant to for-eign statutes. (i) Z and Y are entities organized underthe laws of Country Q and classified as corporationsfor Federal tax purposes. Z and Y combine. Pursuantto statutes of Country Q the following events occursimultaneously: all of the assets and liabilities of Zbecome the assets and liabilities of Y and Z’s sepa-rate legal existence ceases for all purposes.

(ii) The transaction satisfies the requirements ofparagraphs (b)(1)(ii) of this section because the trans-action is effected pursuant to statutes of Country Qand the following events occur simultaneously at theeffective time of the transaction: all of the assetsand liabilities of Z, the combining entity of the trans-feror unit, become the assets and liabilities of Y, thecombining entity and sole member of the transfereeunit, and Z ceases its separate legal existence for allpurposes. Accordingly, the transaction qualifies as astatutory merger or consolidation for purposes of sec-tion 368(a)(1)(A).

(iv) Effective dates. This paragraph(b)(1) applies to transactions occurring af-ter the date these regulations are publishedas final regulations in the Federal Regis-ter. For rules regarding statutory merg-ers or consolidations on or after January24, 2003, and before these regulations arepublished as final regulations in the Fed-eral Register, see §1.368–2T(b)(1). Forrules regarding statutory mergers or con-solidations before January 24, 2003, see§1.368–2(b)(1) as it applies before January24, 2003 (see 26 CFR part 1, revised April1, 2002).

* * * * *

Mark E. Matthews,Deputy Commissioner forServices and Enforcement.

(Filed by the Office of the Federal Register on January 4,2005, 8:45 a.m., and published in the issue of the FederalRegister for January 5, 2005, 70 F.R. 746)

Notice of ProposedRulemaking

Revision of Income TaxRegulations Under Sections358, 367, and 884 DealingWith Statutory Mergers orConsolidations Under Section368(a)(1)(A) Involving One orMore Foreign Corporations

REG–125628–01

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Notice of proposed rulemaking.

SUMMARY: This document containsproposed regulations amending the in-come tax regulations under various pro-visions of the Internal Revenue Code(Code) to account for statutory merg-ers and consolidations under section368(a)(1)(A) (including reorganizationsdescribed in section 368(a)(2)(D) and (E))involving one or more foreign corpora-tions. These proposed regulations areissued concurrently with proposed reg-ulations (REG–117969–00) that wouldamend the definition of a reorganizationunder section 368(a)(1)(A) to include cer-tain statutory mergers or consolidationseffected pursuant to foreign law.

DATES: Written and electronic com-ments and requests to speak and outlines oftopics to be discussed at the public hearingscheduled for May 19, 2005, at 10:00 a.m.must be received by April 28, 2005.

ADDRESSES: Send submissions to:CC:PA:LPD:PR (REG–125628–01), room5203, Internal Revenue Service, P.O. Box7604, Ben Franklin Station, Washing-ton, DC 20044. Submissions may behand delivered Monday through Fridaybetween the hours of 8 a.m. and 4 p.m.to: CC:PA:LPD:PR (REG–125628–01),Courier’s Desk, Internal Revenue Service,1111 Constitution Avenue, NW, Wash-ington, DC, or sent electronically, via theIRS Internet site at: www.irs.gov/regsor via the Federal eRulemaking Por-tal at www.regulations.gov (IRS andREG–125628–01). The public hearingwill be held in the Auditorium, Internal

Revenue Building, 1111 Constitution Av-enue, NW, Washington, DC.

FOR FURTHER INFORMATIONCONTACT: Concerning the pro-posed regulations, Robert W. Lorence,Jr., (202) 622–3860; concerning submis-sions, the hearing, or placement on thebuilding access list to attend the hear-ing, Guy Traynor, (202) 622–7180 (nottoll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information containedin this notice of proposed rulemaking hasbeen submitted to the Office of Manage-ment and Budget for review in accordancewith the Paperwork Reduction Act (44U.S.C. 3507(d)). Comments on the col-lection of information should be sent to theOffice of Management and Budget, Attn:Desk Officer for the Department of theTreasury, Office of Information and Reg-ulatory Affairs, Washington, DC 20503,with copies to the Internal Revenue Ser-vice, Attn: IRS Reports Clearance Officer,SE:W:CAR:MP:T:T:SP, Washington, DC20224. Comments on the collection of in-formation should be received no later thanMarch 7, 2005. Comments are specificallyrequested concerning:

Whether the proposed collection of in-formation is necessary for the proper per-formance of the functions of the IRS, in-cluding whether the information will havepractical utility;

The accuracy of the estimated burdenassociated with the proposed collection ofinformation (see below);

How the quality, utility, and clarity ofthe information to be collected may be en-hanced;

How the burden of complying with theproposed collection of information can beminimized, including through the appli-cation of automated collection techniquesor other forms of information technology;and

Estimates of capital or start-up costsand costs of operation, maintenance, andpurchase of services to provide informa-tion.

The collection of informationin this proposed regulation is in§1.367(a)–3(d)(2)(vi)(B)(1)(ii). This in-formation is required to inform the IRS

2005–7 I.R.B. 536 February 14, 2005

of a domestic corporation that is claimingan exception from the application of sec-tion 367(a) and (d) to certain transfers ofproperty to a foreign corporation that isre-transferred by the foreign corporationto a domestic corporation controlled bythe foreign corporation. The informationis in the form of a statement attached to thedomestic corporation’s U.S. income taxreturn for the year of the transfer certifyingthat if the foreign corporation disposes ofthe stock of the domestic controlled cor-poration with a tax avoidance purpose, thedomestic corporation will file an incometax return (or amended return, as the casemay be) reporting gain. The collectionof information is mandatory. The likelyrespondents are domestic corporations.

Estimated total annual reporting bur-den: 50 hours.

Estimated average annual burden hoursper respondent: 1 hour.

Estimated number of respondents: 50.Estimated annual frequency of re-

sponses: on occasion.An agency may not conduct or sponsor,

and a person is not required to respond to, acollection of information unless it displaysa valid control number assigned by the Of-fice of Management and Budget.

Books or records relating to a collectionof information must be retained as longas their contents may become material inthe administration of any internal revenuelaw. Generally, tax returns and tax returninformation are confidential, as requiredby 26 U.S.C. 6103.

Background

Section 368(a)(1)(A) defines a reorga-nization to include a statutory mergeror consolidation (A reorganization).For transactions completed before Jan-uary 24, 2003, regulations under section368(a)(1)(A) provided that a reorganiza-tion was a merger or consolidation effectedpursuant to the corporation law of theUnited States or a State or Territory or theDistrict of Columbia. See §1.368–2(b)(1),as in effect before January 24, 2003.

On January 24, 2003, the IRS and theTreasury Department issued proposed reg-ulations (REG–126485–01, 2003–1 C.B.542 [68 FR 3477]) and temporary regula-tions (T.D. 9038, 2003–1 C.B. 524 [68 FR3384]), revising the definition of a statu-tory merger or consolidation. The pro-

posed and temporary regulations define astatutory merger or consolidation in a man-ner intended to ensure that those transac-tions are not divisive in nature. Accord-ingly, the regulations generally require thatall the assets and liabilities of the mergedcorporation (other than assets distributedor liabilities discharged in the transaction)are transferred to the acquiring corporationand that the separate legal identity of themerged corporation ceases to exist in thetransaction.

Pursuant to a notice of proposed rule-making (proposed section 368 regula-tions) published contemporaneously withthis document, the IRS and Treasury areproposing further revisions to the defini-tion of a statutory merger or consolidationto take into account those transactionseffected pursuant to foreign law. The pro-posed section 368 regulations amend the2003 proposed regulations and providethat an A reorganization may occur, if cer-tain conditions are satisfied, pursuant tothe laws of a foreign jurisdiction, includ-ing a U.S. possession.

In light of this change, this documentcontains proposed amendments to the reg-ulations under certain international Codeprovisions (sections 367, 884, and 6038B)to account for statutory mergers and con-solidations involving one or more foreigncorporations. Current international taxregulations are premised on an A reor-ganization being limited to a statutorymerger or consolidation involving do-mestic corporations effected pursuant todomestic law. See, e.g., Rev. Rul. 57–465,1957–2 C.B. 250. As a result, conformingchanges must be made to these interna-tional tax regulations to ensure that theyapply appropriately to statutory mergersand consolidations effected pursuant toforeign law. The proposed regulationsalso modify the section 367(a) and (b)regulations to address several other relatedissues.

Explanation of Provisions

A. Basis and Holding Period Rules

The proposed regulations provide basisand holding period rules for certain trans-actions involving foreign corporationswith section 1248 shareholders in order topreserve relevant section 1248 amounts. Asection 1248 shareholder is a U.S. person

that satisfies the ownership requirementsof section 1248(a) with respect to a foreigncorporation. Section 1248(a) applies to aU.S. person that owns stock (directly, in-directly, or constructively) with 10 percentor more of the voting power in the foreigncorporation at any time during the 5-yearperiod ending on the sale or exchange ofthe stock when the foreign corporation wasa controlled foreign corporation (CFC).Gain recognized by a section 1248 share-holder on the sale or exchange of stockof the foreign corporation is included ingross income as a dividend to the extent ofthe earnings and profits of the foreign cor-poration that are attributable to the stocksold or exchanged and that were accumu-lated while the stock was held by the U.S.person when the foreign corporation wasa CFC (the section 1248 amount).

The IRS and Treasury believe thatit is important to preserve section 1248amounts in certain nonrecognition ex-changes of foreign corporation stock.Preservation of section 1248 amounts is afunction of the holding period and basis inthe stock of the foreign corporation beingexchanged. One of the underlying policiesof section 367(b) is the preservation ofthe potential application of section 1248in connection with certain nonrecognitionexchanges. H. Rep. No. 94–658, 94th

Cong., 1st Sess., at 242 (Nov. 12, 1975).These proposed regulations provide ba-sis and holding period rules to preservesection 1248 amounts in the context ofcertain section 354 exchanges and certaintriangular reorganizations.

The basis and holding period rules ofthe proposed regulations also apply to aforeign corporate shareholder of a foreigncorporation that is a party to the reorgani-zation, provided that the foreign corporateshareholder has at least one U.S. personthat is a section 1248 shareholder with re-spect to the foreign corporate shareholderand to the foreign corporation. This ruleis necessary to preserve application of sec-tion 964(e) to the foreign corporate share-holder with respect to lower-tier foreigncorporations. Under section 964(e), if aCFC sells or exchanges stock in anotherforeign corporation, gain recognized onthe sale or exchange is included in the in-come of the CFC as a dividend to the sameextent that it would have been includedunder section 1248(a) if the CFC were aU.S. person. Such dividend income may

February 14, 2005 537 2005–7 I.R.B.

be treated as subpart F income that is in-cluded in the income of U.S. shareholdersof the CFC.

1. Section 354 exchanges

The proposed regulations apply to cer-tain section 354 exchanges involving for-eign corporations, including exchanges ofmultiple blocks of stock. The proposedregulations preserve the bases and hold-ing periods in different blocks of stock incertain foreign target corporations by re-quiring the exchanging shareholder to es-tablish the particular shares of stock thatwere received in exchange for shares ofa particular block of target stock. If theexchanging shareholder cannot establishthe particular shares of target stock thatwere received for shares of a particularblock of stock, then the shareholder mustdesignate which shares of stock were re-ceived in exchange for shares of a par-ticular block of stock, provided that thedesignation is consistent with the terms ofthe exchange. These tracing methods areused to determine the resulting tax con-sequences when stock received in a non-recognition exchange is subsequently soldor otherwise exchanged. If the exchangingshareholder cannot establish, and does notdesignate, the particular shares received,the shareholder is treated as selling or oth-erwise exchanging a share received in anonrecognition exchange for a share thatwas purchased or acquired at the earliesttime.

The IRS and Treasury recently pub-lished proposed section 358 regulations(REG–116564–03, 2004–20 I.R.B. 927)that determine the basis of stock or secu-rities received in section 354 exchanges(proposed section 358 regulations). Theproposed section 358 regulations gener-ally provide that the basis of each share ofstock or security received in an exchangeto which section 354, 355, or 356 applieswill be the same as the basis of the shareof stock or security exchanged therefor.For these purposes, the determination ofwhich share of stock or security is receivedin exchange for a particular share of stockor security is made in accordance with theterms of the exchange or distribution.

These proposed regulations apply theprinciples of the proposed section 358 reg-ulations to certain exchanges of stock ofa foreign corporation by either a section

1248 shareholder, or a foreign corporateshareholder where at least one U.S. personis a section 1248 shareholder with respectto such foreign corporate shareholder andto the foreign corporation whose shares areexchanged (collectively and individually,section 367(b) shareholder), to ensure thepreservation of section 1248 amounts. Theproposed regulations also include specificguidance on the shareholder’s holding pe-riod in the stock received in the section354 exchange. The proposed regulationsdo not, however, apply to distributions de-scribed in section 355.

Consistent with the proposed section358 regulations, the proposed regulationshereunder would not apply to section 351exchanges or to exchanges to which bothsection 351 and section 354 (or section356) apply, if, in addition to stock beingreceived, other property is received or lia-bilities are assumed. This limitation is in-tended to prevent a conflict between therules for determining basis in a section 351exchange (including the application of sec-tion 357(c)) and the rules proposed in thisdocument. The IRS and Treasury are con-sidering approaches for the preservation ofsection 1248 amounts in section 351 trans-actions in which liabilities are assumed orother property is received, and commentsare requested in this regard.

In addition, the IRS and Treasury areconsidering developing specific rules forsituations in which stock of the foreign ac-quiring corporation is not issued in the ex-change (for example, when the exchangingshareholder owns all the stock of the for-eign acquiring corporation). One possibleapproach may be for each existing share ofstock in that corporation to be divided intoportions to account for the different basisand holding periods of the stock of the for-eign acquiring corporation and the stock ofthe acquired corporation in order to pre-serve section 1248 amounts. Commentsare requested regarding this approach orpossible alternative approaches.

2. Triangular reorganizations

The proposed regulations provide spe-cial basis and holding period rules for tri-angular reorganizations where the merg-ing or surviving corporation is a foreigncorporation with a section 367(b) share-holder. These rules apply to reorganiza-tions described in section 368(a)(1)(A) and

(a)(2)(D) (forward triangular merger) andto parenthetical section 368(a)(1)(C) reor-ganizations. In these transactions, the sur-viving corporation (S) acquires substan-tially all the assets of the acquired corpora-tion (T), and the T shareholders exchangetheir T stock for stock of the corporation(P) that is in control (within the meaningof section 368(c)) of S. These rules alsoapply to reorganizations described in sec-tion 368(a)(1)(A) and (a)(2)(E) (reversetriangular merger). In a reverse triangu-lar merger, S, a controlled subsidiary of P,merges into T, the surviving corporation,and the T shareholders exchange their Tstock for stock of P.

Under current regulations, in a forwardtriangular merger or a parenthetical C re-organization, P’s basis in its S stock is ad-justed as if P had acquired the T assets di-rectly from T in a section 362(b) exchangeand then had transferred the T assets toS in a transaction in which P’s basis inS stock is determined under section 358.See §1.358–6(c)(1) (commonly referred toas the “over-the-top” basis rules). Undercurrent regulations, in a reverse triangu-lar merger, P’s basis in the T stock it re-ceives immediately after the transaction isequal to its basis in its S stock immedi-ately before the transaction adjusted as if Thad merged into S in a forward triangularmerger and the over-the-top basis rules hadapplied. See §1.358–6(c)(2). If a reversetriangular merger also qualifies as a section351 transfer or a section 368(a)(1)(B) reor-ganization, P can determine its basis in itsS stock either by using the over-the-top ba-sis rules as described in the prior sentenceor by treating P as if it had acquired the Tstock from the former shareholders of T ina transaction in which basis is determinedunder section 362(b) (carryover stock ba-sis).

The IRS and Treasury are concernedthat, in certain exchanges involving for-eign corporations, application of the over-the-top basis rules would not properly pre-serve the section 1248 or 964(e) amountswith respect to the stock of S or T. Theproposed regulations provide that, in de-termining the stock basis of the survivingcorporation in certain triangular reorgani-zations, outside stock basis will be usedinstead of inside asset basis pursuant to§1.358–6(c). For example, in the case ofa forward triangular merger (or a paren-thetical C reorganization), where P is a do-

2005–7 I.R.B. 538 February 14, 2005

mestic corporation, S is a foreign corpo-ration, T is a foreign corporation, and Thas a section 1248 shareholder, the basisand holding period in the T stock, not theT assets, are used to determine P’s basisin the S stock. The same rules apply tocertain reverse triangular mergers, whereS merges into T with T surviving. In thatcase, P’s basis in the T stock immediatelyafter the transaction would reflect the basisand holding period of the T stock instead ofthe T assets.

Under this stock basis approach for tri-angular reorganizations, the proposed reg-ulations provide for a divided basis andholding period in each share of stock inthe surviving corporation to reflect the rel-evant section 1248 amounts in the S stockand T stock. In particular, each share of Sstock in a forward triangular merger, andeach share of T stock in a reverse trian-gular merger, where P is a section 367(b)shareholder immediately after the transac-tion, is divided into portions reflecting thebasis and holding period of the S stock andthe T stock before the transaction. How-ever, the proposed regulations contain a deminimis exception to this rule. Under thisexception, if the value of the S stock im-mediately before the transaction is de min-imis (for example, where S is a corpora-tion formed to facilitate the transaction),then each share of the surviving corpora-tion is not divided; instead, the basis of theS stock is added to the basis of the stockof the surviving corporation held by P. Thevalue of the S stock would be de minimisfor this purpose if it is less than 1 percentof the value of the surviving corporation (Sor T) immediately after the transaction.

If there are two or more blocks of stockin T or S held by a section 367(b) share-holder immediately before the transaction,then each share of the surviving corpora-tion (S or T) is further divided to accountfor each block of stock. If two or moreblocks of stock are held by one or moreshareholders that are not section 367(b)shareholders, then shares in these blocksare aggregated into one divided portionfor basis purposes. If none of the S orT shareholders is a section 367(b) share-holder, then the over-the-top basis rules of§1.358–6 apply instead of the rules in theseproposed regulations.

The proposed regulations provide spe-cial rules when stock of the surviving cor-poration has a divided basis and holding

period. Earnings and profits accumulatedprior to the reorganization are attributedto a divided portion of a share of stockbased on the block of stock whose basisand holding period the divided portion re-flects. Post-reorganization earnings andprofits are attributed to each divided shareof stock pursuant to section 1248 and theregulations thereunder. The amount ofearnings and profits attributed to a dividedshare of stock pursuant to section 1248 arefurther attributed to a divided portion ofsuch share of stock based on its fair marketvalue in relation to the other divided por-tions. Finally, shares of stock are no longerdivided into separate portions if section1248 or 964(e) becomes inapplicable to asubsequent sale or exchange of the stock.

The special basis rules in these pro-posed regulations apply to all triangularreorganizations where T has at least onesection 367(b) shareholder, even if suchshareholders own less than a controllinginterest in T. The IRS and Treasury areconsidering whether the current basis rulesof §1.358–6 should apply in cases wheresection 367(b) shareholders do not own asubstantial percentage of the stock of T, orwhether taxpayers should be permitted toelect to apply the current basis rules un-der §1.358–6 to determine P’s basis in thestock of the surviving corporation (S orT), provided that all section 367(b) share-holders of T include in income the section1248 amounts with respect to the stock ex-changed. Comments are requested in thisregard.

The use of stock basis to determineP’s basis in the surviving corporation alsopresents administrative concerns when aportion of the stock of T is widely held. Inthe case of a reorganization described insection 368(a)(1)(B), which presents simi-lar issues, Rev. Proc. 81–70, 1981–2 C.B.729, provides that statistical samplingtechniques, if appropriate, are permittedto determine the basis of stock receivedby the acquiring corporation. In this re-gard, the IRS and Treasury recently haverequested comments whether Rev. Proc.81–70 should be revised to reflect changesin the marketplace since its publication.See Notice 2004–44, 2004–28 I.R.B. 32.Comments are requested on expandingthis guidance to apply under the proposedregulations, for example in cases whereblocks of T stock are held by persons thatare not section 367(b) shareholders and

such shares are aggregated into a singledivided portion for basis and holding pe-riod purposes.

B. Exceptions to the Application ofSection 367(a)

Under section 367(a), a U.S. person rec-ognizes gain, but not loss, on the transferof property to a foreign corporation in anexchange described in section 351, 354,356, or 361, unless an exception applies.Section 367(a), however, does not applyto a section 354 exchange by a U.S. per-son of: (1) stock of a foreign corporationin a section 368(a)(1)(E) reorganization; or(2) stock of a domestic or foreign corpora-tion for stock of a foreign corporation inan asset reorganization described in sec-tion 368(a)(1)(C), (D), or (F) that is nottreated as an indirect stock transfer under§1.367(a)–3(a).

The proposed regulations amend§1.367(a)–3(a) so that this exception to theapplication of section 367(a) also appliesto A reorganizations (including forwardand reverse triangular mergers). In ad-dition, the proposed regulations clarifythat §1.367(a)–3(a) applies to exchangesdescribed in section 356, as well as insection 354. Section 356 applies to an ex-change that would qualify as a section 354exchange except for the fact that money orother property is received in the exchange.

Taxpayers have questioned why the ex-ception to the application of section 367(a)in §1.367(a)–3(a) includes exchanges ofstock but not exchanges of securities insection 368(a)(1)(E) reorganizations andcertain asset reorganizations. The IRSand Treasury believe that it is appropri-ate to provide comparable treatment forexchanges of securities in this context. Ac-cordingly, Notice 2005–6, 2005–5 I.R.B.448), published contemporaneously withthese proposed regulations, announcesthat the IRS and Treasury intend to amend§1.367(a)–3(a) to apply the exception fromsection 367(a) to exchanges of stock orsecurities. Notice 2005–6 applies to trans-fers of securities after January 5, 2005.Taxpayers also may apply the provisionsof the notice to transfers of securities oc-curring on or after July 20, 1998, and onor before January 5, 2005. In applyingthis notice, however, taxpayers must do soconsistently to all transactions within itsscope.

February 14, 2005 539 2005–7 I.R.B.

The proposed regulations also providerules concerning the application of sec-tion 367(a) to reverse triangular mergers,where stock of P, a corporation that con-trols the merging corporation S, is treatedas transferred (along with any other prop-erty of S) to the surviving corporation T ina section 361 transfer. If S is a domesticcorporation and T is a foreign corporation,section 367(a) applies to the transfer by Sof the P stock to T, unless an exception ap-plies.

The IRS and Treasury believe that, ifthe stock of P is provided to S pursuantto the plan of reorganization, the section361 transfer of the P stock from S to Tshould not be subject to section 367(a), andthe proposed regulations so provide. If Pdoes not provide its stock to S pursuantto the plan of reorganization, then the Pstock will be treated as property of S andthe transfer of such stock will be subject tosection 367(a).

The IRS and Treasury intend to amendthe regulations under section 6038B toconform with the changes made in theseregulations.

C. Concurrent Application of Section367(a) and (b)

The proposed regulations modify thecurrent application of section 367(a) and(b) to transactions that require the inclu-sion in income of the all earnings and prof-its amount under section 367(b). Sec-tion 1.367(a)–3(b)(2) provides rules for theconcurrent application of section 367(a)and (b) to transfers of stock of a foreigncorporation. This may occur, for exam-ple, when a U.S. shareholder exchangesstock of a foreign corporation (foreign ac-quired corporation) for stock of anotherforeign corporation (foreign acquiring cor-poration). See §1.367(a)–3(b)(1). It mayalso occur when an acquiring corporation(foreign or domestic) acquires the assetsof a foreign acquired corporation, and theU.S. shareholder exchanges stock of theforeign acquired corporation for stock ofthe foreign parent of the acquiring corpo-ration in a triangular reorganization.

The U.S. person’s exchange of stock ofthe foreign acquired corporation for stockof either the foreign acquiring corporationor the foreign parent is subject to section367(a). See §1.367(a)–3(b) and (d). If theexchanging U.S. shareholder owns 5 per-

cent or more (by vote or value) of the stockof the foreign acquiring corporation or theforeign parent immediately after the ex-change, the shareholder recognizes gain, ifany, under section 367(a), unless the share-holder enters into a gain recognition agree-ment as provided in §1.367(a)–8. If theexchanging shareholder is not a 5-percentshareholder, then the exchanging share-holder does not recognize gain, if any, onthe exchange.

The U.S. shareholder’s exchange de-scribed above also may be subject tosection 367(b). If the exchanging U.S.shareholder is a section 1248 shareholderof the foreign acquired corporation, andthe stock of the foreign acquiring corpo-ration (or its foreign parent corporation)is not stock in a corporation that is aCFC as to which the U.S. shareholder isa section 1248 shareholder immediatelyafter the exchange, then the exchangingshareholder must include in income thesection 1248 amount with respect to thestock exchanged. See §1.367(b)–4. If,instead, a domestic acquiring corporationacquires the assets of a foreign acquiredcorporation, and the U.S. shareholderexchanges stock of the foreign acquiredcorporation for stock of the foreign parentof the acquiring corporation in a triangu-lar reorganization, then the exchangingshareholder must include in income the allearnings and profits amount with respectto the stock of the acquired corporation.See §1.367(b)–3. Unlike the section1248 amount, the all earnings and profitsamount is not limited by the shareholder’sgain inherent in the stock of the foreignacquired corporation.

In cases where section 367(a) and (b)apply concurrently to a transaction, exist-ing §1.367(a)–3(b)(2) provides that sec-tion 367(b) will not apply if the transfer istaxable under section 367(a). If the trans-fer is taxable under section 367(a), the ex-changing U.S. shareholder will recognizegain inherent in the exchanged stock (sub-ject to recharacterization as dividend in-come under section 1248). If the transfer isnot taxable under section 367(a), becausethe exchanging U.S. shareholder either isnot a 5-percent shareholder or enters intoa gain recognition agreement, then section367(b) applies and the exchange is subjectto either §1.367(b)–3 or 1.367(b)–4 at theshareholder level.

Questions with respect to the concur-rent application of section 367(a) and (b)have arisen in situations that otherwisewould require inclusion of the all earningsand profits amount under §1.367(b)–3.If the all earnings and profits amount isgreater than the section 367(a) gain withrespect to the stock of the foreign ac-quired corporation, under current law theexchanging shareholder effectively mayelect to be taxed on the lesser amount ofgain under section 367(a) simply by fail-ing to file a gain recognition agreement. Inthat case, section 367(b) would not applyand the shareholder would avoid inclusionin income of the greater all earnings andprofits amount.

The ability to elect to recognize thelesser gain inherent in the stock exchangedin such cases is inconsistent with the poli-cies of section 367(b) that apply to inboundtransactions, including preventing conver-sion of tax deferral into tax forgiveness andensuring that the domestic acquiring cor-poration’s section 381 carryover basis re-flects an after-tax amount. Accordingly,the IRS and Treasury believe that the allearnings and profits amount provisions un-der §1.367(b)–3 should not operate elec-tively in these cases. The proposed regu-lations require that, for exchanges subjectto §1.367(b)–3 and section 367(a), section367(b) would apply before section 367(a).In that case, inclusion of the all earningsand profits amount would increase the ex-changing shareholder’s stock basis for pur-poses of computing the shareholder’s gainunder section 367(a). Thus, if the all earn-ings and profits amount exceeds the inher-ent gain in the exchanged stock, gain isnot recognized under section 367(a). If thetransaction does not involve inclusion ofthe all earnings and profits amount (for ex-ample, if §1.367(b)–4 applies), the exist-ing ordering rules continue to apply.

D. Parenthetical Section 368(a)(1)(B)Reorganizations

In a parenthetical reorganization undersection 368(a)(1)(B), if a U.S. shareholderexchanges stock of an acquired corpora-tion for voting stock of a foreign corpo-ration that controls (within the meaningof section 368(c)) the acquiring corpo-ration, the U.S. shareholder is treated asmaking an indirect transfer of stock of theacquired corporation to the foreign con-

2005–7 I.R.B. 540 February 14, 2005

trolling corporation in a transfer subject tosection 367(a). See §1.367(a)–3(d)(1)(iii).This result occurs even if the acquiringcorporation is domestic. If the U.S. share-holder owns five percent or more (by voteor value) of the stock of the foreign con-trolling corporation, the shareholder mustrecognize gain inherent in the exchangedstock, unless a gain recognition agreementis filed. A gain recognition agreementfiled with respect to the transfer may betriggered (and gain on the initial transferof stock will be recognized) if the for-eign controlling corporation disposes ofthe stock of the acquiring corporation,or the acquiring corporation disposes ofthe stock of the acquired corporation,within 5 years of the initial transfer. See§1.367(a)–3(d)(2)(ii).

The proposed regulations revise the in-direct stock transfer rules to include trian-gular section 368(a)(1)(B) reorganizationsin which a U.S. shareholder exchangesstock of the acquired corporation for vot-ing stock of a domestic corporation thatcontrols a foreign acquiring corporation.In such a case, the gain recognition agree-ment may be triggered if the domestic con-trolling corporation disposes of the stockof the foreign acquiring corporation, orthe foreign acquiring corporation disposesof the stock of the acquired corporation,within 5 years of the initial transfer.

E. Transfers of Assets Following CertainAsset Reorganizations

If a U.S. shareholder exchanges stockor securities of an acquired corporationfor stock or securities of a foreign ac-quiring corporation in a reorganizationdescribed in section 368(a)(1)(C), and theforeign acquiring corporation transfers allor part of the assets of the acquired cor-poration to a subsidiary controlled (withinthe meaning of section 368(c)) by theforeign acquiring corporation in a trans-action described in section 368(a)(2)(C),the U.S. shareholder is treated, for pur-poses of section 367(a), as transferring thestock of the acquired corporation to theforeign acquiring corporation to the extentof the assets transferred to the controlledsubsidiary. §1.367(a)–3(d)(1)(v). Section368(a)(2)(C) provides that a transactionotherwise qualifying as a reorganizationunder section 368(a)(1)(A), (B), (C), and(G) will not be disqualified because all or

part of the assets or stock acquired in thetransaction are transferred to a corporationcontrolled by the acquiring corporation.

On August 16, 2004, the IRS and Trea-sury issued proposed regulations under§1.368–2(k) that permit assets or stockacquired in any reorganization undersection 368(a)(1) to be transferred to acorporation controlled by the acquiringcorporation without disqualifying the re-organization. Prior to these proposedregulations, the IRS and Treasury issuedRev. Rul. 2002–85, 2002–2 C.B. 986,which extended this treatment to sec-tion 368(a)(1)(D) reorganizations. Notice2002–77, 2002–2 C.B. 997, issued con-temporaneously with Rev. Rul. 2002–85,provided that §1.367(a)–3(d)(1)(v) wouldbe amended to treat transactions describedin Rev. Rul. 2002–85 as indirect stocktransfers, if the transfer of assets by theacquiring corporation to its controlledsubsidiary occurred pursuant to the planof reorganization.

The effect of the proposed regulationsunder §1.368–2(k) is to permit transfers ofassets or stock to a controlled subsidiary inreorganizations not specifically identifiedor mentioned in section 368(a)(2)(C) (sec-tion 368(a)(1)(D) and (F) reorganizations).The proposed regulations amend the indi-rect stock transfer rules to conform to thechanges in the section 368 regulations. Asa result, the proposed regulations providethat the transfer of assets to a controlledsubsidiary subsequent to an asset reorgani-zation under section 368(a)(1) would con-stitute an indirect transfer of stock, pro-vided the transfer of assets by the foreignacquiring corporation to its controlled sub-sidiary occurs as part of the same transac-tion.

F. Indirect Transfers Involving a Changein Domestic or Foreign Status of AcquiredCorporation

As indicated above, under existing§1.367(a)–3(d)(1)(v), a U.S. shareholderof an acquired corporation is treated astransferring the stock of the acquired cor-poration to the foreign acquiring corpora-tion to the extent of the assets transferredto the controlled subsidiary. Thus, if theacquired corporation is foreign, the U.S.shareholder is treated as transferring stockof a foreign corporation to the foreignacquiring corporation in a transaction

that is subject to the §1.367(a)–3(b) stocktransfer rules. If the acquired corpora-tion is domestic, the U.S. shareholder istreated as transferring stock of a domesticcorporation to the foreign acquiring cor-poration in a transaction that is subject to§1.367(a)–3(c). This deemed transfer ofdomestic stock prevails even if the con-trolled subsidiary is foreign. Similar rulesapply to parenthetical C reorganizations.

Some commentators have suggestedthat the determination of whether domes-tic or foreign stock is deemed transferredshould be based on the status of the con-trolled subsidiary, rather than the statusof the acquired corporation. Under thisapproach, if the acquired corporation weredomestic and the controlled subsidiarywere foreign, the U.S. shareholders wouldbe deemed to transfer foreign corporationstock subject to §1.367(a)–3(b), ratherthan domestic corporation stock subject to§1.367(a)–3(c). The IRS and Treasury be-lieve that, consistent with the frameworkof the current regulations, it is appropriatefor the rules to continue to apply based onthe stock that is owned and exchanged bythe U.S. person in the transaction (ratherthan on the stock of the controlled sub-sidiary). The IRS and Treasury are consid-ering the application of §§1.367(a)–3(b),1.367(a)–3(c), and 1.367(a)–8 to situationswhere the foreign acquiring corporationtransfers assets of the acquired corpora-tion to multiple controlled subsidiaries(including both domestic and foreign sub-sidiaries), comments are requested in thisregard.

G. Coordination of the Indirect StockTransfer Rules and the Asset TransferRules

In the case of an indirect stock transferthat also involves a transfer of assets by adomestic corporation to a foreign corpora-tion, §1.367(a)–3(d)(2)(vi) generally pro-vides that section 367(a) and (d) apply tothe transfer of assets prior to applicationof the indirect stock transfer rules. How-ever, section 367(a) does not apply to suchtransfers to the extent that the foreign ac-quiring corporation transfers the assets re-ceived in the asset transfer to a domesticcorporation controlled (within the mean-ing of section 368(c)) by the foreign ac-quiring corporation in a transfer describedin section 368(a)(2)(C) or in a transfer de-

February 14, 2005 541 2005–7 I.R.B.

scribed in section 351, provided the do-mestic transferee’s basis in the assets is nogreater than the basis that the domestic ac-quired corporation had in such assets. Theinitial asset transfer to the foreign corpora-tion is not subject to section 367(a) in suchcases because the assets re-transferred tothe domestic corporation remain subject toU.S. corporate tax.

The IRS and Treasury are concernedthat asset reorganizations subject to thiscoordination rule may be used to facilitatecorporate inversion transactions. An in-version generally involves a U.S. multina-tional corporation reincorporating outsidethe United States for tax purposes (eitheras a foreign corporation or as a subsidiaryof a new foreign corporation). The IRSand Treasury also are concerned that thecoordination rule might be used to facil-itate divisive transactions. The proposedregulations address both of these concernsby modifying the scope of the coordinationrule.

The revised coordination rule operatesas follows. Section 367(a) and (d) gener-ally apply to the transfer of assets to a for-eign corporation even if the foreign cor-poration transfers all or part of the assetsreceived to a controlled domestic corpora-tion. This general rule, however, is subjectto two exceptions which do not require in-come recognition under section 367(a) and(d) on the transfer of assets to the foreigncorporation to the extent that assets arere-transferred to the domestic controlledcorporation.

The first exception applies if the do-mestic acquired corporation is controlled(within the meaning of section 368(c)) by 5or fewer domestic corporations, appropri-ate basis adjustments as provided in sec-tion 367(a)(5) are made to the stock ofthe foreign acquiring corporation, and anyother conditions provided in regulationsunder section 367(a)(5) are satisfied. Al-though there currently are no regulationsunder section 367(a)(5), this exception willincorporate any conditions or limitationsin future regulations once published.

In cases where the first exception doesnot apply, the second exception applies ifthe following two conditions are satisfied:(1) the indirect transfer of stock of the do-mestic acquired corporation satisfies therequirements of §1.367(a)–3(c)(1)(i), (ii),and (iv), and (c)(6); and (2) the domesticacquired corporation attaches a statement

(described below) to its tax return for thetaxable year of the transfer.

The statement that the domestic ac-quired corporation files must certify that, ifthe foreign acquiring corporation disposesof any stock of the domestic controlledcorporation with a principal purpose ofavoiding U.S. tax that would have beenimposed on the domestic acquired corpo-ration had it disposed of the re-transferredassets, the domestic acquired corporationwill amend its return for the year of theinitial transaction and recognize gain (de-scribed below). The disposition of stockis presumed to have a principal purposeof tax avoidance if the disposition occurswithin 2 years of the transfer. The pre-sumption may be rebutted, however, if thedomestic acquired corporation (or the for-eign acquiring corporation on its behalf)demonstrates to the satisfaction of theCommissioner that the transaction did nothave a principal purpose of tax avoidance.

If the domestic acquired corporationrecognizes gain pursuant to the statement,it is treated as if, immediately prior to theexchange, it had transferred the re-trans-ferred assets, including any intangibleassets, directly to a domestic corporationin exchange for stock of the corporation ina transaction that is treated as a section 351exchange, and immediately sold the stockto an unrelated party at fair market valuein a sale in which it recognizes gain, ifany, but not loss. For purposes of this rule,the deemed transfer to a domestic corpo-ration is treated as a section 351 exchangeregardless of whether all the requirementsfor nonrecognition under section 351 areotherwise satisfied. Treating the domes-tic acquired corporation as recognizinggain on the disposition of stock, ratherthan assets, is intended to approximate theconsequences that would have resultedhad the domestic acquired corporationtransferred the assets to a corporationand sold the stock received in such trans-fer prior to the outbound reorganization.In addition, this treatment is consistentwith other provisions that address divisivetransactions. See, e.g., section 355(e) and§1.367(e)-(2)(b)(2)(iii).

The basis that the foreign acquiringcorporation has in the stock of the do-mestic controlled corporation is increasedby the amount of gain recognized by thedomestic acquired corporation under theserules immediately prior to its disposition;

however, the basis of the re-transferredassets held by the domestic controlledcorporation will not be increased by suchgain. Finally, the anti-abuse provisionunder §1.367(d)–1T(g)(6) will not ap-ply to intangible property included in there-transferred assets.

H. Application of Section 367(b)Regulations to Certain TriangularReorganizations

Section 367(b) applies to exchanges un-der sections 332, 351, 354, 355, 356, and361 (except to the extent described in sec-tion 367(a)(1)) in which the status of a for-eign corporation as a corporation for taxpurposes is necessary for application of therelevant nonrecognition provisions. Ex-cept as provided in regulations, under sec-tion 367(b) a foreign corporation that is aparty to such an exchange is consideredto be a corporation for tax purposes, andtherefore the parties involved in the trans-action are eligible for nonrecognition treat-ment.

Section 1.367(b)–4 applies to acquisi-tions by a foreign corporation (the foreignacquiring corporation) of the stock or as-sets of another foreign corporation (the for-eign acquired corporation) in certain non-recognition exchanges (a section 367(b)exchange). Consistent with section 1248,§1.367(b)–4(b)(1)(i) addresses exchangesby a section 1248 shareholder (or, in cer-tain cases, a CFC shareholder that has asection 1248 shareholder), and generallyrequires such a shareholder to include inincome its section 1248 amount as a re-sult of a section 367(b) exchange, if im-mediately after the exchange (i) the stockreceived in the exchange is not stock ina corporation that is a controlled foreigncorporation as to which the section 1248shareholder described above is a section1248 shareholder, or (ii) the foreign ac-quiring corporation or the foreign acquiredcorporation (if any, such as in a transac-tion described in section 368(a)(1)(B) or351), is not a controlled foreign corpora-tion as to which the section 1248 share-holder described above is a section 1248shareholder.

Therefore, in a triangular reorganiza-tion (such as a triangular reorganizationdescribed in section 368(a)(1)(C)) that iswithin the scope of §1.367(b)–4, a section367(b) shareholder must include in income

2005–7 I.R.B. 542 February 14, 2005

the section 1248 amount if, for example,it receives stock of a domestic corporationin exchange for its stock in a controlledforeign corporation. This is the case be-cause, immediately after the exchange, thesection 367(b) shareholder does not holdstock in a corporation that is a controlledforeign corporation as to which such share-holder is a section 367(b) shareholder.

Pursuant to the basis rules con-tained in this proposed regulation under§1.367(b)–13, the section 1248 amountwith respect to the stock of the foreignacquired corporation that is exchangedcan be properly preserved in the stock ofa foreign corporation owned by a domes-tic corporation when the section 367(b)shareholder receives stock of the domesticcorporation in a triangular reorganization.Consequently, the proposed regulationsprovide that a section 367(b) shareholderreceiving stock of a domestic corporationin a triangular reorganization is not re-quired to include in income the section1248 amount under §1.367(b)–4(b)(1)(i),provided that the domestic corporation,immediately after the exchange, is a sec-tion 1248 shareholder of the survivingcorporation (or in the case of a parenthet-ical section 368(a)(1)(B) reorganization,of the acquired corporation) that is itself acontrolled foreign corporation.

I. Application of Section 367(b)Regulations to Certain OutboundReorganizations

If a domestic corporation is a section1248 shareholder with respect to a foreigncorporation and transfers the stock in suchforeign corporation to another foreign cor-poration in a section 361 transfer, the do-mestic corporation must include in incomethe section 1248 amount, if any, with re-spect to the stock of the transferred for-eign corporation. See section 1248(f)(1)and §1.367(b)–4(b)(2)(ii), Example 4.

Taxpayers have commented that thisrule may result in income inclusions insome cases where the section 1248 amountcould be preserved, such that a current in-clusion may not be necessary or appropri-ate. The IRS and Treasury are consideringthe application of section 367(a)(5) andsection 1248(f)(1) to such transactions, inconjunction with §1.367(b)–13 of theseregulations, to preserve section 1248amounts, and comments are requested

in this regard. The IRS and Treasuryalso are considering, and request com-ments, on situations in which there aremultiple shareholders (including minorityshareholders) of the domestic corporation;multiple assets (including appreciated anddepreciated assets being transferred as partof the section 361 transfer); and liabili-ties being assumed in connection with thetransaction.

J. Nonrecognition Transactions under theFIRPTA and PFIC Provisions

Section 897(a) generally treats gain orloss from the disposition of a U.S. realproperty interest by a nonresident alienindividual or a foreign corporation asgain or loss that is effectively connectedwith the conduct of a trade or businesswithin the United States. Sections 897(d)and (e) provide rules that apply section897 in the context of distributions andnonrecognition exchanges of U.S. realproperty interests. Temporary regulationswere issued under sections 897(d) and(e) providing guidance on the applica-tion of section 897 to certain corporatetransactions involving U.S. real propertyinterests. See §1.897–5T, 1.897–6T, andNotice 89–85, 1989–2 C.B. 403. Theserules do not specifically address A reor-ganizations because such regulations werebased on A reorganizations being limitedto statutory mergers between domesticcorporations. The IRS and Treasury in-tend to revise these regulations to reflectA reorganizations and welcome commentson revisions that are necessary to applythese regulations to A reorganizations, aswell as comments on other issues underthe regulations.

Section 1291(f) provides authority toissue regulations concerning the exchangeof stock in a passive foreign investmentcompany (PFIC) in a nonrecognitiontransaction. Proposed regulations werepublished in the Federal Register (57FR 11047) on April 1, 1992, providingrules for the disposition of PFIC stockby U.S. shareholders in nonrecognitionexchanges. See §1.1291–6 of the pro-posed regulations. The application ofthese proposed regulations is based on Areorganizations being limited to statutorymergers between domestic corporations.The IRS and Treasury intend to revisethese proposed regulations to reflect A re-

organizations and welcome comments onrevisions that are necessary in this regard,as well as comments on other issues underthese regulations.

Proposed Effective Date

Except as otherwise specified, theseregulations are proposed to apply to trans-actions occurring after the date these reg-ulations are published as final regulationsin the Federal Register.

Special Analyses

The IRS and the Treasury Departmenthave determined that this notice of pro-posed rulemaking is not a significant regu-latory action as defined in Executive Or-der 12866. Therefore, a regulatory as-sessment pursuant to that Order is not re-quired. It has also been determined thatsection 553(b) of the Administrative Pro-cedure Act (5 U.S.C. chapter 5) does notapply to these regulations, and that becausethis regulation does not impose a collec-tion of information on small entities, theRegulatory Flexibility Act (5 U.S.C. chap-ter 6) does not apply. Pursuant to section7805(f) of the Code, this regulation will besubmitted to the Chief Counsel for Advo-cacy of the Small Business Administrationfor comment on its impact on small busi-ness.

Comments and Public Hearing

Before these proposed regulations areadopted as final regulations, considerationwill be given to any written comments(a signed original and eight (8) copies)or electronic comments that are submittedtimely to the IRS. The IRS and TreasuryDepartment specifically request commentson the clarity of the proposed regulationsand on how they can be made easier to un-derstand. All comments will be availablefor public inspection and copying.

A public hearing has been scheduled forMay 19, 2005, beginning at 10:00 a.m. inthe Auditorium, Internal Revenue Build-ing, 1111 Constitution Avenue, NW, Wash-ington, DC. Due to building security pro-cedures, visitors must enter at the Consti-tution Avenue entrance. In addition, allvisitors must present photo identificationto enter the building. Because of accessrestrictions, visitors will not be admittedbeyond the immediate entrance area more

February 14, 2005 543 2005–7 I.R.B.

than 30 minutes before the hearing starts.For information about having your nameplaced on the building access list to attendthe hearing, see the FOR FURTHER IN-FORMATION CONTACT portion of thispreamble.

The rules of 26 CFR 601.601(a)(3) ap-ply to the hearing. Persons who wish topresent oral comments must submit writ-ten or electronic comments and an out-line of the topics to be discussed and thetime to be devoted to each topic (a signedoriginal and eight (8) copies) by April 28,2005. A period of 10 minutes will beallotted to each person for making com-ments. An agenda showing the schedulingof the speakers will be prepared after thedeadline for receiving outlines has passed.Copies of the agenda will be available freeof charge at the hearing.

Drafting Information

The principal author of these regula-tions is Robert W. Lorence, Jr., of the Of-fice of Associate Chief Counsel (Interna-tional). However, other personnel fromthe IRS and Treasury Department partic-ipated in their development.

* * * * *

Proposed Amendments to theRegulations

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

PART 1—INCOME TAXES

Paragraph 1. The authority citation forpart 1 continues to read, in part, as follows:

Authority: 26 U.S.C. 7805 * * *Par. 2. In section 1.358–1, paragraph

(a) is amended by adding a sentence at theend of the paragraph to read as follows:

§1.358–1 Basis to distributees.

(a) * * * In the case of certain section354 or 356 exchanges of stock in a foreigncorporation, §1.367(b)–13 applies insteadof the rules of §1.358–2.

* * * * *Par. 3. In §1.358–6, paragraph (e) is

amended by adding a sentence at the endof the paragraph to read as follows:

§1.358–6 Stock basis in certain triangularreorganizations.

* * * * *(e) * * * For certain triangular reorga-

nizations where the surviving corporation(S or T) is foreign, see §1.367(b)–13.

* * * * *Par. 4. Section 1.367(a)–3 is amended

as follows:1. In paragraph (a), remove the third

and fourth sentences, and add five sen-tences in their place.

2. Revise paragraph (b)(2)(i).3. Revise paragraph (c)(5)(vi).

4. In paragraph (d)(1), introductorytext, first sentence, add the parenthetical“(or in a domestic corporation in controlof a foreign acquiring corporation in a tri-angular section 368(a)(1)(B) reorganiza-tion)” after the words “for stock or secu-rities in a foreign corporation”.

5. In paragraph (d)(1), introductorytext, remove the last sentence and add threesentences in its place.

6. In paragraph (d)(1)(i), remove thelast sentence and add a sentence in itsplace.

7. In paragraph (d)(1)(ii), add a sen-tence at the end of the paragraph.

8. Paragraph (d)(1)(iii) is revised.9. In paragraph (d)(1)(iv), remove the

language “Example 7” and add “Example8” in its place, and remove “Example 11”and add “Example 14” in its place.

10. Revise paragraph (d)(1)(v).11. Revise paragraphs (d)(2)(i) and

(ii).12. In paragraph (d)(2)(iv), last sen-

tence, remove the language “Example 4”and add “Examples 5 and 5A” in its place.

13. Revise paragraph (d)(2)(v)(C).14. Redesignate paragraph (d)(2)(v)

(D) as paragraph (d)(2)(v)(F).15. Add new paragraphs (d)(2)(v)(D)

and (E).16. Revise paragraph (d)(2)(vi).17. In paragraph (d)(3), redesignate the

examples as follows and add the followingnew examples:

Redesignate As Add

Example 12 Example 16

Example 15

Examples 11 and 11A Examples 14 and 14A

Examples 10 and 10A Examples 13 and 13A

Example 9 Example 12

Examples 10 and 11

Example 8 Example 9

Examples 7, 7A, 7B, and 7C Examples 8, 8A, 8B, and 8C

Examples 6 and 6A Examples 7 and 7A

Examples 5, 5A, and 5B Examples 6, 6A, and 6B

Examples 6C and 6D

Example 4 Example 5

Example 5A

2005–7 I.R.B. 544 February 14, 2005

Redesignate As Add

Example 3 Example 4

Example 2 Example 3

Example 2

18. In paragraph (d)(3), newly desig-nated Example 6A, paragraph (i), the firstand last sentences are revised.

19. In paragraph (d)(3), newly desig-nated Example 6B and Example 9 are re-vised.

20. In paragraph (d)(3), for each ofthe newly designated examples listed in

the first column, replace the language inthe second column with the language in thethird column:

Redesignated Examples Remove Add

Example 6A, paragraph (i), first sentence Example 5 Example 6

Example 7, paragraph (i) Example 5 Example 6

Example 7A, paragraph (i) and paragraph(ii), penultimate sentence

Example 6 Example 7

Example 8, paragraph (i) Example 5 Example 6

Example 8A, paragraph (i) Example 7 Example 8

Example 8B, paragraph (i) Example 7 Example 8

Example 8C, paragraph (i) Example 7 Example 8

Example 12, paragraph (i), third sentence Example 9 Example 12

Example 13A, paragraph (i) and paragraph(ii), first sentence

Example 10 Example 13

Example 14A, paragraph (i) Example 11 Example 14

22. In paragraph (e)(1), remove thefirst sentence and add two sentences in itsplace.

The revisions and additions are as fol-lows:

§1.367(a)–3 Treatment of transfers ofstock or securities to foreign corporations.

* * * * *(a) * * * However, if, in an exchange

described in section 354 or 356, a U.S.person exchanges stock of a foreign cor-poration in a reorganization described insection 368(a)(1)(E), or a U.S. person ex-changes stock of a domestic or foreign cor-poration for stock of a foreign corporationpursuant to an asset reorganization that isnot treated as an indirect stock transfer un-der paragraph (d) of this section, such sec-tion 354 or 356 exchange is not a trans-fer to a foreign corporation subject to sec-tion 367(a). See paragraph (d)(3), Exam-ple 16, of this section. For purposes of thissection, an asset reorganization is definedas a reorganization described in section

368(a)(1) involving a transfer of assets un-der section 361. If, in a transfer describedin section 361, a domestic merging corpo-ration transfers stock of a controlling cor-poration to a foreign surviving corporationin a reorganization described in sections368(a)(1)(A) and (a)(2)(E), such section361 transfer is not subject to section 367(a)if the stock of the controlling corporationis provided to the merging corporation bythe controlling corporation pursuant to theplan of reorganization; a section 361 trans-fer of other property, including stock ofthe controlling corporation not providedby the controlling corporation pursuant tothe plan of reorganization, by the domesticmerging corporation to the foreign surviv-ing corporation pursuant to such a reorga-nization is subject to section 367(a). Forspecial basis and holding period rules in-volving foreign corporations that are par-ties to certain reorganizations under sec-tion 368(a)(1), see §1.367(b)–13.* * *

(b) * * *(2) * * *

(i) In general. A transfer of foreignstock or securities described in section367(a) and the regulations thereunder aswell as in section 367(b) and the regula-tions thereunder shall be subject concur-rently to sections 367(a) and (b) and theregulations thereunder, except as providedin paragraph (b)(2)(i)(A) or (B) of thissection. See paragraph (d)(3), Example11, of this section.

(A) If a foreign corporation transfers as-sets to a domestic corporation in a transac-tion to which §1.367(b)–3(a) and (b) andthe indirect stock transfer rules of para-graph (d) of this section apply, then the sec-tion 367(b) rules shall apply prior to thesection 367(a) rules. See paragraph (d)(3),Example 15, of this section. This para-graph (b)(2)(i)(A) applies only to transac-tions occurring after the date these regula-tions are published as final regulations inthe Federal Register.

(B) Except as provided in paragraph(b)(2)(i)(A) of this section, section 367(b)and the regulations thereunder shall not ap-ply if the foreign corporation is not treated

February 14, 2005 545 2005–7 I.R.B.

as a corporation under section 367(a)(1).See paragraph (d)(3), Example 14, of thissection.

* * * * *(c) * * *(5) * * *(vi) Transferee foreign corpora-

tion. Except as provided in paragraph(d)(1)(iii)(B) of this section, the transfereeforeign corporation shall be the foreigncorporation that issues stock or securitiesto the U.S. person in the exchange.

* * * * *(d) * * *(1) * * * For examples of the concur-

rent application of the indirect stock trans-fer rules under section 367(a) and the rulesof section 367(b), see paragraph (d)(3), Ex-amples 14 and 15 of this section. Forpurposes of this paragraph (d), if a cor-poration acquiring assets in a reorganiza-tion described in section 368(a)(1) trans-fers all or a portion of such assets to a cor-poration controlled (within the meaning ofsection 368(c)) by the acquiring corpora-tion as part of the same transaction, thesubsequent transfer of assets to the con-trolled corporation will be referred to asa controlled asset transfer. See section368(a)(2)(C).

(i) * * * See paragraph (d)(3), Ex-ample 1 of this section for an exampleof a reorganization described in sections368(a)(1)(A) and (a)(2)(D) involvingdomestic acquired and acquiring corpora-tions, and see paragraph (d)(3), Example10 of this section for an example involv-ing a domestic acquired corporation and aforeign acquiring corporation.

(ii) * * * See paragraph (d)(3), Ex-ample 2 of this section for an exampleof a reorganization described in sections368(a)(1)(A) and (a)(2)(E) involving do-mestic acquired and acquiring corpora-tions, and see paragraph (d)(3), Example11 of this section for an example involv-ing a domestic acquired corporation and aforeign acquiring corporation.

(iii) Triangular reorganizations de-scribed in section 368(a)(1)(B)—(A) AU.S. person exchanges stock of the ac-quired corporation for voting stock of aforeign corporation that is in control (asdefined in section 368(c)) of the acquiringcorporation in a reorganization describedin section 368(a)(1)(B). See paragraph(d)(3), Example 5 of this section.

(B) A U.S. person exchanges stock ofthe acquired corporation for voting stockof a domestic corporation that is in control(as defined in section 368(c)) of a foreignacquiring corporation in a reorganizationdescribed in section 368(a)(1)(B).

(1) For purposes of paragraphs (b) and(c) of this section, the foreign acquiringcorporation is considered to be the trans-feree foreign corporation even though theU.S. transferor receives stock of the do-mestic controlling corporation in the ex-change.

(2) If stock of a foreign acquired cor-poration is exchanged for the voting stockof a domestic corporation in control of aforeign acquiring corporation, then the ex-change will be subject to the rules of para-graph (b) of this section. If the exchang-ing shareholder is a section 1248 share-holder with respect to the foreign acquiredcorporation, the indirect transfer will besubject to sections 367(a) and (b) con-currently. For the application of section367(b) to the exchange, see §§1.367(b)–4and 1.367(b)–13(c).

(3) If stock of a domestic acquired cor-poration is exchanged for the voting stockof a domestic corporation in control of aforeign acquiring corporation, then the ex-change will be subject to the rules of para-graph (c) of this section.

(4) For purposes of applying thegain recognition agreement provisionsof paragraph (d)(2) of this section and§1.367(a)–8, the domestic controlling cor-poration will be treated as the transfereeforeign corporation. Thus, a dispositionof foreign acquiring corporation stock bythe domestic controlling corporation, or adisposition of acquired corporation stockby the foreign acquiring corporation,will trigger the gain recognition agree-ment. See paragraph (d)(3), Example 5Aof this section.

(5) This paragraph (d)(1)(iii)(B) ap-plies only to transactions occurring afterthe date these regulations are publishedas final regulations in the Federal Regis-ter.

* * * * *(v) Transfers of assets to subsidiaries

in certain section 368(a)(1) reorganiza-tions. A U.S. person exchanges stock orsecurities of a corporation (the acquiredcorporation) for stock or securities of aforeign acquiring corporation in an asset

reorganization (other than a triangularsection 368(a)(1)(C) reorganization de-scribed in paragraph (d)(1)(iv) of thissection or a reorganization described insections 368(a)(1)(A) and (a)(2)(D) or(a)(2)(E) described in paragraphs (d)(1)(i)or (ii) of this section) that is followed bya controlled asset transfer. In the case ofa transaction described in this paragraph(d)(1)(v) in which some but not all ofthe assets of the acquired corporation aretransferred in a controlled asset transfer,the transaction shall be considered to bean indirect transfer of stock or securitiessubject to this paragraph (d) only to theextent of the assets so transferred. Theremaining assets shall be treated as havingbeen transferred in an asset transfer ratherthan an indirect stock transfer, and suchasset transfer shall be subject to the otherprovisions of section 367, including sec-tions 367(a)(1), (3), and (5), and (d) if theacquired corporation is a domestic corpo-ration. See paragraph (d)(3), Examples6A and 6B of this section.

* * * * *(2) * * *(i) Transferee foreign corporation. Ex-

cept as provided in paragraph (d)(1)(iii)(B)of this section, the transferee foreign cor-poration shall be the foreign corporationthat issues stock or securities to the U.S.person in the exchange.

(ii) Transferred corporation. Thetransferred corporation shall be the ac-quiring corporation, except as provided inthis paragraph (d)(2)(ii). In the case of atriangular section 368(a)(1)(B) reorgani-zation described in paragraph (d)(1)(iii)of this section, the transferred corpora-tion shall be the acquired corporation. Inthe case of an indirect stock transfer de-scribed in paragraph (d)(1)(i), (ii), or (iv)of this section followed by a controlledasset transfer, or an indirect stock transferdescribed in paragraph (d)(1)(v) of thissection, the transferred corporation shallbe the controlled corporation to whichthe assets are transferred. In the case ofsuccessive section 351 transfers describedin paragraph (d)(1)(vi) of this section, thetransferred corporation shall be the corpo-ration to which the assets are transferredin the final section 351 transfer. Thetransferred property shall be the stock orsecurities of the transferred corporation,as appropriate under the circumstances.

2005–7 I.R.B. 546 February 14, 2005

* * * * *(v) * * *(C) In the case of an asset reorganiza-

tion followed by a controlled asset transfer,as described in paragraph (d)(1)(v) of thissection, the assets of the acquired corpora-tion that are transferred to the corporationcontrolled by the acquiring corporation;

(D) In the case of a triangular reorga-nization described in section 368(a)(1)(C)followed by a controlled asset transfer,or a reorganization described in sections368(a)(1)(A) and (a)(2)(D) followed bya controlled asset transfer, the assets ofthe acquired corporation including thosetransferred to the corporation controlledby the acquiring corporation;

(E) In the case of a reorganizationdescribed in sections 368(a)(1)(A) and(a)(2)(E) followed by a controlled assettransfer, the assets of the acquiring corpo-ration including those transferred to thecorporation controlled by the acquiringcorporation; and

* * * * *(vi) Coordination between asset trans-

fer rules and indirect stock transferrules—(A) General rule. If, pursuantto any of the transactions described inparagraph (d)(1) of this section, a U.S.person transfers (or is deemed to transfer)assets to a foreign corporation in an ex-change described in section 351 or 361,the rules of section 367, including sections367(a)(1), (a)(3), and (a)(5), as well assection 367(d), and the regulations there-under shall apply prior to the applicationof the rules of this section.

(B) Exceptions. (1) If a transactionis described in paragraph (d)(2)(vi)(A) ofthis section, sections 367(a) and (d) shallnot apply to the extent a domestic cor-poration (domestic acquired corporation)transfers its assets to a foreign corporation(foreign acquiring corporation) in an assetreorganization, and such assets (re-trans-ferred assets) are transferred to a domes-tic corporation (domestic controlled cor-poration) controlled (within the meaningof section 368(c)) by the foreign acquiringcorporation as part of the same transaction,provided that the domestic controlled cor-poration’s basis in such assets is no greaterthan the basis that the domestic acquiredcorporation had in such assets and the con-ditions contained in either of the followingparagraphs are satisfied:

(i) The domestic acquired corpora-tion is controlled (within the meaning ofsection 368(c)) by 5 or fewer domesticcorporations, appropriate basis adjust-ments as provided in section 367(a)(5) aremade to the stock of the foreign acquir-ing corporation, and any other conditionsas provided in regulations under section367(a)(5) are satisfied. For purposes ofdetermining whether the domestic ac-quired corporation is controlled by 5 orfewer domestic corporations, all membersof the same affiliated group within themeaning of section 1504 shall be treatedas 1 corporation.

(ii) The requirements of paragraphs(c)(1)(i), (ii), and (iv), and (c)(6) of thissection are satisfied with respect to theindirect transfer of stock in the domesticacquired corporation, and the domesticacquired corporation attaches a statementdescribed in paragraph (d)(2)(vi)(C) ofthis section to its U.S. income tax returnfor the taxable year of the transfer.

(2) Sections 367(a) and (d) shall notapply to transfers described in paragraph(d)(1)(vi) of this section where a U.S. per-son transfers assets to a foreign corpora-tion in a section 351 exchange, to the ex-tent that such assets are transferred by suchforeign corporation to a domestic corpora-tion in another section 351 exchange, butonly if the domestic transferee’s basis inthe assets is no greater than the basis thatthe U.S. transferor had in such assets.

(C) Required statement. The statementrequired by paragraph (d)(2)(vi)(B)(1)(ii)of this section shall be entitled “RequiredStatement under §1.367(a)–3(d) for As-sets Transferred to a Domestic Corpora-tion” and shall be signed under penaltiesof perjury by an authorized officer of thedomestic acquired corporation and by anauthorized officer of the foreign acquir-ing corporation. The required statementshall contain a certification that, if the for-eign acquiring corporation disposes of anystock of the domestic controlled corpora-tion in a transaction described in paragraph(d)(2)(vi)(D) of this section, the domesticacquired corporation shall recognize gainas described in paragraph (d)(2)(vi)(E)(1)of this section. The domestic acquired cor-poration (or the foreign acquiring corpo-ration on behalf of the domestic acquiredcorporation) shall file a U.S. income tax re-turn (or an amended U.S. tax return, as the

case may be) for the year of the transfer re-porting such gain.

(D) Gain recognition transaction . (1)A transaction described in this paragraph(d)(2)(vi)(D) is one where a principal pur-pose of the transfer by the domestic ac-quired corporation is the avoidance of U.S.tax that would have been imposed on thedomestic acquired corporation on the dis-position of the re-transferred assets. Atransfer may have a principal purpose oftax avoidance even though the tax avoid-ance purpose is outweighed by other pur-poses when taken together.

(2) For purposes of paragraph(d)(2)(vi)(D)(1) of this section, a transac-tion is deemed to have a principal purposeof tax avoidance if the foreign acquiringcorporation disposes of any stock of thedomestic controlled corporation (whetherin a recognition or non-recognition trans-action) within 2 years of the transfer. Therule in this paragraph (d)(2)(vi)(D)(2) shallnot apply if the domestic acquired corpora-tion (or the foreign acquiring corporationon behalf of the domestic acquired corpo-ration) demonstrates to the satisfaction ofthe Commissioner that the avoidance ofU.S. tax was not a principal purpose of thetransaction.

(E) Amount of gain recognized andother matters. (1) In the case of a transac-tion described in paragraph (d)(2)(vi)(D)of this section, solely for purposes of thisparagraph (d)(2)(vi)(E), the domestic ac-quired corporation shall be treated as if,immediately prior to the transfer, it trans-ferred the re-transferred assets, includingany intangible assets, directly to a domes-tic corporation in exchange for stock ofsuch domestic corporation in a transactionthat is treated as a section 351 exchange,and immediately sold such stock to an un-related party for its fair market value in asale in which it shall recognize gain, if any(but not loss). Any gain recognized by thedomestic acquired corporation pursuant tothis paragraph (d)(2)(vi)(E) will increasethe basis that the foreign acquiring cor-poration has in the stock of the domesticcontrolled corporation immediately beforethe transaction described in paragraph(d)(2)(vi)(D) of this section, but will notincrease the basis of the re-transferredassets held by the domestic controlled cor-poration. Section 1.367(d)–1T(g)(6) shallnot apply with respect to any intangible

February 14, 2005 547 2005–7 I.R.B.

property included in the re-transferred as-sets described in the preceding sentence.

(2) If additional tax is required to bepaid as a result of a transaction describedin paragraph (d)(2)(vi)(D) of this section,then interest must be paid on that amountat rates determined under section 6621with respect to the period between the dateprescribed for filing the domestic acquiredcorporation’s income tax return for theyear of the transfer and the date on whichthe additional tax for that year is paid.

(F) Examples. For illustrations of therules in paragraph (d)(2)(vi) of this sec-tion, see paragraph (d)(3), Examples 6B,6C, 6D, 9, and 13A of this section.

(G) Effective dates. Paragraph (d)(2)(vi) of this section applies only to trans-actions occurring after the date theseregulations are published as final reg-ulations in the Federal Register. See§1.367(a)–3(d)(2)(vi), as contained in 26CFR Part 1 revised as of April 1, 2004,for transactions occurring on or after July20, 1998, until the date these regulationsare published as final regulations in theFederal Register.

(3) * * *Example 2. Section 368(a)(1)(A)/(a)(2)(E) re-

organization—(i) Facts. The facts are the same asin Example 1, except that Newco merges into W andNewco receives stock of W which it distributes to Fin a reorganization described in sections 368(a)(1)(A)and (a)(2)(E). Pursuant to the reorganization, A re-ceives 40 percent of the stock of F in an exchangedescribed in section 354.

(ii) Result. The consequences of the transfer aresimilar to those described in Example 1. Pursuantto paragraph (d)(1)(ii) of this section, the reorganiza-tion is subject to the indirect stock transfer rules. Fis treated as the transferee foreign corporation, andW is treated as the transferred corporation. Providedthat the requirements of paragraph (c)(1) of this sec-tion are satisfied, including the requirement that Aenter into a five-year gain recognition agreement asdescribed in §1.367(a)–8, A’s exchange of W stockfor F stock under section 354 will not be subject tosection 367(a)(1).

* * * * *Example 5A. Triangular section 368(a)(1)(B) re-

organization—(i) Facts. The facts are the same asin Example 5, except that F is a domestic corporationand S is a foreign corporation.

(ii) Result. U’s exchange of Y stock for stock ofF, a domestic corporation in control of S, the foreignacquiring corporation, is treated as an indirect transferof Y stock to a foreign corporation under paragraph(d)(1)(iii) of this section. U’s exchange of Y stockfor F stock will not be subject to section 367(a)(1)provided that all of the requirements of paragraph(c)(1) are satisfied, including the requirement that Uenter in a five-year gain recognition agreement. Insatisfying the 50 percent or less ownership require-

ments of paragraph (c)(1)(i) and (ii) of this section,U’s indirect ownership of S stock (through its directownership of F stock) will determine whether the re-quirement of paragraph (c)(1)(i) is satisfied and willbe taken into account in determining whether the re-quirement of paragraph (c)(1)(ii) is satisfied. Seeparagraph (c)(4)(iv)). For purposes of applying thegain recognition agreement provisions of paragraph(d)(2) of this section and §1.367(a)–8, F is treated asthe transferee foreign corporation. The gain recogni-tion agreement would be triggered if F sold all or aportion of the stock of S, or if S sold all or a portionof the stock of Y.

* * * * *Example 6A. Section 368(a)(1)(C) reorganization

followed by a controlled asset transfer—(i) Facts.The facts are the same as in Example 6, except thatthe transaction is structured as a section 368(a)(1)(C)reorganization, followed by a controlled asset trans-fer, and R is a foreign corporation. * * * F then con-tributes Businesses B and C to R in a controlled assettransfer. * * *

* * * * *Example 6B. Section 368(a)(1)(C) reorganization

followed by a controlled asset transfer to a domesticcontrolled corporation—(i) Facts. The facts are thesame as in Example 6A, except that R is a domesticcorporation.

(ii) Result. As in Example 6A, the outbound trans-fer of the Business A assets to F is not affected bythe rules of this paragraph (d) and is subject to thegeneral rules under section 367. However, the Busi-ness A assets qualify for the section 367(a)(3) activetrade or business exception. The Business B and Cassets are part of an indirect stock transfer under thisparagraph (d) but must first be tested under sections367(a) and (d). The Business B assets qualify forthe active trade or business exception under section367(a)(3); the Business C assets do not. However,pursuant to paragraph (d)(2)(vi)(B) of this section, theBusiness C assets are not subject to section 367(a) or(d), provided that the basis of the Business C assets inthe hands of R is no greater than the basis of the assetsin the hands of Z, and appropriate basis adjustmentsare made pursuant to section 367(a)(5) to the stockof F held by V. (In this case, no adjustments are re-quired because, pursuant to section 358, V takes a ba-sis of $30 in the stock of F, which is equal to V’s pro-portionate share of the basis in the assets of Z ($30)transferred to F.) V also is deemed to make an indi-rect transfer of stock under the rules of paragraph (d).To preserve non-recognition treatment under section367(a), V must enter into a 5-year gain recognitionagreement in the amount of $50, the amount of the ap-preciation in the Business B and C assets, as the trans-fer of such assets by Z was not taxable under section367(a)(1) and constituted an indirect stock transfer.

Example 6C. Section 368(a)(1)(C) reorganizationfollowed by a controlled asset transfer to a domesticcontrolled corporation—(i) Facts. The facts are thesame as in Example 6B, except that Z is owned by in-dividuals, none of whom qualify as five-percent tar-get shareholders with respect to Z within the meaningof paragraph (c)(5)(iii) of this section. The followingadditional facts are present. No U.S. persons that areeither officers or directors of Z own any stock of Fimmediately after the transfer. F is engaged in an ac-tive trade or business outside the United States that

satisfies the test set forth in paragraph (c)(3) of thissection.

(ii) Result. The transfer of the Business A as-sets is not affected by the rules of this paragraph (d).However, the transfer of such assets is subject to gainrecognition under section 367(a)(1), because the sec-tion 367(a)(3) active trade or business exception isinapplicable pursuant to section 367(a)(5). The Busi-ness B and C assets are part of an indirect stock trans-fer under this paragraph (d) but must first be testedunder sections 367(a) and (d). The transfer of theBusiness B assets (which otherwise would satisfy thesection 367(a)(3) active trade or business exception)generally is subject to section 367(a)(1) pursuant tosection 367(a)(5). The transfer of the Business C as-sets generally is subject to sections 367(a)(1) and (d).However, pursuant to paragraph (d)(2)(vi)(B) of thissection, the transfer of the Business B and C assets isnot subject to sections 367(a)(1) and (d), provided thebasis of the Business B and C assets in the hands of Ris no greater than the basis in the hands of Z and cer-tain other requirements are satisfied. Since Z is notcontrolled within the meaning of section 368(c) by5 or fewer domestic corporations, the indirect trans-fer of Z stock must satisfy the requirements of para-graphs (c)(1)(i), (ii), and (iv), and (c)(6) of this sec-tion, and Z must attach a statement described in para-graph (d)(2)(vi)(C) of this section to its U.S. incometax return for the taxable year of the transfer. In gen-eral, the statement must contain a certification that,if F disposes of the stock of R (in a recognition ornonrecognition transaction) and a principal purposeof the transfer is the avoidance of U.S. tax that wouldhave been imposed on Z on the disposition of theBusiness B and C assets transferred to R, then Z (or Fon behalf of Z) will file a return (or amended return asthe case may be) recognizing gain ($50), as if, imme-diately prior to the reorganization, Z transferred theBusiness B and C assets to a domestic corporation inexchange for stock in a transaction treated as a section351 exchange and immediately sold such stock to anunrelated party for its fair market value. A transac-tion is deemed to have a principal purpose of U.S. taxavoidance if F disposes of R stock within two years ofthe transfer, unless Z (or F on behalf of Z) can rebutthe presumption to the satisfaction of the Commis-sioner. See paragraph (d)(2)(vi)(D)(2) of this section.With respect to the indirect transfer of Z stock, therequirements of paragraphs (c)(1)(i), (ii), and (iv) ofthis section are satisfied. Thus, assuming Z attachesthe statement described in paragraph (d)(2)(vi)(C) ofthis section to its U.S. income tax return and satisfiesthe reporting requirements of (c)(6) of this section,the transfer of Business B and C assets is not subjectto section 367(a) or (d).

Example 6D. Section 368(a)(1)(C) reorgani-zation followed by a controlled asset transfer to adomestic controlled corporation—(i) Facts. Thefacts are the same as in Example 6C, except that theZ shareholders receive 60 percent of the F stock inexchange for their Z stock in the reorganization.

(ii) Result. The requirement of paragraph (c)(1)(i)of this section is not satisfied because the Z share-holders that are U.S. persons do not receive 50percent or less of the total voting power and thetotal value of the stock of F in the transaction. Ac-cordingly, Z shareholders that are U.S. persons aresubject to section 367(a)(1) on their exchange ofZ stock for F stock pursuant to the reorganization.

2005–7 I.R.B. 548 February 14, 2005

For the same reason, the conditions of paragraph(d)(2)(vi)(B)(1)(ii) of this section are not met. Ac-cordingly, the transfer of Business B and C assets issubject to sections 367(a)(1) and (d), even thoughsuch assets are re-transferred to R, a domestic corpo-ration. As in Example 6C, the transfer of Business Aassets, which is not affected by the rules of paragraph(d) of this section, is subject to gain recognitionunder sections 367(a)(1) and (5).

* * * * *Example 9. Concurrent application with a con-

trolled asset transfer—(i) Facts. The facts are thesame as in Example 8, except that R transfers theBusiness A assets to M, a wholly owned domesticsubsidiary of R, in a controlled asset transfer. In ad-dition, V’s basis in its Z stock is $90.

(ii) Result. Pursuant to paragraph (d)(2)(vi)(B) ofthis section, sections 367(a) and (d) do not apply toZ’s transfer of the Business A assets to R, becausesuch assets are re-transferred to M, a domestic corpo-ration, provided that the basis of the Business A as-sets in the hands of M is no greater than the basis ofthe assets in the hands of Z, and certain other require-ments are satisfied. Because Z is controlled (withinthe meaning of section 368(c)) by V, a domestic cor-poration, appropriate basis adjustments must be madepursuant to section 367(a)(5) to the stock of F held byV. (In this case, no adjustments are required because,pursuant to section 358, V takes a basis of $90 in thestock of F, which is less than V’s proportionate shareof the basis in the assets of Z ($100) transferred to R.)Section 367(a)(1) does not apply to Z’s transfer of itsBusiness B assets to R (which are not re-transferredto M) because such assets qualify for an exceptionto gain recognition under section 367(a)(3). With re-spect to the indirect transfer of Z stock, such trans-fer is not subject to gain recognition under section367(a)(1) if the requirements of paragraph (c) of thissection are satisfied, including the requirement thatV enter into a 5-year gain recognition agreement andcomply with the requirements of §1.367(a)–8 with re-spect to the gain ($100) realized on the Z stock. Un-der paragraphs (d)(2)(i) and (ii) of this section, thetransferee foreign corporation is F and the transferredcorporation is M. Pursuant to paragraph (d)(2)(iv) ofthis section, a disposition by F of the stock of R, ora disposition by R of the stock of M, will trigger thegain recognition agreement. To determine whether anasset disposition constitutes a deemed disposition ofthe transferred corporation’s stock under the rules of§1.367(a)–8(e)(3)(i), both the Business A assets in Mand the Business B assets in R must be considered.

Example 10. Concurrent application in sec-tion 368(a)(1)(A)/(a)(2)(D) reorganization—(i)Facts. The facts are the same as in Example 8,except that R acquires all of the assets of Z in areorganization described in sections 368(a)(1)(A)and (a)(2)(D). Pursuant to the reorganization, Vreceives 30 percent of the stock of F in a section 354exchange.

(ii) Result. The consequences of the transactionare similar to those in Example 8. The assets of Busi-nesses A and B that are transferred to R must be testedunder section 367(a) prior to the consideration of theindirect stock transfer rules of this paragraph (d). TheBusiness B assets qualify for the active trade or busi-ness exception under section 367(a)(3). Because theBusiness A assets do not qualify for the exception,Z must recognize $40 of gain under section 367(a)

on the transfer of Business A assets to R. BecauseV and Z file a consolidated return, V’s basis in thestock of Z is increased from $100 to $140 as a resultof Z’s $40 gain. V’s indirect transfer of Z stock willbe taxable under section 367(a) unless V enters intoa gain recognition agreement in the amount of $60($200 value of Z stock less $140 adjusted basis) andthe other requirements of paragraph (c)(1) of this sec-tion are satisfied.

Example 11. Section 368(a)(1)(A)/(a)(2)(E) re-organization—(i) Facts. F, a foreign corporation,owns all the stock of D, a domestic corporation. V, adomestic corporation, owns all the stock of Z, a for-eign corporation. V has a basis of $100 in the stockof Z which has a fair market value of $200. D isan operating corporation with assets valued at $100with a basis of $60. In a reorganization described insections 368(a)(1)(A) and (a)(2)(E), D merges into Z,and V exchanges its Z stock for 55 percent of the out-standing F stock.

(ii) Result. Under paragraph (d)(1)(ii) of thissection, V is treated as making an indirect transferof Z stock to F. V’s exchange of Z stock for F stockwill be taxable under section 367(a) (and section1248 will be applicable) if V fails to enter into a5-year gain recognition agreement in accordancewith the requirements of §1.367(a)–8. Under para-graph (b)(2) of this section, if V enters into a gainrecognition agreement, the exchange will be subjectto the provisions of section 367(b) and the regula-tions thereunder as well as section 367(a). Under§1.367(b)–4(b) of this chapter, however, no incomeinclusion is required because both F and Z are con-trolled foreign corporations with respect to whichV is a section 1248 shareholder immediately afterthe exchange. Under paragraphs (d)(2)(i) and (ii) ofthis section, the transferee foreign corporation is F,and the transferred corporation is Z (the acquiringcorporation). If F disposes (within the meaning of§1.367(a)–8(e)) of all (or a portion) of Z stock withinthe 5-year term of the agreement (and V has notmade a valid election under §1.367(a)–8(b)(1)(vii)),V is required to file an amended return for the yearof the transfer and include in income, with interest,the gain realized but not recognized on the initialsection 354 exchange. To determine whether Z (thetransferred corporation) disposes of substantiallyall of its assets, the assets of Z immediately priorto the transaction are taken into account, pursuantto paragraph (d)(2)(v)(B) of this section. BecauseD is owned by F, a foreign corporation, section367(a)(5) precludes any assets of D from qualifyingfor nonrecognition under section 367(a)(3). Thus, Drecognizes $40 of gain on the transfer of its assets toZ under section 367(a)(1).

* * * * *Example 15. Concurrent application of indirect

stock transfer rules and section 367(b)— (i) Facts. F,a foreign corporation, owns all of the stock of Newco,a domestic corporation. P, a domestic corporation,owns all of the stock of FC, a foreign corporation. P’sbasis in the stock of FC is $50 and the value of FCstock is $100. The all earnings and profits amountwith respect to the FC stock held by P is $60. See§1.367(b)–2(d). In a reorganization described insections 368(a)(1)(A) and (a)(2)(D) (and paragraph(d)(1)(i) of this section), Newco acquires all of theproperties of FC, and P exchanges its stock in FC for20 percent of the stock in F.

(ii) Result. Because a domestic corporation,Newco, acquires the assets of a foreign corpo-ration, FC, in an asset reorganization to which§1.367(b)–3(a) and (b) and the indirect stock rulesof paragraph (d) of this section apply, the section367(b) rules apply before the section 367(a) rulesapply. See §1.367(a)–3(b)(2)(i)(A). Under the rulesof section 367(b), P must include in income the allearnings and profits amount of $60 with respectto its FC stock. See §1.367(b)–3. Although P’sexchange of FC stock for F stock under section 354is an indirect stock transfer, no gain is recognizedunder section 367(a), because P’s basis in the FCstock is increased by the amount ($60) includedin income under the rules of section 367(b). See§1.367(b)–2(e)(3)(ii). Alternatively, if P’s all earn-ings and profits amount were $30, then the amountof the income inclusion and basis adjustment underthe rules of section 367(b) would be $30, and theamount of gain subject to section 367(a)(1) would be$20 unless P entered into a 5-year gain recognitionagreement in accordance with §1.367(a)–8.

* * * * *(e) * * *(1) In general. Except as provided in

paragraphs (b)(2)(i)(A), (d)(1)(iii)(B), and(d)(2)(vi)(G), or in this paragraph (e), therules in paragraphs (a), (b), and (d) of thissection apply to transfers occurring on orafter July 20, 1998. The rules in para-graphs (a) and (d) of this section, as theyapply to section 368(a)(1)(A) reorganiza-tions (including reorganizations describedin section 368(a)(2)(D) or (E)) involvinga foreign acquiring or acquired corpora-tion, apply only to transfers occurring af-ter the date these regulations are publishedas final regulations in the Federal Regis-ter. * * *

* * * * *Par. 5. Section 1.367(a)–8 is amended

as follows:1. In paragraphs (c)(2) and (d), remove

the words “district director” and add “Di-rector of Field Operations” in their place.

2. In paragraph (e)(1)(i), a sentence isadded after the first sentence.

The addition reads as follows:

§1.367(a)–8 Gain recognition agreementrequirements.

* * * * *(e) * * *(1) * * *(i) * * * It also includes an in-

direct disposition of the stock of thetransferred corporation as described in§1.367(a)–3(d)(2)(iv). * * *

* * * * *

February 14, 2005 549 2005–7 I.R.B.

Par. 6. In §1.367(b)–1(a), remove thethird and fourth sentences and add a sen-tence in their place to read as follows:

§1.367(b)–1 Other transfers.

(a) * * * For rules coordinating the con-current application of sections 367(a) and(b), including the extent to which section367(b) does not apply if the foreign corpo-ration is not treated as a corporation undersection 367(a), see §1.367(a)–3(b)(2)(i).* * *

* * * * *Par. 7. In §1.367(b)–3(b)(3)(ii), revise

paragraph (i) of Example 5 to read as fol-lows:

§1.367(b)–3 Repatriation of foreigncorporate assets in certain nonrecognitiontransactions.

* * * * *(b) * * *(3) * * *(ii) * * *Example 5—(i) Facts. DC1, a domestic corpo-

ration, owns all of the outstanding stock of FC1, aforeign corporation. FC1 owns all of the outstand-ing stock of FC2, a foreign corporation. The all earn-ings and profits amount with respect to the FC2 stockowned by FC1 is $20. In a reorganization describedin section 368(a)(1)(A), DC2, a domestic corporationunrelated to FC1 or FC2, acquires all of the assetsand liabilities of FC2 pursuant to a State W merger.FC2 receives DC2 stock and distributes such stock toFC1. The FC2 stock held by FC1 is canceled, andFC2 ceases its separate legal existence.

* * * * *Par. 8. Section 1.367(b)–4 is amended

as follows.1. Paragraph (a) is revised.2. Redesignate paragraph (b)(1)(ii) as

paragraph (b)(1)(iii), and add new para-graph (b)(1)(ii).

3. In newly designated paragraph(b)(1)(iii), after Example 3, add Examples3A and 3B.

The revisions and additions read as fol-lows:

§1.367(b)–4 Acquisition of foreigncorporate stock or assets by a foreigncorporation in certain nonrecognitiontransactions.

(a) Scope. This section applies to an ac-quisition by a foreign corporation (the for-eign acquiring corporation) of the stock or

assets of a foreign corporation (the foreignacquired corporation) in an exchange de-scribed in section 351 or a reorganizationdescribed in section 368(a)(1). In the caseof a reorganization described in sections368(a)(1)(A) and (a)(2)(E), this section ap-plies if stock of the foreign surviving cor-poration is exchanged for stock of a for-eign corporation in control of the mergingcorporation; in such a case, the foreign sur-viving corporation is treated as a foreignacquired corporation for purposes of thissection. A foreign corporation that under-goes a reorganization described in section368(a)(1)(E) is treated as both the foreignacquired corporation and foreign acquir-ing corporation for purposes of this sec-tion. See §1.367(a)–3(b)(2) for transac-tions subject to the concurrent applicationof this section and section 367(a).

(b) * * *(1) * * *(ii) Exception. In the case of a trian-

gular reorganization described in section368(a)(1)(B) or (C), or a reorganizationdescribed in sections 368(a)(1)(A) and(a)(2)(D) or (E), an exchange is not de-scribed in paragraph (b)(1)(i) of this sec-tion if the stock received in the exchangeis stock of a domestic corporation and,immediately after the exchange, such do-mestic corporation is a section 1248 share-holder of the acquired corporation (in thecase of a triangular section 368(a)(1)(B)reorganization) or the surviving corpo-ration (in the case of a reorganizationdescribed in sections 368(a)(1)(A) and(a)(2)(D) or (E)) and such acquired or sur-viving corporation is a controlled foreigncorporation. See paragraph (b)(1)(iii) ofthis section, Example 3B for an illustrationof this rule.

(iii) * * *Example 3A. (i) Facts. The facts are the same

as in Example 3, except that FC1 merges into FC2in a reorganization described in sections 368(a)(1)(A)and (a)(2)(E). Pursuant to the reorganization, DC ex-changes its FC2 stock for stock of FP.

(ii) Result. The result is similar to the result inExample 3. The transfer is an indirect stock transfersubject to section 367(a). See §1.367(a)–3(d)(1)(ii).Accordingly, DC’s exchange of FC2 stock for FPstock will be taxable under section 367(a) (and sec-tion 1248 will be applicable) if DC fails to enter into again recognition agreement. If DC enters into a gainrecognition agreement, the exchange will be subjectto the provisions of section 367(b) and the regula-tions thereunder, as well as section 367(a). If FP andFC2 are controlled foreign corporations as to whichDC is a (direct or indirect) section 1248 shareholder

immediately after the reorganization, then paragraph(b)(1)(i) of this section does not apply to requireinclusion in income of the section 1248 amountand the amount of the gain recognition agreementis the amount of gain realized on the indirect stocktransfer. If FP or FC2 is not a controlled foreigncorporation as to which DC is a (direct or indirect)section 1248 shareholder immediately after the ex-change, then DC must include in income the section1248 amount ($20) attributable to the FC2 stock thatDC exchanged. Under these circumstances, the gainrecognition agreement would be the amount of gainrealized on the indirect transfer, less the $20 section1248 income inclusion.

Example 3B. (i) Facts. The facts are the same asExample 3, except that USP, a domestic corporation,owns the controlling interest (within the meaning ofsection 368(c)) in FC1 stock. FC2 merges into FC1in a reorganization described in sections 368(a)(1)(A)and (a)(2)(D). Pursuant to the reorganization, DCexchanges its FC2 stock for USP stock.

(ii) Result. Because DC receives stock of a do-mestic corporation, USP, in the section 354 exchange,the transfer is not an indirect stock transfer subjectto section 367(a). Accordingly, the exchange willbe subject only to the provisions of section 367(b)and the regulations thereunder. Under paragraph(b)(1)(ii)(A) of this section, because the stock re-ceived is stock of a domestic corporation (USP) and,immediately after the exchange, USP is a section1248 shareholder of FC1 (the acquiring corporation)and FC1 is a controlled foreign corporation, theexchange is not described in paragraph (b)(1)(i) ofthis section and DC includes no amount in its grossincome. See §1.367(b)–13(b) and (c) for the basisand holding period rules applicable to this transac-tion, which cause USP’s adjusted basis and holdingperiod in the stock of FC1 after the transaction toreflect the basis and holding period that DC had inits FC2 stock.

* * * * *Par. 9. In §1.367(b)–6, paragraph

(a)(1), add a sentence to the end to read asfollows:

§1.367(b)–6 Effective dates andcoordination rules.

(a) * * *(1) * * * The rules of §§1.367(b)–3 and

1.367(b)–4, as they apply to reorganiza-tions described in section 368(a)(1)(A) (in-cluding reorganizations described in sec-tion 368(a)(2)(D) or (E)) involving a for-eign acquiring or foreign acquired corpo-ration, apply only to transfers occurring af-ter the date these regulations are publishedas final regulations in the Federal Regis-ter.

* * * * *Par. 10. Section 1.367(b)–13 is added

to read as follows:

2005–7 I.R.B. 550 February 14, 2005

§1.367(b)–13 Special rules fordetermining basis and holding period.

(a) Scope and definitions—(1) Scope.This section provides special basis andholding period rules for certain transac-tions involving the acquisition of propertyby a foreign acquiring corporation innonrecognition exchanges. Special rulesapply to determine the basis and holdingperiod of stock in a foreign corporation re-ceived by certain shareholders in a section354 or 356 exchange. In addition, specialrules apply to determine the basis andholding period of stock of certain foreignsurviving corporations held by a control-ling corporation whose stock is issued inan exchange under section 354 or 356 ina triangular reorganization. This sectionapplies to transactions that are subject tosection 367(b) as well as section 367(a),including transactions concurrently sub-ject to sections 367(a) and (b).

(2) Definitions. For purposes of thissection, the following definitions apply:

(i) A foreign acquired corporation isa foreign corporation whose stock orassets are acquired by a foreign corpo-ration in a reorganization described insection 368(a)(1). In a reverse triangularmerger, where T is a foreign corpora-tion, T is treated as a foreign acquiredcorporation. A foreign corporation thatundergoes a reorganization described insection 368(a)(1)(E) is treated as a foreignacquired corporation.

(ii) A block of stock has the meaningprovided in §1.1248–2(b).

(iii) A triangular reorganizationis a reorganization described in§1.358–6(b)(2)(i), (ii), or (iii) (butnot a reorganization described in§1.358–6(b)(2)(iv)). A triangular Creorganization, a forward triangularmerger, and a reverse triangular mergereach is a reorganization described in§1.358–6(b)(2)(i), (ii), or (iii), respec-tively. For purposes of triangular reorga-nizations—

(A) P is a corporation that is a party toa reorganization that is in control (withinthe meaning of section 368(c)) of anotherparty to the reorganization and whosestock is transferred pursuant to the reorga-nization;

(B) S is a corporation that is a party tothe reorganization and that is controlled byP; and

(C) T is a corporation that is anotherparty to the reorganization.

(b) Determination of basis and holdingperiod for exchanges of foreign stock—(1)Application. Except as provided in para-graph (b)(4) of this section, this paragraph(b) applies to a shareholder that exchangesstock of a foreign acquired corporation inan exchange under section 354 or 356 forstock of a controlled foreign corporation,if—

(i) Immediately before the exchange ei-ther such shareholder is a section 1248shareholder with respect to the foreign ac-quired corporation, or such shareholder isa foreign corporation and a United Statesperson is a section 1248 shareholder withrespect to both such foreign corporationand the foreign acquired corporation; and

(ii) The exchange is not described in§1.367(b)–4(b)(1)(i), (2)(i), or (3).

(2) Basis and holding period rules—(i)If a shareholder surrenders a share of stockin an exchange under the terms of section354 or 356, the basis and holding periodof each share of stock received in the ex-change shall be the same as the basis andholding period of the allocable portion ofthe share or shares of stock exchangedtherefor, as adjusted under §1.358–1 (suchthat the section 1248 amount of each shareof stock exchanged is preserved in theshare or shares of stock received). If morethan one share of stock is received in ex-change for one share of stock, the basisof the share of stock surrendered shall beallocated to the shares of stock received inthe exchange in proportion to the fair mar-ket value of the shares of stock received. Ifone share of stock is received in respect ofmore than one share of stock or a fractionof a share of stock is received, the basis ofthe shares of stock surrendered must be al-located to the share of stock received, or afraction thereof received, in a manner thatreflects, to the greatest extent possible,that a share of stock is received in respectof shares of stock acquired on the samedate and at the same price. The provisionsof this paragraph may be applied, to theextent possible, on the basis of blocks ofstock.

(ii) If a shareholder that purchased oracquired shares of stock in a corporationon different dates or at different prices ex-changes such shares of stock under theterms of section 354 or 356, and the share-holder is not able to identify which partic-

ular share or shares of stock (or portion ofa share of stock) is received in exchangefor a particular share or shares of stock, theshareholder may designate which share orshares of stock is received in exchange fora particular share or shares of stock, pro-vided that such designation is consistentwith the terms of the exchange or distribu-tion. The designation must be made on orbefore the first date on which the basis ofa share of stock received is relevant. Thebasis of a share received, for example, isrelevant when such share is sold or oth-erwise transferred. The designation willbe binding for purposes of determining theFederal tax consequences of any sale ortransfer of a share received. If the share-holder fails to make a designation, thenthe shareholder will not be able to identifywhich share is sold or transferred for pur-poses of determining the basis of propertysold or transferred under section 1012 and§1.1012–1(c) and, instead, will be treatedas selling or transferring the share receivedin respect of the earliest share purchased oracquired. See paragraph (e), Example 1 ofthis section for an illustration of this para-graph (b).

(3) In the case of a triangular reorgani-zation, this paragraph (b) applies only tothe exchange of T stock for P stock byT shareholders. See paragraph (c) of thissection to determine the basis and holdingperiod of stock of the surviving corpora-tion (S or T) held by P immediately after atriangular reorganization.

(4) Paragraphs (b)(1) through (3) of thissection shall not apply to determine the ba-sis of a share of stock received by a share-holder in an exchange described in bothsection 351 and section 354 or 356, if, inconnection with the exchange, the share-holder exchanges property for stock in anexchange to which neither section 354 nor356 applies or liabilities of the shareholderare assumed.

(c) Determination of basis and holdingperiod for triangular reorganizations—(1)Application. In the case of a triangularreorganization, this paragraph (c) applies,if—

(i) In the case of a reverse triangularmerger—

(A) Immediately before the transaction,either P is a section 1248 shareholder withrespect to S, or P is a foreign corpora-tion and a United States person is a sec-

February 14, 2005 551 2005–7 I.R.B.

tion 1248 shareholder with respect to bothP and S; and

(B) P’s exchange of S stock is not de-scribed in §1.367(b)–3(a) and (b) or in§1.367(b)–4(b)(1)(i), (2)(i), or (3); or

(ii)(A) Immediately before the transac-tion, a shareholder of T is either a section1248 shareholder with respect to T or a for-eign corporation and a United States per-son is a section 1248 shareholder with re-spect to both such foreign corporation andT; and

(B) With respect to at least one ofthe exchanging shareholders describedin paragraph (c)(1)(ii)(A) of this sec-tion, the exchange of T stock is not de-scribed in §1.367(b)–3(a) and (b) or in§1.367(b)–4(b)(1)(i), (2)(i), or (3).

(2) Basis and holding period rules. Inthe case of a triangular reorganization de-scribed in this paragraph (c), each shareof stock of the surviving corporation (Sor T) held by P must be divided into por-tions attributable to the S stock and theT stock immediately before the exchange.See paragraph (e) of this section, Examples2 through 5 for illustrations of this rule.

(i) Portions attributable to S stock—(A)In the case of a forward triangular mergeror a triangular C reorganization, the basisand holding period of the portion of eachshare of surviving corporation stock attrib-utable to the S stock is the basis and hold-ing period of such share of stock immedi-ately before the exchange.

(B) In the case of a reverse triangularmerger, the basis and holding period of theportion of each share of surviving corpo-ration stock attributable to the S stock isthe basis and the holding period immedi-ately before the exchange of a proportion-ate amount of the S stock to which theportion relates. If P is a shareholder de-scribed in paragraph (c)(1)(i)(A) of thissection with respect to S, and P exchangestwo or more blocks of S stock pursuant tothe transaction, then each share of the sur-viving corporation (T) attributable to the Sstock must be further divided into separateportions to account for the separate blocksof stock in S.

(C) If the value of S stock immediatelybefore the triangular reorganization is lessthan one percent of the value of the sur-viving corporation stock immediately afterthe triangular reorganization, then P maydetermine its basis in the surviving corpo-ration stock by applying the rules of para-

graph (c)(2)(ii) of this section to determinethe basis and holding period of the sur-viving corporation stock attributable to theT stock, and then increasing the basis ofeach share of surviving corporation stockby the proportionate amount of P’s aggre-gate basis in the S stock immediately be-fore the exchange (without dividing thestock of the surviving corporation into sep-arate portions attributable to the S stock).

(ii) Portions attributable to Tstock—(A) If any exchanging share-holder of T stock is described in para-graph (c)(1)(ii) of this section, the basisand holding period of the portion of eachshare of stock in the surviving corporationattributable to the T stock is the basis andholding period immediately before theexchange of a proportionate amount of theT stock to which such portion relates. Ifany exchanging shareholder of T stock isdescribed in paragraph (c)(1)(ii) of thissection, and such shareholder exchangestwo or more blocks of T stock pursuant tothe transaction, then each share of surviv-ing corporation stock attributable to the Tstock must be further divided into separateportions to account for the separate blocksof T stock.

(B) If no exchanging shareholder of Tstock is described in paragraph (c)(1)(ii)of this section, the rules of §1.358–6(c)apply to determine the basis of the portionof each share of the surviving corporationattributable to T immediately before theexchange.

(d) Special rules applicable to dividedshares of stock—(1) In general—(i) Sharesof stock in different blocks can be aggre-gated into one divided portion for basispurposes, if such shares immediately be-fore the exchange are owned by one ormore shareholders that are—

(A) Neither section 1248 shareholderswith respect to the corporation nor foreigncorporate shareholders; or

(B) Foreign corporate shareholders,provided that no United States persons aresection 1248 shareholders with respect toboth such foreign corporate shareholdersand the corporation.

(ii) For purposes of determining theamount of gain realized on the sale or ex-change of stock that has a divided portionpursuant to paragraph (c) of this section,any amount realized on such sale or ex-change will be allocated to each dividedportion of the stock based on the relative

fair market value of the stock to whichthe portion is attributable at the time theportions were created.

(iii) Shares of stock will no longer berequired to be divided if section 1248 orsection 964(e) would not apply to a dispo-sition or exchange of such stock.

(2) Pre-exchange earnings and prof-its. All earnings and profits (or deficits)accumulated by a foreign corporation be-fore the reorganization and attributable toa share (or block) of stock for purposes ofsection 1248 are attributable to the dividedportion of stock with the basis and hold-ing period of that share (or block). See§1.367(b)–4(d).

(3) Post-exchange earnings and prof-its. Any earnings and profits (or deficits)accumulated by the surviving corporationsubsequent to the reorganization are at-tributed to each divided share of stock pur-suant to section 1248 and the regulationsthereunder. The amount of earnings andprofits (or deficits) attributable to a dividedshare of stock is further attributed to the di-vided portions of such share of stock basedon the relative fair market value of each di-vided portion of stock.

(e) Examples. The rules of this sectionare illustrated by the following examples:

Example 1. (i) Facts. US1 is a domestic corpo-ration that owns all the stock of FT, a foreign corpora-tion with 100 shares of stock outstanding. Each shareof FT stock is valued at $10x. Because US1 acquiredthe stock of FT at two different dates, US1 owns twoblocks of FT stock for purposes of section 1248. Thefirst block consists of 60 shares. The shares in the firstblock have a basis of $300x ($5x per share), a hold-ing period of 10 years, and $240x ($4x per share) ofearnings and profits attributable to the shares for pur-poses of section 1248. The second block consists of40 shares. The shares in the second block have a ba-sis of $600x ($15x per share), a holding period of 2years, and $80x ($2x per share) of earnings and prof-its attributable to the shares for purposes of section1248. US2, a domestic corporation, owns all of thestock of FP, a foreign corporation, which owns all ofthe stock of FS, a foreign corporation. FT merges intoFS with FS surviving in a reorganization described insection 368(a)(1)(A). Pursuant to the reorganization,US1 receives 50 shares of FS stock with a value of$1,000x for its FT stock in an exchange that qualifiesfor nonrecognition under section 354.

(ii) Basis and holding period determination—(A)US1 is a section 1248 shareholder of FT immediatelybefore the exchange and exchanges its FT stock forstock of a controlled foreign corporation (FS) as towhich US1 is a section 1248 shareholder immediatelyafter the exchange. US1 is not required to includeincome under §1.367(b)–4(b) with respect to the ex-change. Accordingly, the basis and holding period ofthe FS stock received by US1 is determined pursuantto paragraph (b) of this section.

2005–7 I.R.B. 552 February 14, 2005

(B) Pursuant to paragraph (b) of this section, 30shares of the FS stock received by US1 in the reor-ganization (valued at $20x per share and exchangedfor US1’s first block of 60 shares of FT stock) have abasis of $300x ($10x per share), a holding period of10 years, and $240x of earnings and profits ($8x pershare) attributable to such shares for purposes of sec-tion 1248. In addition, 20 shares of the FS stock (val-ued at $20 per share and exchanged for US1’s sec-ond block of 40 shares of FT stock) have a basis of$600x ($30x per share), a holding period of 2 years,and $80x of earnings and profits ($4x per share) at-tributable to such shares for purposes of section 1248.

(iii) Subsequent Disposition. Assume, subse-quent to the exchange, US1 disposes of 20 shares ofFS stock. On or before the date of the dispositionwhen the basis of the F1 shares received by US1becomes relevant, US1 can designate the 20 sharesfrom the first block, the second block, or from anycombination of shares in both blocks.

Example 2. (i) Facts. The facts are the same as inExample 1, except that US1 receives 50 shares of FPstock (instead of FS stock) with a value of $1,000x inexchange for its FT stock. Accordingly, the merger ofFT into FS qualifies as forward triangular merger, andimmediately after the exchange US1 is a section 1248shareholder with respect to FP and FS. Additionally,prior to the transaction, FP owned two blocks of FSstock. Each block consisted of 10 shares with a valueof $200x ($20x per share). The shares in the firstblock had a basis of $50x ($5x per share), a holdingperiod of 10 years, and $50x ($5x per share) of earn-ings and profits attributable to such shares for pur-poses of section 1248. The shares in the second blockhad a basis of $100x ($10x per share), a holding pe-riod of 5 years, and $20x ($2x per share) of earningsand profits attributable to such shares for purposes ofsection 1248.

(ii) Basis and holding period determination. (A)The basis and holding period of the FP shares re-ceived by US1 in the exchange are determined pur-suant to paragraph (b) of this section and are identicalto the results in Example 1.

(B)(1) US1 is a section 1248 shareholder ofFT immediately before the transaction. More-over, US1 is not required to include income under§1.367(b)–3(b) or 1.367(b)–4(b) as described inparagraph (c)(2) of this section. Accordingly, thebasis and holding period of the FS stock held by FPimmediately after the triangular reorganization isdetermined pursuant to paragraph (c) of this section.

(2) Pursuant to paragraph (c) of this section, eachshare of FS stock is divided into portions attributableto the basis and holding period of the FS stock held byFP immediately before the exchange (the FS portion)and the FT stock held by US1 immediately before theexchange (the FT portion). The basis and holding pe-riod of the FS portion is the basis and holding periodof the FS stock held by FP immediately before theexchange. Thus, each share of FS stock in the firstblock has a portion with a basis of $5x, a value of$20x, a holding period of 10 years, and $5x of earn-ings and profits attributable to such portion for pur-poses of section 1248. Each share of FS stock in thesecond block has a portion with a basis of $10x, avalue of $20x, a holding period of 5 years, and $2xof earnings and profits attributable to such portion forpurposes of section 1248.

(3) Because the exchanging shareholder of FTstock (US1) is a section 1248 shareholder, the hold-ing period and basis of the FT portion is the hold-ing period and the proportionate amount of the ba-sis of the FT stock immediately before the exchangeto which such portion relates. Further, because US1exchanged two blocks of FT stock, the FT portionmust be divided into two separate portions attribut-able to the two blocks of FT stock. Thus, each shareof FS stock will have a second portion with a basisof $15x ($300x basis / 20 shares), a value of $30x($600x value / 20 shares), a holding period of 10years, and $12x of earnings and profits ($240x / 20shares) attributable to such portion for purposes ofsection 1248. Each share of FS stock will have athird portion with a basis of $30x ($600x basis / 20shares), a value of $20x ($400x value / 20 shares), aholding period of 2 years, and $4x of earnings andprofits ($80x / 20 shares) attributable to such portionfor purposes of section 1248.

(iii) Assume, immediately after the transaction,FP disposes of a share of FS stock from the first block.When FP disposes of any share of its FS stock, it istreated as disposing of each divided portion of suchshare. With respect to the first portion (attributableto the FS stock), FP recognizes a gain of $15x ($20xvalue - $5x basis), $5x of which is treated as a divi-dend under section 1248. With respect to the secondportion (attributable to the first block of FT stock), FPrecognizes a gain of $15x ($30x value - $15x basis),$12x of which is treated as a dividend under section1248. With respect to the third portion (attributable tothe second block of FT stock), FP recognizes a capi-tal loss of $10x ($20x value - $30x basis).

(iv) Assume further, immediately after the trans-action, FP also disposes of a share of stock from thesecond block of FS stock. With respect to the firstportion (attributable to the FS stock), FP recognizes again of $10x ($20x value - $10x basis), $2x of whichis treated as a dividend under section 1248. With re-spect to the second portion (attributable to the firstblock of FT stock), FP recognizes a gain of $15x($30x value - $15x basis), $12x of which is treatedas a dividend under section 1248. With respect tothe third portion (attributable to the second block ofFT stock), FP recognizes a capital loss of $10x ($20xvalue - $30x basis).

Example 2A. (i) Facts. The facts are the same asin Example 2, except that FS merges into FT withFT surviving in a reverse triangular merger. Pursuantto the merger, US1 receives FP stock with a valueof $1,000x in exchange for its FT stock, and FP re-ceives 10 shares of FT stock with a value of $1,400xin exchange for its FS stock. Immediately after theexchange, US1 is a section 1248 shareholder with re-spect to FP and FT.

(ii) Basis and holding period determination—(A)The basis and holding period of the FP shares re-ceived by US1 and the stock of the surviving corpora-tion held by FP are the same as in Example 2, exceptthat each share of the surviving corporation (FT, in-stead of FS) will be divided into four portions insteadof three portions. Because FP exchanges two blocksof FS stock, the FS portion must be divided into twoseparate portions attributable to the two blocks of FSstock. Because US1 exchanges two blocks of FTstock, the FT portion must be divided into two sep-arate portions attributable to the two blocks of FTstock.

(B) Thus, each share of the surviving corpora-tion (FT) will have a first portion (attributable to thefirst block of FS stock) with a basis of $5x ($50x /10 shares), a value of $20x ($200x / 10 shares), aholding period of 10 years, and $5x of earnings andprofits ($50x / 10 shares) attributable to such portionfor purposes of section 1248. Each share of FT stockwill have a second portion (attributable to the secondblock of FS stock) with a basis of $10x ($100x / 10shares), a value of $20x ($200x / 10 shares), a hold-ing period of 5 years, and $2x of earnings and prof-its ($20x / 10 shares) attributable to such portion forpurposes of section 1248. Moreover, each share of FTstock will have a third portion (attributable to the firstblock of FT stock) with a basis of $30x ($300x basis /10 shares), a value of $60x ($600x value / 10 shares),a holding period of 10 years, and $24x of earnings andprofits ($240x / 10 shares) attributable to such portionfor purposes of section 1248. Lastly, each share ofFT stock will have a fourth portion (attributable to thesecond block of FT stock) with a basis of $60x ($600xbasis / 10 shares), a value of $40x ($400x value / 10shares), a holding period of 2 years, and $8x of earn-ings and profits ($80x / 10 shares) attributable to suchportion for purposes of section 1248.

Example 3. (i) Facts. USP, a domestic corpora-tion, owns all the stock of FS, a foreign corporationwith 10 shares of stock outstanding. Each share of FSstock has a value of $10x, a basis of $5x, a holdingperiod of 10 years, and $7x of earnings and profits at-tributable to such share for purposes of section 1248.FP, a foreign corporation, owns the stock of FT, an-other foreign corporation. FP and FT do not have anysection 1248 shareholders. FT has assets with a valueof $100x, a basis of $50x, and no liabilities. The FTstock held by FP has a value of $100x and a basisof $75x. FT merges into FS with FS surviving in aforward triangular merger. Pursuant to the reorgani-zation, FP receives USP stock with a value of $100xin exchange for its FT stock.

(ii) Basis and holding period determination—(A)Because USP is a section 1248 shareholder of FS im-mediately before the transaction, the basis and hold-ing period of the FS stock held by USP immediatelyafter the triangular reorganization is determined pur-suant to paragraph (c) of this section.

(B) Pursuant to paragraph (c) of this section, eachshare of FS stock is divided into portions attributableto the basis and holding period of the FS stock heldby USP immediately before the exchange (the FS por-tion) and the basis of FT’s net assets (the FT portion)immediately before the exchange. The basis of FT’snet assets (and not FT stock) is used to determine theFT portion because FT does not have a section 1248shareholder immediately before the transaction. Asa result, the rules of §1.358–6(c) apply to determinethe basis of the FT portion of each share of FS stock.The basis and holding period of the FS portion is thebasis and holding period of the FS stock held by USPimmediately before the exchange. Thus, each shareof FS stock has a portion with a basis of $5x, a valueof $10x, and a holding period of 10 years. The ba-sis of the FT portion is the basis of the FT assets towhich such portion relates. Thus, each share of FSstock has a second portion with a basis of $5x ($50xbasis in FT’s assets / 10 shares) and a value of $10x($100x value of FT’s assets / 10 shares). All of FS’searnings and profits prior to the transaction ($70x) isattributed solely to the FS portion in each share of FS

February 14, 2005 553 2005–7 I.R.B.

stock. The FS portion of each share of FS stock hasearnings and profits of $7x ($70x / 10 shares) attribut-able to such portion for purposes of section 1248. Asa result of each share of stock being divided into por-tions, the basis of the FS stock is not averaged withthe basis of the FT assets to increase the section 1248amount with respect to the stock of the surviving cor-poration (FS).

Example 4. (i) Facts. US, a domestic corporation,owns all of the stock of FT, a foreign corporation.The FT stock held by US constitutes a single blockof stock with a value of $1,000x, a basis of $600x,and holding period of 5 years. USP, a domestic cor-poration, forms FS, a foreign corporation, pursuantto the plan of reorganization and capitalizes it with$10x of cash. FS merges into FT with FT survivingin a reverse triangular merger and a reorganization de-scribed in section 368(a)(1)(B). Pursuant to the reor-ganization, US receives USP stock with a value of$1,000x in exchange for its FT stock, and USP re-ceives 10 shares of FT stock with a value of $1,010xin exchange for its FS stock.

(ii) Basis and holding period determination. (A)US and USP are section 1248 shareholders of FT andFS, respectively, immediately before the transaction.Neither US nor USP is required to include income un-der §1.367(b)–3(b) or 1.367(b)–4(b) as described inparagraph (c)(2) of this section. The basis and hold-ing period of the FT stock held by USP is determinedpursuant to paragraph (c) of this section.

(B) Pursuant to paragraph (c) of this section,because the exchanging shareholder of FT stock(US) is a section 1248 shareholder of FT, each shareof the surviving corporation (FT) has a proportionateamount of the basis and holding period of the FTstock immediately before the exchange to which suchshare relates. Thus, the portion of each share of FTstock attributable to the FT stock has a basis of $60x($600x basis / 10 shares), a value of $100x ($1,000xvalue / 10 shares), and a holding period of 5 years.Because the value of FS stock immediately beforethe triangular reorganization ($10x) is less than onepercent of the value of the surviving corporation(FT) immediately after the triangular reorganization($1,010x), USP may determine its basis in the stockof the surviving corporation (FT) by increasing thebasis of each share of FT stock by the proportionateamount of USP’s aggregate basis in the FS stockimmediately before the exchange (without dividingeach share of FT stock into separate portions to ac-count for FS and FT). If USP so elects, USP’s basisin each share of FT stock is increased by $1x ($10xbasis in FS stock / 10 shares). As a result, each shareof FT stock has a basis of $61x, a value of $101x,and a holding period of 5 years.

Example 5. (i) Facts. US, a domestic corpora-tion, owns all of the stock of FT, a foreign corpora-tion. The FT stock held by US constitutes one blockof stock with a basis of $170x, a value of $200x, aholding period of 5 years, and $10x of earnings andprofits attributable to such stock for purposes of sec-tion 1248. FP, a foreign corporation, owns all thestock of FS, a foreign corporation. FS has 10 sharesof stock outstanding. No United States person is asection 1248 shareholder with respect to FP or FS.The FS stock held by FP has a value of $100x and abasis of $50x ($5x per share). FT merges into FS withFS surviving in a forward triangular merger. Pursuantto the merger, US receives FP stock with a value of

$200x for its FT stock in an exchange that qualifiesfor non-recognition under section 354. FP is a con-trolled foreign corporation and US is a section 1248shareholder with respect to FP and FS immediatelyafter the exchange.

(ii) Basis and holding period determination. (A)Because US is a section 1248 shareholder of FT im-mediately before the transaction, and US is not re-quired to include income under §§1.367(b)–3(b) and1.367(b)–4(b) as described in paragraph (c)(2) of thissection, the basis and holding period of the FS stockheld by FP immediately after the triangular reorgani-zation is determined pursuant to paragraph (c) of thissection.

(B) Pursuant to paragraph (c) of this section, eachshare of FS stock is divided into portions attributableto the basis and holding period of the FS stock held byFP immediately before the exchange (the FS portion)and the FT stock held by US immediately before theexchange (the FT portion). The basis and holding pe-riod of the FS portion is the basis and holding periodof the FS stock held by FP immediately before theexchange. Thus, each share of FS stock has a por-tion with a basis of $5x and a value of $10x. Becausethe exchanging shareholder of FT stock (US) is a sec-tion 1248 shareholder of FT, the basis and holdingperiod of the FT portion is the proportionate amountof the basis and the holding period of the FT stockimmediately before the exchange to which such por-tion relates. Thus, each share of FS stock will havea second portion with a basis of $17x ($170x basis /10 shares), a value of $20x ($200x value / 10 shares),a holding period of 5 years, and $1x of earnings andprofits ($10x earnings and profits / 10 shares) attrib-utable to such portion for purposes of section 1248.

(iii) Subsequent disposition. (A) Several yearsafter the merger, FP disposes of all of its FS stock ina transaction governed by section 964(e). At the timeof the disposition, FS stock has decreased in value to$210x (a post-merger reduction in value of $90x), andFS has incurred a post-merger deficit in earnings andprofits of $30x.

(B) Pursuant to paragraph (d)(1)(ii) of this sec-tion, for purposes of determining the amount of gainrealized on the sale or exchange of stock that has adivided portion, any amount realized on such saleor exchange is allocated to each divided portion ofthe stock based on the relative fair market value ofthe stock to which the portion is attributable at thetime the portions were created. Immediately beforethe merger, the value of the FS stock in relation tothe value of both the FS stock and the FT stock wasone-third ($100x / ($100x plus $200x)). Likewise,immediately before the merger, the value of the FTstock in relation to the value of both the FT stockand the FS stock was two-thirds ($200x / $100x plus$200x). Accordingly, one-third of the $210x amountrealized is allocated to the FS portion of each shareand two-thirds to the FT portion of each share. Thus,the amount realized allocated to the FS portion ofeach share is $7x (one-third of $210x divided by 10shares). The amount realized allocated to the FT por-tion of each share is $14x (two-thirds of $210x di-vided by 10 shares).

(C) Pursuant to paragraph (d)(3) of this section,any earnings and profits (or deficits) accumulated bythe surviving corporation subsequent to the reorgani-zation are attributed to the divided portions of sharesof stock based on the relative fair market value of

each divided portion of stock. Accordingly, one-thirdof the post-merger earnings and profits deficit of $30xis allocated to the FS portion of each share and two-thirds to the FT portion of each share. Thus, thedeficit in earnings and profits allocated to the FS por-tion of each share is $1x (one-third of $30x dividedby 10 shares). The deficit in earnings and profits al-located to the FT portion of each share is $2x (two-thirds of $30x divided by 10 shares).

(D) When FP disposes of its FS stock, FP istreated as disposing of each divided portion of ashare of stock. With respect to the FS portion ofeach share of stock, FP recognizes a gain of $2x ($7xvalue - $5x basis), which is not recharacterized asa dividend because a deficit in earnings and profitsof $1x is attributable to such portion for purposes ofsection 1248. With respect to the FT portion of eachshare of stock, FP recognizes a loss of $3x ($14xvalue - $17x basis).

(e) Effective date. This section appliesto exchanges occurring after the date theseregulations are published as final regula-tions in the Federal Register.

Par. 11. Section 1.884–2 is amendedas follows:

1. Paragraphs (c)(3) through (c)(6)(i)(A) are revised.

2. Paragraphs (c)(6)(i)(B), (C), and (D)are added.

3. Paragraphs (c)(6)(ii) through (f) arerevised.

4. Paragraph (g) is amended by addinga sentence at the end.

The revisions and additions read as fol-lows:

§1.884–2 Special rules for terminationor incorporation of a U.S. trade orbusiness or liquidation or reorganizationof a foreign corporation or its domesticsubsidiary.

* * * * *(c)(3) through (c)(6)(i)(A) [Re-

served]. For further guidance, see§1.884–2T(c)(3) through (c)(6)(i)(A).

(c)(6)(i)(B) Shareholders of the trans-feree (or of the transferee’s parent inthe case of a triangular reorganizationdescribed in section 368(a)(1)(C) ora reorganization described in sections368(a)(1)(A) and 368(a)(2)(D) or (E))who in the aggregate owned more than25 percent of the value of the stock of thetransferor at any time within the 12-monthperiod preceding the close of the year inwhich the section 381(a) transaction oc-curs sell, exchange or otherwise disposeof their stock or securities in the transfereeat any time during a period of three years

2005–7 I.R.B. 554 February 14, 2005

from the close of the taxable year in whichthe section 381(a) transaction occurs.

(c)(6)(i)(C) In the case of a triangu-lar reorganization described in section368(a)(1)(C) or a reorganization describedin sections 368(a)(1)(A) and 368(a)(2)(D)or (E), the transferee’s parent sells, ex-changes, or otherwise disposes of its stockor securities in the transferee at any timeduring a period of three years from theclose of the taxable year in which the sec-tion 381(a) transaction occurs.

(c)(6)(i)(D) A corporation related toany such shareholder or the shareholder it-self if it is a corporation (subsequent to anevent described in paragraph (c)(6)(i)(A)or (B) of this section) or the transferee’sparent (subsequent to an event describedin paragraph (c)(6)(i)(C) of this section),uses, directly or indirectly, the proceeds orproperty received in such sale, exchangeor disposition, or property attributablethereto, in the conduct of a trade or busi-ness in the United States at any time duringa period of three years from the date of salein the case of a disposition of stock in thetransferor, or from the close of the taxableyear in which the section 381(a) transac-tion occurs in the case of a dispositionof the stock or securities in the transferee(or the transferee’s parent in the case ofa triangular reorganization described insection 368(a)(1)(C) or a reorganizationdescribed in sections 368(a)(1)(A) and(a)(2)(D) or (E)). Where this paragraph(c)(6)(i) applies, the transferor’s branchprofits tax liability for the taxable year inwhich the section 381(a) transaction oc-curs shall be determined under §1.884–1,taking into account all the adjustmentsin U.S. net equity that result from thetransfer of U.S. assets and liabilities to thetransferee pursuant to the section 381(a)transaction, without regard to any provi-sions in this paragraph (c). If an eventdescribed in paragraph (c)(6)(i)(A), (B),or (C) of this section occurs after the closeof the taxable year in which the section381(a) transaction occurs, and if additionalbranch profits tax is required to be paidby reason of the application of this para-graph (c)(6)(i), then interest must be paidon that amount at the underpayment ratesdetermined under section 6621(a)(2), withrespect to the period between the date thatwas prescribed for filing the transferor’sincome tax return for the year in which thesection 381(a) transaction occurs and the

date on which the additional tax for thatyear is paid. Any such additional tax lia-bility together with interest thereon shallbe the liability of the transferee within themeaning of section 6901 pursuant to sec-tion 6901 and the regulations there under.

(c)(6)(ii) through (f) [Reserved]. Forfurther guidance, see §1.884–2T(c)(6)(ii)through (f).

(g) * * * Paragraphs (c)(6)(i)(B), (C),and (D), are applicable for tax years be-ginning after December 31, 1986, exceptthat such paragraphs are applicable totransactions occurring after the date theseregulations are published as final regula-tions in the Federal Register in the caseof reorganizations described in sections368(a)(1)(A) and 368(a)(2)(D) or (E).

Par. 12. In §1.884–2T, paragraphs(c)(6)(i)(B), (C), and (D) are revised toread as follows:

§1.884–2T Special rules for terminationor incorporation of a U.S. trade orbusiness or liquidation or reorganizationof a foreign corporation or its domesticsubsidiary (Temporary).

* * * * *(c) * * *(6) * * *(i) * * *(B), (C), and (D) [Reserved]. For fur-

ther guidance, see §1.884–2(c)(6)(i)(B),(C), and (D).

Mark E. Matthews,Deputy Commissioner forServices and Enforcement.

(Filed by the Office of the Federal Register on January 4,2005, 8:45 a.m., and published in the issue of the FederalRegister for January 5, 2005, 70 F.R. 749)

Archer MSAs

Announcement 2005–12

PURPOSE

Sections 220(i) and (j) of the InternalRevenue Code provide that if the num-ber of Archer Medical Savings Account(Archer MSA) returns filed for 2003 ora statutorily specified projection of thenumber of Archer MSA returns that willbe filed for 2004 exceeds 750,000, thenFebruary 1, 2005, is a “cut-off” date for

the Archer MSA pilot project. The Inter-nal Revenue Service (IRS) has determinedthat the applicable number of Archer MSAreturns filed for 2003 is 60,832 and that theapplicable number of Archer MSA returnsprojected to be filed for 2004 is 56,492(after reduction in each case for statutorilyspecified exclusions, such as the exclu-sion for previously uninsured taxpayers).Consequently, February 1, 2005, is not a“cut-off” date and 2004 is not a “cut-off’year for the Archer MSA pilot project.

BACKGROUND

The Health Insurance Portability andAccountability Act of 1996 added section220 to the Code to permit eligible individu-als to establish Archer MSAs under a pilotproject effective January 1, 1997. Thepilot project, as amended by The WorkingFamilies Tax Relief Act of 2004 (WFTRA)§ 322, has a scheduled “cut-off” year of2005, but may have an earlier “cut-off”year if the number of individuals whohave established Archer MSAs exceedscertain numerical limitations. Trustees’reports for Archer MSAs established fromJanuary 1, 2004, through June 30, 2004,were due no later than January 3, 2005.IRS is required to publish a determinationof whether 2004 is a “cut-off” year nolater than February 1, 2005. See sections220(i) and (j) as amended by WFTRA;Ann. 2004–82, 2004–45 I.R.B. 834.

If a year is a “cut-off” year, section220(i)(1) generally provides that no in-dividual will be eligible for a deductionor exclusion for Archer MSA contribu-tions for any taxable year beginning af-ter the “cut-off’ year unless the individ-ual (A) was an active Archer MSA partic-ipant for any taxable year ending on or be-fore the close of the “cut-off” year, or (B)first became an active Archer MSA par-ticipant for a taxable year ending after the“cut-off” year by reason of coverage undera high deductible health plan of an ArcherMSA-participating employer.

Section 220(j)(2)(A) provides that thenumerical limitation for 2004 is exceededif the number of Archer MSA returns filedon or before April 15, 2004, for taxableyears ending with or within the 2003 cal-endar year, plus the Secretary’s estimateof the number of Archer MSA returns forthose taxable years which will be filedafter April 15, 2004, exceeds 750,000.

February 14, 2005 555 2005–7 I.R.B.

For this purpose, section 220(j)(2)(A) pro-vides that a tax return is an Archer MSAreturn for a taxable year if any exclusionis claimed under section 106(b) or anydeduction is claimed under section 220for that taxable year. Section 220(j)(2)(B)provides, as an alternative test, that thenumerical limitation for 2004 is also ex-ceeded if the sum of 90 percent of theArcher MSA returns for 2003 plus theproduct of 2.5 and the number of ArcherMSAs for taxable years beginning in 2004that are established during the portion of2004 preceding July 1 (based on reportsby Archer MSA trustees and custodians),exceeds 750,000.

Under section 220(j)(3), in determiningwhether any calendar year is a “cut-off”year, the Archer MSA of any previouslyuninsured individual is not taken into ac-count. In addition, section 220(j)(4)(D)specifies that, to the extent practical, allArcher MSAs established by an individualare aggregated and two married individu-als opening separate Archer MSAs are tobe treated as having a single Archer MSAfor purposes of determining the number ofArcher MSAs.

A total of 66,015 tax returns reportingan excludable or deductible contribution to

an Archer MSA for the 2003 taxable yearwere filed by April 15, 2004. Of this to-tal, 15,513 taxpayers were reported as be-ing previously uninsured. It has been es-timated that an additional 13,220 tax re-turns reporting Archer MSA contributionsfor the 2003 taxable year have been orwill be filed after April 15, 2004, includ-ing 2,890 taxpayers who were previouslyuninsured. Accordingly, it has been deter-mined that there were 79,235 (66,015 plus13,220) Archer MSA returns for 2003. Ofthis total, 18,403 (15,513 plus 2,890) werefor taxpayers reported as being previouslyuninsured. As a result, 60,832 (79,235 mi-nus 18,403) Archer MSA returns count to-ward the applicable statutory limitation for2004 Archer MSA returns of 750,000.

Based on the Forms 8851 filed on orbefore January 3, 2005, by Archer MSAtrustees and custodians, it has been deter-mined that 4,062 taxpayers who did nothave Archer MSA contributions for 2003established Archer MSAs for 2004 duringthe portion of 2004 preceding July 1. Ofthis total, 3,362 taxpayers were reportedby trustees and custodians as previouslyuninsured, and therefore are not taken intoaccount in determining whether 2004 is a“cut-off” year. In addition, 3 taxpayers

were reported by trustees and custodiansas excludable from the count because hisor her spouse also established an ArcherMSA. Accordingly, the applicable numberof Archer MSAs established from January1, 2004, through June 30, 2004, is 697(4,062 minus (3,362 plus 3)). The alterna-tive limitation for 2004 (90 percent of theapplicable number of Archer MSA returnsfor 2003 plus the product of 2.5 and thenumber of applicable Archer MSAs estab-lished from January 1, 2004, through June30, 2004) is 56,492 (90 percent of 60,832plus 2.5 multiplied by 697), which is lessthan the statutory limit of 750,000. Thus,2004 is not a “cut-off” year for the ArcherMSA pilot project by reason of either the2004 Archer MSA returns test of section220(j)(2)(A) or the alternative test of sec-tion 220(j)(2)(B) of the Code.

Questions regarding this announcementmay be directed to Elizabeth Purcell inthe Office of Division Counsel/AssociateChief Counsel (Tax Exempt and Govern-ment Entities) at (202) 622–6080 (not atoll-free number).

2005–7 I.R.B. 556 February 14, 2005

Definition of TermsRevenue rulings and revenue procedures(hereinafter referred to as “rulings”) thathave an effect on previous rulings use thefollowing defined terms to describe the ef-fect:

Amplified describes a situation whereno change is being made in a prior pub-lished position, but the prior position is be-ing extended to apply to a variation of thefact situation set forth therein. Thus, ifan earlier ruling held that a principle ap-plied to A, and the new ruling holds that thesame principle also applies to B, the earlierruling is amplified. (Compare with modi-fied, below).

Clarified is used in those instanceswhere the language in a prior ruling is be-ing made clear because the language hascaused, or may cause, some confusion.It is not used where a position in a priorruling is being changed.

Distinguished describes a situationwhere a ruling mentions a previously pub-lished ruling and points out an essentialdifference between them.

Modified is used where the substanceof a previously published position is beingchanged. Thus, if a prior ruling held that aprinciple applied to A but not to B, and thenew ruling holds that it applies to both A

and B, the prior ruling is modified becauseit corrects a published position. (Comparewith amplified and clarified, above).

Obsoleted describes a previously pub-lished ruling that is not considered deter-minative with respect to future transac-tions. This term is most commonly used ina ruling that lists previously published rul-ings that are obsoleted because of changesin laws or regulations. A ruling may alsobe obsoleted because the substance hasbeen included in regulations subsequentlyadopted.

Revoked describes situations where theposition in the previously published rulingis not correct and the correct position isbeing stated in a new ruling.

Superseded describes a situation wherethe new ruling does nothing more than re-state the substance and situation of a previ-ously published ruling (or rulings). Thus,the term is used to republish under the1986 Code and regulations the same po-sition published under the 1939 Code andregulations. The term is also used whenit is desired to republish in a single rul-ing a series of situations, names, etc., thatwere previously published over a period oftime in separate rulings. If the new rul-ing does more than restate the substance

of a prior ruling, a combination of termsis used. For example, modified and su-perseded describes a situation where thesubstance of a previously published rulingis being changed in part and is continuedwithout change in part and it is desired torestate the valid portion of the previouslypublished ruling in a new ruling that is selfcontained. In this case, the previously pub-lished ruling is first modified and then, asmodified, is superseded.

Supplemented is used in situations inwhich a list, such as a list of the names ofcountries, is published in a ruling and thatlist is expanded by adding further names insubsequent rulings. After the original rul-ing has been supplemented several times, anew ruling may be published that includesthe list in the original ruling and the ad-ditions, and supersedes all prior rulings inthe series.

Suspended is used in rare situationsto show that the previous published rul-ings will not be applied pending somefuture action such as the issuance of newor amended regulations, the outcome ofcases in litigation, or the outcome of aService study.

AbbreviationsThe following abbreviations in current useand formerly used will appear in materialpublished in the Bulletin.

A—Individual.Acq.—Acquiescence.B—Individual.BE—Beneficiary.BK—Bank.B.T.A.—Board of Tax Appeals.C—Individual.C.B.—Cumulative Bulletin.CFR—Code of Federal Regulations.CI—City.COOP—Cooperative.Ct.D.—Court Decision.CY—County.D—Decedent.DC—Dummy Corporation.DE—Donee.Del. Order—Delegation Order.DISC—Domestic International Sales Corporation.DR—Donor.E—Estate.EE—Employee.E.O.—Executive Order.

ER—Employer.ERISA—Employee Retirement Income Security Act.EX—Executor.F—Fiduciary.FC—Foreign Country.FICA—Federal Insurance Contributions Act.FISC—Foreign International Sales Company.FPH—Foreign Personal Holding Company.F.R.—Federal Register.FUTA—Federal Unemployment Tax Act.FX—Foreign corporation.G.C.M.—Chief Counsel’s Memorandum.GE—Grantee.GP—General Partner.GR—Grantor.IC—Insurance Company.I.R.B.—Internal Revenue Bulletin.LE—Lessee.LP—Limited Partner.LR—Lessor.M—Minor.Nonacq.—Nonacquiescence.O—Organization.P—Parent Corporation.PHC—Personal Holding Company.PO—Possession of the U.S.PR—Partner.

PRS—Partnership.PTE—Prohibited Transaction Exemption.Pub. L.—Public Law.REIT—Real Estate Investment Trust.Rev. Proc.—Revenue Procedure.Rev. Rul.—Revenue Ruling.S—Subsidiary.S.P.R.—Statement of Procedural Rules.Stat.—Statutes at Large.T—Target Corporation.T.C.—Tax Court.T.D. —Treasury Decision.TFE—Transferee.TFR—Transferor.T.I.R.—Technical Information Release.TP—Taxpayer.TR—Trust.TT—Trustee.U.S.C.—United States Code.X—Corporation.Y—Corporation.Z —Corporation.

February 14, 2005 i 2005–7 I.R.B.

Numerical Finding List1

Bulletins 2005–1 through 2005–7

Announcements:

2005-1, 2005-1 I.R.B. 257

2005-2, 2005-2 I.R.B. 319

2005-3, 2005-2 I.R.B. 270

2005-4, 2005-2 I.R.B. 319

2005-5, 2005-3 I.R.B. 353

2005-6, 2005-4 I.R.B. 377

2005-7, 2005-4 I.R.B. 377

2005-8, 2005-4 I.R.B. 380

2005-9, 2005-4 I.R.B. 380

2005-10, 2005-5 I.R.B. 450

2005-11, 2005-5 I.R.B. 451

2005-12, 2005-7 I.R.B. 555

Notices:

2005-1, 2005-2 I.R.B. 274

2005-2, 2005-3 I.R.B. 337

2005-3, 2005-5 I.R.B. 447

2005-4, 2005-2 I.R.B. 289

2005-5, 2005-3 I.R.B. 337

2005-6, 2005-5 I.R.B. 448

2005-7, 2005-3 I.R.B. 340

2005-8, 2005-4 I.R.B. 368

2005-9, 2005-4 I.R.B. 369

2005-10, 2005-6 I.R.B. 474

2005-11, 2005-7 I.R.B. 493

2005-12, 2005-7 I.R.B. 494

2005-14, 2005-7 I.R.B. 498

2005-15, 2005-7 I.R.B. 527

Proposed Regulations:

REG-117969-00, 2005-7 I.R.B. 533

REG-125628-01, 2005-7 I.R.B. 536

REG-129709-03, 2005-3 I.R.B. 351

REG-139683-04, 2005-4 I.R.B. 371

REG-152945-04, 2005-6 I.R.B. 484

REG-159824-04, 2005-4 I.R.B. 372

Revenue Procedures:

2005-1, 2005-1 I.R.B. 1

2005-2, 2005-1 I.R.B. 86

2005-3, 2005-1 I.R.B. 118

2005-4, 2005-1 I.R.B. 128

2005-5, 2005-1 I.R.B. 170

2005-6, 2005-1 I.R.B. 200

2005-7, 2005-1 I.R.B. 240

2005-8, 2005-1 I.R.B. 243

2005-9, 2005-2 I.R.B. 303

2005-10, 2005-3 I.R.B. 341

2005-11, 2005-2 I.R.B. 307

2005-12, 2005-2 I.R.B. 311

2005-14, 2005-7 I.R.B. 528

Revenue Rulings:

2005-1, 2005-2 I.R.B. 258

2005-2, 2005-2 I.R.B. 259

2005-3, 2005-3 I.R.B. 334

2005-4, 2005-4 I.R.B. 366

2005-5, 2005-5 I.R.B. 445

2005-6, 2005-6 I.R.B. 471

2005-7, 2005-6 I.R.B. 464

2005-8, 2005-6 I.R.B. 466

2005-9, 2005-6 I.R.B. 470

2005-10, 2005-7 I.R.B. 492

Tax Conventions:

2005-3, 2005-2 I.R.B. 270

Treasury Decisions:

9164, 2005-3 I.R.B. 320

9165, 2005-4 I.R.B. 357

9167, 2005-2 I.R.B. 261

9168, 2005-4 I.R.B. 354

9169, 2005-5 I.R.B. 381

9170, 2005-4 I.R.B. 363

9171, 2005-6 I.R.B. 452

9172, 2005-6 I.R.B. 468

1 A cumulative list of all revenue rulings, revenue procedures, Treasury decisions, etc., published in Internal Revenue Bulletins 2004–27 through 2004–52 is in Internal Revenue Bulletin2004–52, dated December 27, 2004.

2005–7 I.R.B. ii February 14, 2005

Finding List of Current Actions onPreviously Published Items1

Bulletins 2005–1 through 2005–7

Notices:

88-30

Obsoleted by

Notice 2005-4, 2005-2 I.R.B. 289

88-132

Obsoleted by

Notice 2005-4, 2005-2 I.R.B. 289

89-29

Obsoleted by

Notice 2005-4, 2005-2 I.R.B. 289

89-38

Obsoleted by

Notice 2005-4, 2005-2 I.R.B. 289

Proposed Regulations:

REG-149519-03

Corrected by

Ann. 2005-11, 2005-5 I.R.B. 451

REG-114726-04

Corrected by

Ann. 2005-10, 2005-5 I.R.B. 450

Revenue Procedures:

98-16

Modified and superseded by

Rev. Proc. 2005-11, 2005-2 I.R.B. 307

2001-22

Superseded by

Rev. Proc. 2005-12, 2005-2 I.R.B. 311

2002-9

Modified and amplified by

Rev. Proc. 2005-9, 2005-2 I.R.B. 303

2004-1

Superseded by

Rev. Proc. 2005-1, 2005-1 I.R.B. 1

2004-2

Superseded by

Rev. Proc. 2005-2, 2005-1 I.R.B. 86

2004-3

Superseded by

Rev. Proc. 2005-3, 2005-1 I.R.B. 118

2004-4

Superseded by

Rev. Proc. 2005-4, 2005-1 I.R.B. 128

2004-5

Superseded by

Rev. Proc. 2005-5, 2005-1 I.R.B. 170

Revenue Procedures— Continued:

2004-6

Superseded by

Rev. Proc. 2005-6, 2005-1 I.R.B. 200

2004-7

Superseded by

Rev. Proc. 2005-7, 2005-1 I.R.B. 240

2004-8

Superseded by

Rev. Proc. 2005-8, 2005-1 I.R.B. 243

2004-35

Corrected by

Ann. 2005-4, 2005-2 I.R.B. 319

2004-60

Superseded by

Rev. Proc. 2005-10, 2005-3 I.R.B. 341

Revenue Rulings:

92-63

Modified and superseded by

Rev. Rul. 2005-3, 2005-3 I.R.B. 334

95-63

Modified and superseded by

Rev. Rul. 2005-3, 2005-3 I.R.B. 334

2004-43

Revoked by

Rev. Rul. 2005-10, 2005-7 I.R.B. 492

2004-103

Superseded by

Rev. Rul. 2005-3, 2005-3 I.R.B. 334

1 A cumulative list of current actions on previously published items in Internal Revenue Bulletins 2004–27 through 2004–52 is in Internal Revenue Bulletin 2004–52, dated December 27,2004.

February 14, 2005 iii 2005–7 I.R.B.*U.S. Government Printing Office: 2005—310–365/70002