INCOME TAXRev. Rul. 2000–4, page 331.Business expenses; capital expenditures; ISO 9000costs. Cost incurred by a taxpayer to obtain, maintain,and renew ISO 9000 certification are deductible as ordi-nary and necessary business expenses under section 162of the Code, except to the extent they result in the cre-ation or acquisition of an asset having a useful life sub-stantially beyond the taxable year (e.g., a quality manual).Rev. Proc. 99–49 modified and amplified.

T.D. 8853, page 377.Final regulations under section 7701(l) of the Code rechar-acterize fast-pay stock arrangements. The regulationsalso impose reporting requirements on certain partici-pants in fast-pay stock arrangements.

T.D. 8857, page 365.Final regulations under section 832(b) of the Code relate to thedetermination of underwriting income by insurance companiesother than life insurance companies by providing guidance forpurposes of determining the amount of unearned premiumsthat are subject to the 20 percent reduction rule.

T.D. 8858, page 332.Temporary regulations revise the rules governing allocation ofpurchase price in deemed and actual asset acquisitions, andother rules, under sections 338 and 1060 of the Code.

EMPLOYEE PLANS

Notice 2000–3, page 413.This notice provides additional guidance on the safe harbormethods contained in sections 401(k)(12) and 401(m)(11) ofthe Code for satisfying the nondiscrimination tests containedin section 401(k) and 401(m). The notice also requests pub-lic comments on certain issues affecting cash or deferredarrangements. Notice 98–52 modified.

Notice 2000–8, page 420.Weighted average interest rate update. The weightedaverage interest rate for January 2000 and the resulting per-missible range of interest rates used to calculate current lia-bility for purposes of the full funding limitation of section412(c)(7) of the Code are set forth.

EXCISE TAX

T.D. 8855, page 374.Final regulations under section 4251 of the Code relate toprepaid telephone cards.

Announcement 2000–5, page 427.Comments are requested on proposed regulations relatingto requirements for excise tax returns and deposits.

Internal Revenue

bbuulllleettiinnBulletin No. 2000–4

January 24, 2000

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.

Department of the TreasuryInternal Revenue Service

Finding Lists begin on page ii.(Continued on the page following the Introduction)

IRB 2000-4 1/28/00 10:26 AM Page 1

The Internal Revenue Bulletin is the authoritative instrumentof the Commissioner of Internal Revenue for announcing offi-cial rulings and procedures of the Internal Revenue Serviceand for publishing Treasury Decisions, Executive Orders, TaxConventions, legislation, court decisions, and other items ofgeneral interest. It is published weekly and may be obtainedfrom the Superintendent of Documents on a subscriptionbasis. Bulletin contents are consolidated semiannually intoCumulative 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 applicationof the tax laws, including all rulings that supersede, revoke,modify, or amend any of those previously published in theBulletin. All published rulings apply retroactively unless other-wise indicated. Procedures relating solely to matters of in-ternal management are not published; however, statementsof internal practices and procedures that affect the rightsand duties of taxpayers are published.

Revenue rulings represent the conclusions of the Service onthe application of the law to the pivotal facts stated in therevenue ruling. In those based on positions taken in rulingsto taxpayers or technical advice to Service field offices,identifying details and information of a confidential natureare deleted to prevent unwarranted invasions of privacy andto comply with statutory requirements.

Rulings and procedures reported in the Bulletin do not havethe force and effect of Treasury Department Regulations,but they may be used as precedents. Unpublished rulingswill not be relied on, used, or cited as precedents by Servicepersonnel in the disposition of other cases. In applying pub-lished rulings and procedures, the effect of subsequent leg-islation, regulations, court decisions, rulings, and proce-

dures must be considered, and Service personnel and oth-ers concerned are cautioned against reaching the same con-clusions in other cases unless the facts and circumstancesare substantially the same.

The Bulletin is divided into four parts as follows:

Part I.—1986 Code.This part includes rulings and decisions based on provisionsof the 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 Subpart B, Legislation and RelatedCommittee Reports.

Part III.—Administrative, Procedural, and Miscellaneous.To the extent practicable, pertinent cross references tothese subjects are contained in the other Parts and Sub-parts. Also included in this part are Bank Secrecy Act Admin-istrative Rulings. Bank Secrecy Act Administrative Rulingsare issued by the Department of the Treasury’s Office of theAssistant Secretary (Enforcement).

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

The first Bulletin for each month includes a cumulative indexfor the matters published during the preceding months.These monthly indexes are cumulated on a semiannual basis,and are published in the first Bulletin of the succeeding semi-annual period, respectively.

The IRS Mission

Provide America’s taxpayers top quality service by help-ing them understand and meet their tax responsibilities

and by applying the tax law with integrity and fairness toall.

Introduction

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.

IRB 2000-4 1/28/00 10:26 AM Page 2

ADMINISTRATIVE

Rev. Proc. 2000–12, page 387.This procedure contains the qualified intermediary (QI)withholding agreement as well as guidance for enteringinto the agreement. The objective of the QI withholdingagreement is to simplify withholding and reporting obliga-tions for payments of income (including interest, divi-dends, royalties, and gross proceeds) made to an accountholder through one or more foreign intermediaries. Rev.Proc. 98–27 superseded and Notice 99–8 obsoleted.

REG–105606–99, page 421.Proposed regulations under section 41(f) of the Code relateto the computation and allocation of the credit for increasing

research activities for members of a controlled group of tax-payers. A public hearing is scheduled for April 26, 2000.

Notice 2000–7, page 419.Section 1504(d) elections; deferral of termination.This notice provides guidance regarding the effect of the re-peal of certain Canadian banking legislation on electionsunder section 1504(d) of the Code.

Announcement 2000–6, page 428.This announcement corrects final regulations T.D. 8845,1999–51 I.R.B. 684, under section 6501 of the Code relat-ing to the valuation of prior gifts in determining estate andgift tax liability, and to the period of assesing and collectinggift tax.

2000–4 I.R.B. January 24, 2000

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2000–4 I.R.B. 331 January 24, 2000

Section 162.–Trade or BusinessExpenses

26 CFR 1.162-1: Business expenses.(Also §§ 263, 263A; §§ 1.263(a)-1, 1.263(a)–2,1.263A–1)

Business expenses; capital expendi-tures; ISO 9000 costs. Costs incurred bya taxpayer to obtain, maintain, and renewISO 9000 certification are deductible asordinary and necessary business expensesunder section 162 of the Code, except tothe extent they result in the creation or ac-quisition of an asset having a useful lifesubstantially beyond the taxable year(e.g., a quality manual). Rev. Proc. 99–49modified and amplified.

Rev. Rul. 2000–4

ISSUE

Are costs incurred by a taxpayer to ob-tain, maintain, and renew ISO 9000 certi-fication deductible as ordinary and neces-sary business expenses under § 162 of theInternal Revenue Code, or must they becapitalized under §§ 263 or 263A?

FACTS

ISO 9000 is a series of internationalstandards for quality management sys-tems that was developed by the Interna-tional Organization for Standardization(ISO). The ISO 9000 series of standardsis comprised of several specific require-ments that are intended to ensure a qualityprocess in providing services or productsto an organization’s customers.

To obtain ISO 9000 certification, an orga-nization may incur internal and externalcosts to assess its current quality processes,create a quality manual, train its employees,and implement the new quality system. Inaddition, the organization incurs costs to ob-tain formal certification from an independentauditor (or “registrar”) that its quality man-agement system conforms to a specific ISO9000 standard. This certification generallylasts from two to four years. After the initialcertification, the organization incurs addi-tional costs for periodic audits to maintain itscertification and to renew the certificationupon expiration of the initial certification pe-

riod. All these expenditures are referred toherein as “ISO 9000 costs.”

Although ISO 9000 certification is vol-untary, it increasingly is a contractual re-quirement for doing business with manyorganizations, both public and private,worldwide. ISO 9000 certification also isan alternative to product certification insome foreign markets, particularly theEuropean Union.

LAW AND ANALYSIS

Section 162 and § 1.162–1(a) of the In-come Tax Regulations generally allow adeduction for all the ordinary and neces-sary expenses paid or incurred during thetaxable year in carrying on any trade orbusiness. Courts generally have construed§ 162 as containing five conditions that anexpenditure must meet to qualify for de-duction. The expenditure must be (1) anexpense, (2) ordinary, (3) necessary, (4)paid or incurred during the taxable year,and (5) made to carry on a trade or busi-ness. See Commissioner v. Lincoln Sav.and Loan Ass’n, 403 U.S. 345 (1971).

Section 263(a) and § 1.263(a)–1(a) pro-vide that no deduction is allowed for anyamount paid out for permanent improve-ments or betterments made to increase thevalue of any property or estate. Section1.263(a)–2(a) provides that capital expen-ditures include the cost of acquisition, con-struction, or erection of buildings, machin-ery and equipment, furniture and fixtures,and similar property having a useful lifesubstantially beyond the taxable year.

Section 263A provides that the directand indirect costs properly allocable to realor tangible personal property produced bythe taxpayer or real or personal property de-scribed in § 1221(1) that is acquired by thetaxpayer for resale must be capitalized.Section 1.263A–1(e)(4)(iv)(F) cites qualitycontrol policy as an example of an indirectcost that generally is not allocated to pro-duction or resale activities.

Through provisions such as §§ 162(a),263(a), and 263A, the Code generally en-deavors to match expenses with the rev-enues of the taxable period to which the ex-penses are properly attributable, therebyresulting in a more accurate calculation ofnet income for tax purposes. See, e.g., IN-DOPCO, Inc. v. Commissioner, 503 U.S.

79, 84 (1992);Commissioner v. IdahoPower Co., 418 U.S. 1, 16 (1974). More-over, as the Supreme Court has specificallyrecognized, the “decisive distinctions [be-tween capital and ordinary expenditures]are those of degree and not of kind,” and acareful examination of the particular factsof each case is required. Deputy v. duPont, 308 U.S. 488, 496 (1940); Welch v.Helvering, 290 U.S. 111, 114 (1933).

In determining whether a current deduc-tion or capitalization is the appropriate taxtreatment for an expenditure, it is importantto consider the extent to which the expendi-ture will produce future benefits. See IN-DOPCO, 503 U.S. at 87–88. ISO 9000certification potentially results in a numberof benefits for a taxpayer. For example, cer-tification may improve the overall quality ofthe taxpayer’s business operations, give thetaxpayer a marketing advantage by differen-tiating it from non-certified competitors, en-able the taxpayer to retain customers thatbegin requiring their suppliers to be certi-fied, and enable the taxpayer to expand itsexisting business to new markets and newcustomers that require their suppliers to becertified. These benefits generally both re-late to the current taxable year and extendbeyond the taxable year in which the tax-payer obtains ISO 9000 certification. Sec-tion 263(a), however, requires an examina-tion of not only the duration of the benefits,but also the extent of the benefits. See IN-DOPCO, 503 U.S. at 87 (the mere presenceof an incidental future benefit may not war-rant capitalization). See alsoRev. Rul.96–62, 1996–2 C.B. 9 (training costs gener-ally are deductible under § 162 even thoughthey may have some future benefit); Rev.Rul. 94–12, 1994–1 C.B. 36 (incidental re-pair costs generally are deductible under §162 even though they may have some futurebenefit); Rev. Rul. 92–80, 1992–2 C.B. 57(advertising costs generally are deductibleunder § 162 even though they may havesome future effect on business activities).

ISO 9000 certification does not result infuture benefits that are more than incidental.The benefits derived from ISO 9000 certifi-cation are akin to the current benefits de-rived from advertising, training, and similarexpenditures incurred in operating the tax-payer’s business, retaining existing cus-tomers, or simply improving the overallquality or attractiveness of the taxpayer’s

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

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January 24, 2000 332 2000–4 I.R.B.

business operations. Although the en-hanced marketability of the taxpayer’s ser-vices or products resulting from ISO 9000certification may yield future benefits suchas repeat business or increased marketshare, these future benefits are incidental tothe primary benefit of current sales. Expen-ditures that primarily benefit current opera-tions generally are deductible. See, e.g., VanIderstine Co. v. Commissioner, 261 F.2d211 (2nd Cir. 1958) (payments made to sup-pliers to ensure a continuing supply of rawmaterials were deductible); Snow v. Com-missioner, 31 T.C. 585 (1958), acq., 1959–2C.B. 7 (payments made to protect and sup-plement the taxpayer’s income from its ex-isting law business were deductible).Seealso T.J. Enterprises, Inc. v. Commissioner,101 T.C. 581 (1993) (expenses incurred toprotect, maintain, or preserve a taxpayer’sbusiness generally are deductible).

Further, even if ISO 9000 certificationfacilitates the expansion of the taxpayer’sexisting business, the mere ability to sell innew markets and to new customers, with-out more, does not result in significant fu-ture benefits. Compare Briarcliff CandyCorp. v. Commissioner, 475 F.2d 775 (2nd

Cir. 1973) (expenditures incurred by thetaxpayer to develop a new market forwholesale customers, which gave the tax-payer little more than an expectation orhope of future sales, were deductible under§ 162); Sun Microsystems v. Commissioner,T.C. Memo 1993–467 (costs incurred topromote sales of computer workstationswere not capital expenditures because theanticipated long-term benefits from thecustomer relationship were “softer” andmore speculative than the immediate bene-fits from the sales) with FMR Corp. v.Commissioner, 110 T.C. 402 (1998) (coststo develop and launch mutual funds, whichresulted in new long-term managementcontracts, were capital expenditures).

Because ISO 9000 certification yieldsonly incidental future benefits, ISO 9000costs are distinguishable from costs incurredto obtain licenses, stock trading privileges,state bar certifications, and similar market-entry requirements that have been held to becapital expenditures. Unlike ISO 9000 cer-tification, these requirements are an essen-tial element to the establishment of the tax-payer’s business and result either in aseparate and distinct asset or in significantfuture benefits. See, e.g., Nachman v. Com-missioner, 191 F.2d 934 (5th Cir. 1951)

(payment to obtain liquor license was a cap-ital expenditure);Harman v. Commissioner,72 T.C. 362 (1979) (initiation fees requiredto obtain a seat on the New York Stock Ex-change were capital expenditures); Sharonv. Commissioner, 66 T.C. 515 (1976), aff’d,591 F.2d 1273 (9th Cir. 1978) (costs in-curred by an attorney for admission to vari-ous bars were capital expenditures).

Accordingly, ISO 9000 certification doesnot itself result in the creation of an assethaving a useful life substantially beyond thetaxable year. To the extent the ISO 9000certification processresults in the creationof an asset, however, § 263(a) requires cap-italizing the costs allocable to creating thatasset. For example, the costs of creating aquality manual must be capitalized, eventhough costs of periodic updates to the man-ual may be deducted. § 263A; §1.263A–2(a)(2)(ii), Domestic ManagementBureau v. Commissioner, 38 B.T.A. 640(1938) (costs of preparing and printing atraining manual were capital expenditures);Rev. Rul. 96–62 (costs of routine updates oftraining materials are deductible). In addi-tion, if the certification process requires theacquisition of an asset, such as machineryand equipment, the costs of that asset mustbe capitalized under § 263(a).

Further, ISO 9000 costs, other than costsincurred during the certification process thatare allocable to creating an asset such as aquality manual, are not costs that are alloca-ble to production or resale activities for pur-poses of the uniform capitalization rules of§ 263A, and thus are not subject to the rulesset forth in that section or the regulationsthereunder. See§ 1.263A–1(e)(4)(iv)(F)(quality control expenditures generally ex-cepted from uniform capitalization rules).

HOLDING

Costs incurred by a taxpayer to obtain,maintain, and renew ISO 9000 certifica-tion are deductible as ordinary and nec-essary business expenses under § 162,except to the extent they result in the cre-ation or acquisition of an asset having auseful life substantially beyond the tax-able year (e.g.,a quality manual).

APPLICATION

Any change in a taxpayer’s method ofaccounting to conform with this revenueruling is a change in method of account-ing to which the provisions of §§ 446 and481 and the regulations thereunder apply.

A taxpayer wanting to change its methodof accounting to conform with the holdingin this revenue ruling must follow the au-tomatic change in accounting method pro-visions of Rev. Proc. 99–49, 1999–52I.R.B. 725, except that the scope limita-tions in section 4.02 of Rev. Proc. 99-49do not apply. However, if the taxpayer isunder examination, before an appeals of-fice, or before a federal court with respectto any income tax issue, the taxpayermust provide a copy of the Form 3115,Application for Change in AccountingMethod, to the examining agent(s), ap-peals officer, or counsel for the govern-ment, as appropriate, at the same time thatit files the copy of the Form 3115 with thenational office. The Form 3115 must con-tain the name(s) and telephone number(s)of the examining agent(s), appeals officer,or counsel for the government, as appro-priate.

EFFECT ON OTHER DOCUMENTS

Rev. Proc. 99–49 is modified and am-plified to include the prospective changein accounting method in the APPENDIX.

DRAFTING INFORMATION

The principal author of this revenueruling is Kimberly L. Koch of the Officeof Assistant Chief Counsel (Income Taxand Accounting). For further informationregarding this revenue ruling, contact Ms.Koch at (202) 622-4950 (not a toll-freecall).

Section 263.—CapitalExpenditures

26 CFR 1.263(a)–1: Capital expenditures; ingeneral.

Are costs incurred by a taxpayer to obtain, main-tain, and renew ISO 9000 certification deductible asordinary and necessary business expenses under§162, except to the extent they result in the creationor acquisition of an asset having a useful life sub-stantially beyond the taxable year (e.g., a qualitymanual)? See Rev. Rul. 2000–4, page 331.

Section 338.—Certain StockPurchases Treated As AssetAcquisitions

26 CFR 1.338–1T: General principles; status of oldtarget and new target (temporary).

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2000–4 I.R.B. 333 January 24, 2000

T.D. 8858

DEPARTMENT OF THE TREASURYInternal Revenue Service26 CFR Parts 1 and 602

Purchase Price Allocations inDeemed and Actual AssetAcquisitions

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Temporary regulations.

SUMMARY: This document containstemporary regulations relating to the allo-cation of purchase price in deemed andactual asset acquisitions. The temporaryregulations determine the amount realizedand the amount of basis allocated to eachasset transferred in a deemed or actualasset acquisition and affect transactionsreported on either Form 8023 or Form8594. The intended effect of the tempo-rary regulations is to remove and replacemany of the current temporary and finalregulations sections under sections 338and 1060 and renumber others.

DATES: Effective Date: These regula-tions are effective January 6, 2000.

Applicability Dates: For dates of ap-plicability of these regulations, see§1.338(i)–1T and §1.1060–1T(a)(2).

FOR FURTHER INFORMATION CON-TACT: Richard Starke of the Office ofAssistant Chief Counsel (Corporate),(202) 622-7790 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information con-tained in these temporary regulationshave been reviewed and approved by theOffice of Management and Budget in ac-cordance with the Paperwork ReductionAct of 1995 (44 U.S.C. 3507(d)) underthe control number 1545-1658.

An agency may not conduct or sponsor,and a person is not required to respond to,a collection of information unless it dis-plays a valid control number assigned bythe Office of Management and Budget.

The collections of information in these

temporary regulations are in §§1.338–2T(d),1.338–2T(e)(4), 1.338–5T(d)(3),1.338–10T(a)(4), 1.338(h)(10)–1T(d)(2),and 1.1060–1T(e)(ii)(A) and (B). The col-lections of information are necessary tomake an election to treat a sale of stock as asale of assets, to calculate and collect the ap-propriate amount of tax in a deemed or ac-tual asset acquisition, and to determine thebases of assets acquired in a deemed or ac-tual asset acquisition.

These collections of information are re-quired to obtain a benefit. The likely re-spondents and/or recordkeepers are smallbusinesses or organizations, businesses,or other for-profit institutions, and farms.

The regulation provides that a section338 election is made by filing Form 8023.The burden for this requirement is re-flected in the burden of Form 8023. Theregulation also provides that both a sellerand a purchaser must each file an asset ac-quisition statement on Form 8594. Theburden for this requirement is reflected inthe burden of Form 8594.

The burden for the collection of infor-mation in §1.338–2T(e)(4) is as follows:Estimated total annual reporting/record-keeping burden: 25 hoursEstimated average annual burden per re-spondent/recordkeeper: 0.56 hoursEstimated number of respondents/record-keepers: 45Estimated annual frequency of responses:On occasion

Comments concerning the accuracy ofthis burden estimate and suggestions forreducing this burden should be sent to theInternal Revenue Service, Attn: IRSReports Clearance Officer, OP:FS:FP,Washington, DC 20224, and to the Officeof Management and Budget, Attn: DeskOfficer for the Department of the Trea-sury, Office of Information and Regula-tory Affairs, Washington, DC 20503.

Books or records relating to a collec-tion of information must be retained aslong as their contents may become mater-ial in the administration of any internalrevenue law. Generally, tax returns andtax return information are confidential, asrequired by 26 U.S.C. 6103.

Background

On August 10, 1999, the IRS and Trea-sury published in the Federal Register(REG–107069–97, 64 FR 43461 (1999–36

I.R.B. 346)) a notice of proposed rulemak-ing. The notice contained proposed regula-tions under sections 338 and 1060 of the In-ternal Revenue Code of 1986. Thetemporary and final regulations promul-gated in this Treasury decision are substan-tively the same as the proposed regulationspublished on August 10, 1999. The Ser-vice and Treasury believe that the com-ments received on the proposed regulationswarrant further consideration. For instance,the Service and the Treasury received sev-eral comments requesting reconsiderationof (1) the provision in §1.338–3(b)(2)(ii) ofthe proposed regulations stating that a pur-chase of target stock occurs only so long asmore than a nominal amount is paid forsuch share, and (2) the example in§1.338–1(a)(2) of the proposed regulationsstating that if target is an insurance com-pany for which a section 338 election ismade, then the deemed asset sale will becharacterized and taxed as an assumption-reinsurance transaction. The temporaryregulations reserve the purchase issue ad-dressed in §1.338–3(b)(2)(ii) of the pro-posed regulations pending further consider-ation of the comments. The temporaryregulations retain the assumption-reinsur-ance example because the example prop-erly illustrates the principles of the pro-posed and temporary regulations. TheService and Treasury will give further con-sideration to the interaction of section 338and the assumption-reinsurance rules andthe need for additional guidance on how theassumption-reinsurance rules should workin the context of a deemed asset sale.

Notwithstanding such comments, theproposed regulations generally were favor-ably received, and the Service and Treasuryare convinced that, in general, the proposedregulations provide clearer guidance andbetter rules than the current final and tem-porary regulations under sections 338 and1060. Accordingly, pending further reviewof the comments received on the proposedregulations, the Service and Treasury arereplacing existing temporary and final reg-ulations with the proposed rules publishedon August 10, 1999.

As soon as feasible, final regulationswill be promulgated, replacing these newtemporary regulations. All comments re-ceived in response to the requests forcomments contained in the notice of Au-gust 10, 1999, will be considered in thecourse of preparing the final regulations.

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January 24, 2000 334 2000–4 I.R.B.

Special Analyses

It has been determined that these tempo-rary regulations are not a significant regula-tory action as defined in Executive Order12866. Therefore, a regulatory assessment isnot required. It has been determined that afinal regulatory flexibility analysis is re-quired for the collection of information inthis Treasury decision under 5 U.S.C. 604.This analysis is set forth below under theheading “Final Regulatory Flexibility ActAnalysis.” Pursuant to section 7805(f) ofthe Internal Revenue Code, these temporaryregulations will be submitted to the ChiefCounsel for Advocacy of the Small BusinessAdministration for comment on their impacton small business.

Final Regulatory Flexibility ActAnalysis

This analysis is required under the Reg-ulatory Flexibility Act (5 U.S.C. chapter6). This regulatory action is intended tosimplify and clarify the current rules re-lating to both deemed and actual asset ac-quisitions. The current rules were devel-oped over a long period of time and havebeen repeatedly amended. The IRS andTreasury believe these temporary regula-tions will significantly improve the clarityof the rules relating to both deemed andactual asset acquisitions.

The major objective of these temporaryregulations is to modify the rules for allo-cating purchase price in both deemed andactual asset acquisitions. In addition,these temporary regulations replace thegeneral rules for electing to treat a stocksale as an asset sale.

These collections of information may af-fect small businesses if the stock of a cor-poration which is a small entity is acquired

in a qualified stock purchase or if a trade orbusiness which is also a small business istransferred in a taxable transaction. Form8023 (on which an election to treat a stocksale as an asset sale is filed) has been sub-mitted to and approved by the Office ofManagement and Budget. With respect toForm 8023, the IRS estimated that 201forms would be filed each year and thateach taxpayer would require 12.98 hours tocomply. Form 8594 (on which a sale or ac-quisition of assets constituting a trade orbusiness is reported) has also been submit-ted to and approved by the Office of Man-agement and Budget. With respect to Form8594, the IRS estimated that 20,000 formswould be filed each year and that each tax-payer would require 12.25 hours to comply.These estimates have been made availablefor public comment and no public com-ments have been received. The regulationsdo not impose new requirements on smallbusinesses and, in fact, should lessen anydifficulties associated with the existing re-porting requirements by clarifying the rulesassociated with deemed and actual asset ac-quisitions.

The collections of information requiretaxpayers to file an election in order totreat a stock sale as an asset sale. In addi-tion, taxpayers must file a statement re-garding the amount of consideration allo-cated to each class of assets under theresidual method. The professional skillsthat would be necessary to make the elec-tion or allocate the consideration wouldbe the same as those required to prepare areturn for the small business.

Consideration was given to limiting thereporting requirements under section1060 to trades or businesses meeting athreshold level of business activity. How-ever, any threshold derived without fur-

ther information would be arbitrary. In-stead, these regulations authorize theCommissioner to exclude certain transac-tions from the reporting requirements.

Drafting Information

The principal author of these regula-tions is Richard Starke, Office of the As-sistant Chief Counsel (Corporate). How-ever, other personnel from the IRS andTreasury Department participated exten-sively in their development.

* * * * *

Adoption of Amendments to theRegulations

Accordingly, 26 CFR parts 1 and 602are amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation forpart 1 is amended by removing the entriesfor 1.338(b)–1, 1.338(b)–3T, and1.1060–1T and by adding entries in nu-merical order to read in part as follows:

Authority: 26 U.S.C. 7805 * * *Section 1.338–6T also issued under 26U.S.C. 337(d), 338, and 1502.Section 1.338–7T also issued under 26U.S.C. 337(d), 338, and 1502.Section 1.338–8 also issued under 26U.S.C. 337(d), 338, and 1502.Section 1.338–9 also issued under 26U.S.C. 337(d), 338, and 1502.Section 1.338–10T also issued under 26U.S.C. 337(d), 338, and 1502.* * *Section 1.1060–1T also issued under 26U.S.C. 1060.* * *

Par. 2. In the list below, for each sec-tion indicated in the left column, removethe language in the middle column andadd the language in the right column:

Section Remove Add

1.56(g)–1(k)(1) of §1.338(b)–2T(b), of §1.338–6T(b), if otherwise if otherwise

1.56(g)–1(k)(1) of §§1.338(b)–2T(c)(1) of §1.338–6T(c)(1) and (2) also and (2) also

1.368–1(a) (k) and 1.338–2(c)(3). (k) and 1.338–3T(c)(3).

1.368–1(e)(6), Example see §1.338–2(c)(3) (which see §1.338–3T(c)(3) (which4, paragraph (ii)

1.597–2(d)(5)(iii)(B) (see §1.338(b)–3T) (see §1.338–7T)

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2000–4 I.R.B. 335 January 24, 2000

§1.338–0 through 1.338–3 [Removed]Par. 3. Sections 1.338–0 through

1.338–3 are removed.Par. 4. Sections 1.338–0T through

1.338–3T are added to read as follows:§1.338–0T Outline of topics (temporary).

This section lists the captions containedin the regulations under section 338 asfollows:§1.338–1T General principles; status ofold target and new target (temporary).

(a) In general.(1) Deemed transaction.(2) Application of other rules of law.(3) Overview.(b) Treatment of target under other provi-

sions of the Internal Revenue Code.(1) General rule for subtitle A.(2) Exceptions for subtitle A.(3) General rule for other provisions ofthe Internal Revenue Code.(c) Anti-abuse rule.(1) In general.(2) Examples.

§1.338–2T Nomenclature and defini-tions; mechanics of the section 338 elec-tion (temporary).

(a) Scope.(b) Nomenclature.(c) Definitions.(1) Acquisition date.(2) Acquisition date assets.(3) Affiliated group.(4) Common parent.(5) Consistency period.

(6) Deemed asset sale.(7) Deemed sale gain.(8) Deemed sale return.(9) Domestic corporation.(10) Old target’s final return.(11) Purchasing corporation.(12) Qualified stock purchase.(13) Related persons.(14) Section 338 election.(15) Section 338(h)(10) election.(16) Selling group.(17) Target; old target; new target.(18) Target affiliate.(19) 12-month acquisition period.(d) Time and manner of making election.(e) Special rules for foreign corporations

or DISCs.(1) Elections by certain foreign purchas-

ing corporations.(i) General rule.(ii) Qualifying foreign purchasing corpo-

ration.(iii) Qualifying foreign target.(iv) Triggering event.(v) Subject to United States tax.(2) Acquisition period.(3) Statement of section 338 may be filed

by United States shareholders in cer-tain cases.

(4) Notice requirement for U.S. personsholding stock in foreign market.

(i) General rule.(ii) Limitation.(iii) Form of notice.(iv) Timing of notice.(v) Consequence of failure to comply.

(vi) Good faith effort to comply.

§1.338–3T Qualification for the section338 election (temporary).

(a) Scope.(b) Rules relating to qualified stock pur-

chases.(1) Purchasing corporation requirement.(2) Purchase.(i) Definition.(ii) Purchase of target. [Reserved](iii) Purchase of target affiliate.(3) Acquisitions of stock from related

corporations.(i) In general.(ii) Time for testing relationship.(iii) Cases where section 338(h)(3)(C) ap-

plies—acquisitions treated as pur-chases.

(iv) Examples.(4) Acquisition date for tiered targets.(i) Stock sold in deemed asset sale.(ii) Examples.(5) Effect of redemptions.(i) General rule.(ii) Redemptions from persons unrelated

to the purchasing corporation.(iii) Redemptions from the purchasing

corporation or related persons during12-month acquisition period.

(A) General rule.(B) Exception for certain redemptions

from related corporations.(iv) Examples.(c) Effect of post-acquisition events on el-

igibility for section 338 election.

1.597–5(c)(3)(i) under §§1.338(b)–2T(b), under §1.338–6T(b), (c)(1) and (2). (c)(1) and (2).

1.597–5(d)(2)(i) under §§1.338(b)–2T(b), under §1.338–6T(b), (c)(1) and (2). (c)(1) and (2).

1.921–1T(b)(1), A–1 and §1.338–1(d). and §1.338–2T(d).

1.1031(d)–1T see §1.1060–1T(b), (d), see §1.1060–1T(b), (c), and (g) Example (3). and (d) Example 1.

1.1031(j)–1(b)(2)(iii) in §1.1060–1T(d). in §1.338–6T(b), to which reference is made by §1.1060–1T(c)(2).

1.1502–75(k) See §1.338(h)(10)– See §1.338(h)(10)–1(e)(6) for 1T(d)(7) for

1.1502–76(b)(1)(ii)(A)(1) See §1.338–1(e)(5) See §1.338–10T(a)(5) (deemed (deemed

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January 24, 2000 336 2000–4 I.R.B.

(1) Post-acquisition elimination of target.(2) Post-acquisition elimination of the

purchasing corporation.(3) Consequences of post-acquisition

elimination of target.(i) Scope.(ii) Continuity of interest.(iii) Control requirement.(iv) Example.

§1.338-4T Aggregate deemed sale price;various aspects of taxation of the deemedasset sale (temporary).

(a) Scope.(b) Determination of ADSP.(1) General rule.(2) Time and amount of ADSP.(i) Original determination.(ii) Redetermination of ADSP.(iii) Example.(c) Grossed-up amount realized on the

sale to the purchasing corporation ofthe purchasing corporation’s recentlypurchased target stock.

(1) Determination of amount.(2) Example.(d) Liabilities of old target.(1) In general.(2) Time and amount of liabilities.(3) Interaction with deemed sale gain.(e) Calculation of deemed sale gain.(f) Other rules apply in determining

ADSP.(g) Examples.(h) Deemed sale of target affiliate stock.(1) Scope.(2) In general.(3) Deemed sale of foreign target affiliate

by a domestic target.(4) Deemed sale producing effectively

connected income.(5) Deemed sale of insurance company

target affiliate electing under section953(d).

(6) Deemed sale of DISC target affiliate.(7) Anti-stuffing rule.(8) Examples.

§1.338–5T Adjusted grossed-up basis(temporary).

(a) Scope.(b) Determination of AGUB.(1) General rule.(2) Time and amount of AGUB.(i) Original determination.(ii) Redetermination of AGUB.(iii) Examples.(c) Grossed-up basis of recently pur-

chased stock.(d) Basis of nonrecently purchased stock;

gain recognition election.(1) No gain recognition election.(2) Procedure for making gain recogni-

tion election.(3) Effect of gain recognition election.(i) In general.(ii) Basis amount.(iii) Losses not recognized.(iv) Stock subject to election.(e) Liabilities of new target.(1) In general.(2) Time and amount of liabilities.(3) Interaction with deemed sale gain.(f) Adjustments by the Internal Revenue

Service.(g) Examples.

§1.338–6T Allocation of ADSP andAGUB among target assets(temporary).

(a) Scope.(1) In general.(2) Fair market value.(i) In general.(ii) Transaction costs.(iii) Internal Revenue Service authority.(b) General rule for allocating ADSP and

AGUB.(1) Reduction in the amount of considera-

tion for Class I assets.(2) Other assets.(i) In general.(ii) Class II assets.(iii) Class III assets.(iv) Class IV assets.(v) Class V assets.(vi) Class VI assets.(vii) Class VII assets.(3) Other items designated by the Internal

Revenue Service.(c) Certain limitations and other rules for

allocation to an asset.(1) Allocation not to exceed fair market

value.(2) Allocation subject to other rules.(3) Special rule for allocating AGUB

when purchasing corporation has non-recently purchased stock.

(i) Scope.(ii) Determination of hypothetical pur-

chase price.(iii) Allocation of AGUB.(4) Liabilities taken into account in deter-

mining amount realized on subsequentdisposition.

(d) Examples.

§1.338–7T Allocation of redetermined

ADSP and AGUB among target assets(temporary).

(a) Scope.(b) Allocation of redetermined ADSP and

AGUB.(c) Special rules for ADSP.(1) Increases or decreases in deemed sale

gain taxable notwithstanding old tar-get ceases to exist.

(2) Procedure for transactions in whichsection 338(h)(10) is not elected.

(i) Deemed sale gain included in new tar-get’s return.

(ii) Carryovers and carrybacks.(A) Loss carryovers to new target taxable

years.(B) Loss carrybacks to taxable years of

old target.(C) Credit carryovers and carrybacks.(3) Procedure for transactions in which

section 338(h)(10) is elected.(d) Special rules for AGUB.(1) Effect of disposition or depreciation of

acquisition date assets.(2) Section 38 property.(e) Examples.

§1.338–8 Asset and stock consistency.

(a) Introduction.(1) Overview.(2) General application.(3) Extension of the general rules.(4) Application where certain dividends

are paid.(5) Application to foreign target affiliates.(6) Stock consistency.(b) Consistency for direct acquisitions.(1) General rule.(2) Section 338(h)(10) elections.(c) Gain from disposition reflected in

basis of target stock.(1) General rule.(2) Gain not reflected if section 338 elec-

tion made for target.(3) Gain reflected by reason of distribu-

tions.(4) Controlled foreign corporations.(5) Gain recognized outside the consoli-

dated group.(d) Basis of acquired assets.(1) Carryover basis rule.(2) Exceptions to carryover basis rule for

certain assets.(3) Exception to carryover basis rule for

de minimis assets.(4) Mitigation rule.(i) General rule.(ii) Time for transfer.

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(e) Examples.(1) In general.(2) Direct acquisitions.(f) Extension of consistency to indirect

acquisitions.(1) Introduction.(2) General rule.(3) Basis of acquired assets.(4) Examples.(g) Extension of consistency if dividends

qualifying for 100 percent dividendsreceived deduction are paid.

(1) General rule for direct acquisitionsfrom target.

(2) Other direct acquisitions having sameeffect.

(3) Indirect acquisitions.(4) Examples.(h) Consistency for target affiliates that

are controlled foreign corporations.(1) In general.(2) Income or gain resulting from asset

dispositions.(i) General rule.(ii) Basis of controlled foreign corpora-

tion stock.(iii) Operating rule.(iv) Increase in asset or stock basis.(3) Stock issued by target affiliate that is a

controlled foreign corporation.(4) Certain distributions.(i) General rule.(ii) Basis of controlled foreign corpora-

tion stock.(iii) Increase in asset or stock basis.(5) Examples.(i) [Reserved](j) Anti-avoidance rules.(1) Extension of consistency rules.(2) Qualified stock purchase and 12-

month acquisition period.(3) Acquisitions by conduits.(i) Asset ownership.(A) General rule.(B) Application of carryover basis rule.(ii) Stock acquisitions.(A) Purchase by conduit.(B) Purchase of conduit by corporation.(C) Purchase of conduit by conduit.(4) Conduit.(5) Existence of arrangement.(6) Predecessor and successor.(i) Persons.(ii) Assets.(7) Examples.

§1.338–9 International aspects of section338.

(a) Scope.(b) Application of section 338 to foreign

targets.(1) In general.(2) Ownership of FT stock on the acquisi-

tion date.(3) Carryover FT stock.(i) Definition.(ii) Carryover of earnings and profits.(iii) Cap on carryover of earnings and

profits.(iv) Post-acquisition date distribution of

old FT earnings and profits.(v) Old FT earnings and profits unaf-

fected by post-acquisition datedeficits.

(vi) Character of FT stock as carryoverFT stock eliminated upon disposition.

(4) Passive foreign investment companystock.

(c) Dividend treatment under section1248(e).

(d) Allocation of foreign taxes.(e) Operation of section 338(h)(16). [Re-

served](f) Examples.

§1.338–10T Filing of returns(tempo-rary).

(a) Returns including tax liability fromdeemed asset sale.

(1) In general.(2) Old target’s final taxable year other-

wise included in consolidated returnof selling group.

(i) General rule.(ii) Separate taxable year.(iii) Carryover and carryback of tax attrib-

utes.(iv) Old target is a component member of

purchasing corporation’s controlledgroup.

(3) Old target is an S corporation.(4) Combined deemed sale return.(i) General rule.(ii) Gain and loss offsets.(iii) Procedure for filing a combined re-

turn.(iv) Consequences of filing a combined

return.(5) Deemed sale excluded from purchas-

ing corporation’s consolidated return.(6) Due date for old target’s final return.(i) General rule.(ii) Application of §1.1502–76(c).(A) In general.(B) Deemed extension.(C) Erroneous filing of deemed sale re-

turn.(D) Erroneous filing of return for regular

tax year.(E) Last date for payment of tax.(7) Examples.(b) Waiver.(1) Certain additions to tax.(2) Notification.(3) Elections or other actions required to

be specified on a timely filed return.(i) In general.(ii) New target in purchasing corpora-

tion’s consolidated return.(4) Examples.

§1.338(h)(10)–1T Deemed asset sale andliquidation (temporary).

(a) Scope.(b) Definitions.(1) Consolidated target.(2) Selling consolidated group.(3) Selling affiliate; affiliated target.(4) S corporation target(5) S corporation shareholders.(6) Liquidation.(c) Section 338(h)(10) election.(1) In general.(2) Simultaneous joint election require-

ment.(3) Irrevocability.(4) Effect of invalid election.(d) Certain consequences of section

338(h)(10) election.(1) P.(2) New T.(3) Old T—deemed sale.(i) In general.(ii) Tiered targets.(4) Old T and selling consolidated group,

selling affiliate, or S corporationshareholders—deemed liquidation;tax characterization.

(i) In general.(ii) Tiered targets.(5) Selling consolidated group, selling af-

filiate, or S corporation shareholders.(i) In general.(ii) Basis and holding period of T stock

not acquired.(iii) T stock sale.(6) Nonselling minority shareholders

other than nonselling S corporationshareholders.

(i) In general.(ii) T stock sale.(iii) T stock not acquired.(7) Consolidated return of selling consoli-

dated group.

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(8) Availability of the section 453 install-ment method.

(i) In deemed asset sale.(ii) In deemed liquidation.(9) Treatment consistent with an actual

asset sale.(e) Examples.(f) Inapplicability of provisions.(g) Required information.

§1.338(i)–1T Effective dates (temporary).§1.338–1T General principles; status ofold target and new target (temporary).

(a) In general—(1) Deemed transac-tion. Elections are available under sec-tion 338 when a purchasing corporationacquires the stock of another corporation(the target) in a qualified stock purchase.One type of election, under section338(g), is available to the purchasing cor-poration. Another type of election, undersection 338(h)(10), is, in more limited cir-cumstances, available jointly to the pur-chasing corporation and the sellers of thestock. (Rules concerning eligibility forthese elections are contained in §§1.338–2T, 1.338–3T, and1.338(h)(10)–1T.) Although target is asingle corporation under corporate law, ifa section 338 election is made, then twoseparate corporations, old target and newtarget, generally are considered to existfor purposes of subtitle A of the InternalRevenue Code. Old target is treated astransferring all of its assets to an unrelatedperson in exchange for consideration thatincludes the assumption of, or taking sub-ject to, liabilities, and new target is treatedas acquiring all of its assets from an unre-lated person in exchange for considera-tion that includes the assumption of ortaking subject to liabilities. (Such trans-action is, without regard to its characteri-zation for Federal income tax purposes,referred to as the deemed asset sale andthe income tax consequences thereof asthe deemed sale gain.) If a section338(h)(10) election is made, old target isalso deemed to liquidate following thedeemed asset sale.

(2) Application of other rules of law.Other rules of law apply to determine thetax consequences to the parties as if theyhad actually engaged in the transactionsdeemed to occur under section 338 and§§1.338–0T through 1.338–7T, 1.338–8,1.338–9, 1.338–10T, 1.338(h)(10)–1T,and 1.338(i)–1T except to the extent oth-erwise provided in §§1.338–0T through

1.338–7T, 1.338–8, 1.338–9, 1.338–10T,1.338(h)(10)–1T, and 1.338(i)–1T. Seealso §1.338–6T(c)(2). Other rules of lawmay characterize the transaction as some-thing other than or in addition to a saleand purchase of assets; however, it mustbe a taxable transaction. For example, iftarget is an insurance company for whicha section 338 election is made, thedeemed asset sale would be characterizedand taxed as an assumption–reinsurancetransaction under applicable Federal in-come tax law. See §1.817–4(d).

(3) Overview. Definitions and specialnomenclature and rules for making thesection 338 election are provided in§1.338–2T. Qualification for the section338 election is addressed in §1.338–3T.The amount for which old target is treatedas selling all of its assets (the aggregatedeemed sale price, or ADSP) is addressedin §1.338–4T. The amount for which newtarget is deemed to have purchased all itsassets (the adjusted grossed-up basis, orAGUB) is addressed in §1.338–5T. Sec-tion 1.338–6T addresses allocation bothof ADSP among the assets old target isdeemed to have sold and of AGUB amongthe assets new target is deemed to havepurchased. Section 1.338–7T addressesallocation of ADSP or AGUB when thoseamounts change after the close of new tar-get’s first taxable year. Asset and stockconsistency are addressed in §1.338–8.International aspects of section 338 arecovered in §1.338–9. Rules for the filingof returns are provided in §1.338–10T.Eligibility for and treatment of section338(h)(10) elections is addressed in§1.338(h)(10)–1T.

(b) Treatment of target under other pro-visions of the Internal Revenue Code—(1)General rule for subtitle A. Except asprovided in this section, new target istreated as a new corporation that is unre-lated to old target for purposes of subtitleA of the Internal Revenue Code. Thus—

(i) New target is not considered relatedto old target for purposes of section 168and may make new elections under sec-tion 168 without taking into account theelections made by old target; and

(ii) New target may adopt, without ob-taining prior approval from the Commis-sioner, any taxable year that meets the re-quirements of section 441 and anymethod of accounting that meets the re-quirements of section 446. Notwithstand-

ing §1.441–1T(b)(2), a new target mayadopt a taxable year on or before the lastday for making the election under section338 by filing its first return for the desiredtaxable year on or before that date.

(2) Exceptions for subtitle A. New tar-get and old target are treated as the samecorporation for purposes of—

(i) The rules applicable to employeebenefit plans (including those plans de-scribed in sections 79, 104, 105, 106, 125,127, 129, 132, 137, and 220), qualifiedpension, profit-sharing, stock bonus andannuity plans (sections 401(a) and403(a)), simplified employee pensions(section 408(k)), tax qualified stock op-tion plans (sections 422 and 423), welfarebenefit funds (sections 419, 419A,512(a)(3), and 4976), voluntary employeebenefit associations (section 501(c)(9)and the regulations thereunder);

(ii) Sections 1311 through 1314 (relat-ing to the mitigation of the effect of limi-tations) if a section 338(h)(10) election isnot made for target;

(iii) Section 108(e)(5) (relating to thereduction of purchase money debt);

(iv) Section 45A (relating to the IndianEmployment Credit), section 51 (relatingto the Work Opportunity Credit), section51A (relating to the Welfare to WorkCredit), and section 1396 (relating to theEmpowerment Zone Act);

(v) Sections 401(h) and 420 (relating tomedical benefits for retirees);

(vi) Section 414 (relating to definitionsand special rules);

and(vii) Any other provision designated in

the Internal Revenue Bulletin by the In-ternal Revenue Service. See§601.601(d)(2)(ii) of this chapter (relat-ing to the Internal Revenue Bulletin). See§1.1001–3(e)(4)(F) providing that anelection under section 338 does not resultin the substitution of a new obligor on tar-get’s debt.

(3) General rule for other provisions ofthe Internal Revenue Code. Except asprovided in the regulations under section338 or in the Internal Revenue Bulletin bythe Internal Revenue Service (see§601.601(d)(2)(ii) of this chapter), newtarget is treated as a continuation of oldtarget for purposes other than subtitle A ofthe Internal Revenue Code. For exam-ple—

(i) New target is liable for old target’s

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2000–4 I.R.B. 339 January 24, 2000

Federal income tax liabilities, includingthe tax liability for the deemed sale gainand those tax liabilities of the other mem-bers of any consolidated group that in-cluded old target that are attributable totaxable years in which those corporationsand old target joined in the same consoli-dated return (see §1.1502–6(a));

(ii) Wages earned by the employees ofold target are considered wages earned bysuch employees from new target for pur-poses of sections 3101 and 3111 (FederalInsurance Contributions Act) and section3301 (Federal Unemployment Tax Act);and

(iii) Old target and new target must usethe same employer identification number.

(c) Anti-abuse rule—(1) In general .For purposes of applying the residualmethod of §§1.338–0T through 1.338–7T,1.338–8, 1.338–9, 1.338–10T,1.338(h)(10)–1T, and 1.338(i)–1T, theCommissioner is authorized to treat anyproperty (including cash) transferred byold target in connection with the transac-tions resulting in the application of theresidual method as, nonetheless, propertyof target at the close of the acquisitiondate if the property so transferred, within24 months after the deemed asset sale, isowned by new target, or is owned, di-rectly or indirectly, by a member of theaffiliated group of which new target is amember and continues after the electionto be held or used to more than an in-significant extent in connection with oneor more of the activities of new target.The Commissioner is authorized to treatany property (including cash) transferredto old target in connection with the trans-actions resulting in the application of theresidual method as, nonetheless, not beingproperty of target at the close of the ac-quisition date if the property so trans-ferred by the transferor is, within 24months after the deemed asset sale, notowned by new target but owned, directlyor indirectly, by a member of the affiliatedgroup of which new target is a member orowned by new target but held or used tomore than an insignificant extent in con-nection with an activity conducted, di-rectly or indirectly, by another member ofthe affiliated group of which new target isa member in combination with otherproperty acquired, directly or indirectly,from the transferor of the property (or amember of the same affiliated group) to

old target. For purposes of this para-graph (c)(1), an interest in an entity isconsidered held or used in connectionwith an activity if property of the entity isso held or used. The authority under thisparagraph (c)(1) includes the making ofany necessary correlative adjustments.

(2) Examples.The following examplesillustrate this paragraph (c):

Example 1. Prior to a qualified stock purchaseunder section 338, target transfers one of its assets toa related party. The purchasing corporation thenpurchases the target stock and also purchases thetransferred asset from the related party. After itspurchase of target, the purchasing corporation andtarget are members of the same affiliated group. Asection 338 election is made. Under an arrangementwith the purchaser, target continues to use the sepa-rately transferred asset to more than an insignificantextent in connection with its own activities. Apply-ing the anti-abuse rule of this paragraph (c), theCommissioner may consider target to own the trans-ferred asset for purposes of applying section 338 andits allocation rules.

Example 2. Target (T) owns all the stock of T1.T1 leases intellectual property to T, which T uses inconnection with its own activities. P, a purchasingcorporation, wishes to buy the T-T1 chain of corpo-rations. P, in connection with its planned purchaseof the T stock, contracts to consummate a purchaseof all the stock of T1 on March 1 and of all the stockof T on March 2. Section 338 elections are there-after made for both T and T1. Immediately after thepurchases, P, T and T1 are members of the same af-filiated group. T continues to lease the intellectualproperty from T1 and to use the property to morethan an insignificant extent in connection with itsown activities. Thus, an asset of T, the T1 stock,was removed from T ‘s own assets prior to the quali-fied stock purchase of the T stock, T1’s own assetsare used after the deemed asset sale in connectionwith T’s own activities, and the T1 stock is after thedeemed asset sale owned by P, a member of thesame affiliated group of which T is a member. Ap-plying the anti-abuse rule of this paragraph (c), theCommissioner may, for purposes of application ofsection 338 both to T and to T1, consider P to havebought only the stock of T, with T at the time of thequalified stock purchases of both T and T1 (the qual-ified stock purchase of T1 being triggered by thedeemed sale under section 338 of T’s assets) owningT1. The Commissioner would accordingly applysection 338 first at the T level and then at the T1level.

§1.338–2T Nomenclature and defini-tions; mechanics of the section 338 elec-tion (temporary).

(a) Scope. This section prescribes rulesrelating to elections under section 338.

(b) Nomenclature. For purposes of theregulations under section 338 (except asotherwise provided):

(1) T is a domestic target corporationthat has only one class of stock outstand-ing. Old T refers to T for periods ending

on or before the close of T’s acquisitiondate; new T refers to T for subsequent pe-riods.

(2) P is the purchasing corporation.(3) The P group is an affiliated group of

which P is a member.(4) P1, P2, etc., are domestic corpora-

tions that are members of the P group.(5) T1, T2, etc., are domestic corpora-

tions that are target affiliates of T. Thesecorporations (T1, T2, etc.) have only oneclass of stock outstanding and may alsobe targets.

(6) S is a domestic corporation (unre-lated to P and B) that owns T prior to thepurchase of T by P. (S is referred to incases in which it is appropriate to con-sider the effects of having all of the out-standing stock of T owned by a domesticcorporation.)

(7) A, a U.S. citizen or resident, is anindividual (unrelated to P and B) whoowns T prior to the purchase of T by P.(A is referred to in cases in which it is ap-propriate to consider the effects of havingall of the outstanding stock of T owned byan individual who is a U.S. citizen or resi-dent. Ownership of T by A and ownershipof T by S are mutually exclusive circum-stances.)

(8) B, a U.S. citizen or resident, is anindividual (unrelated to T, S, and A) whoowns the stock of P.

(9) F, used as a prefix with the otherterms in this paragraph (b), connotes for-eign, rather than domestic, status. For ex-ample, FT is a foreign corporation (as de-fined in section 7701(a)(5)) and FA is anindividual other than a U.S. citizen or res-ident.

(10) CFC, used as a prefix with theother terms in this paragraph (b) referringto a corporation, connotes a controlledforeign corporation (as defined in section957, taking into account section 953(c)).A corporation identified with the prefix Fmay be a controlled foreign corporation.The prefix CFC is used when the corpora-tion’s status as a controlled foreign corpo-ration is significant.

(c) Definitions. For purposes of theregulations under section 338 (except asotherwise provided):

(1) Acquisition date.The term acquisi-tion datehas the same meaning as in sec-tion 338(h)(2).

(2) Acquisition date assets. Acquisitiondate assetsare the assets of the target held

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at the beginning of the day after the acqui-sition date (other than assets that were notassets of old target).

(3) Affiliated group. The term affili-ated grouphas the same meaning as insection 338(h)(5). Corporations are affili-ated on any day they are members of thesame affiliated group.

(4) Common parent. The term commonparenthas the same meaning as in section1504.

(5) Consistency period.The consis-tency periodis the period described insection 338(h)(4)(A) unless extended pur-suant to §1.338–8(j)(1).

(6) Deemed asset sale. The deemedasset saleis the transaction described in§1.338–1T(a)(1) that is deemed to occurfor purposes of subtitle A of the InternalRevenue Code if a section 338 election ismade.

(7) Deemed sale gain. Deemed salegain refers to, in the aggregate, the Fed-eral income tax consequences (generally,the income, gain, deduction, and loss) ofthe deemed asset sale. Deemed sale gainalso refers to the Federal income tax con-sequences of the transfer of a particularasset in the deemed asset sale.

(8) Deemed sale return. The deemedsale returnis the return on which target’sdeemed sale gain is reported that does notinclude any other items of target. Targetfiles a deemed sale return when a section338 election (but not a section 338(h)(10)election) is filed for target and target is amember of a selling group (defined inparagraph (c)(16) of this section) that filesa consolidated return for the period thatincludes the acquisition date or is an Scorporation. See §1.338–10T.

(9) Domestic corporation.A domesticcorporationis a corporation—

(i) That is domestic within the meaningof section 7701(a)(4) or that is treated asdomestic for purposes of subtitle A of theInternal Revenue Code (e.g., to which anelection under section 953(d) or 1504(d)applies); and

(ii) That is not a DISC, a corporationdescribed in section 1248(e), or a corpo-ration to which an election under section936 applies.

(10) Old target’s final return. Old tar-get’s final returnis the income tax returnof old target for the taxable year ending atthe close of the acquisition date that in-cludes the deemed sale gain. If the disaf-

filiation rule of §1.338–10T(a)(2)(i) ap-plies or if target is an S corporation, tar-get’s deemed sale return is considered oldtarget’s final return.

(11) Purchasing corporation.The termpurchasing corporationhas the samemeaning as in section 338(d)(1). The pur-chasing corporation may also be referredto as purchaser. Unless otherwise pro-vided, any reference to the purchasingcorporation is a reference to all membersof the affiliated group of which the pur-chasing corporation is a member. Seesections 338(h)(5) and (8). Also, unlessotherwise provided, any reference to thepurchasing corporation is, with respect toa deemed purchase of stock under section338(a)(2), a reference to new target withrespect to its own deemed purchase ofstock in another target.

(12) Qualified stock purchase. Theterm qualified stock purchasehas thesame meaning as in section 338(d)(3).

(13) Related persons. Two persons arerelated if stock in a corporation owned byone of the persons would be attributedunder section 318(a) (other than section318(a)(4)) to the other.

(14) Section 338 election. A section338 electionis an election to apply sec-tion 338(a) to target. A section 338 elec-tion is made by filing a statement of sec-tion 338 election pursuant to paragraph(d) of this section. The form on whichthis statement is filed is referred to in theregulations under section 338 as the Form8023 Elections Under Section 338 forCorporations Making Qualified StockPurchases.

(15) Section 338(h)(10) election.Asection 338(h)(10) electionis an electionto apply section 338(h)(10) to target. Asection 338(h)(10) election is made bymaking a joint election for target under§1.338(h)(10)–1T.

(16) Selling group. The selling groupis the affiliated group (as defined in sec-tion 1504) eligible to file a consolidatedreturn that includes target for the taxableperiod in which the acquisition date oc-curs. However, a selling group is not anaffiliated group of which target is thecommon parent on the acquisition date.

(17) Target; old target; new target.Targetis the target corporation as definedin section 338(d)(2). Old target refers totarget for periods ending on or before theclose of target’s acquisition date. New

target refers to target for subsequent peri-ods.

(18) Target affiliate. The term targetaffiliate has the same meaning as in sec-tion 338(h)(6) (applied without section338(h)(6)(B)(i)). Thus, a corporation de-scribed in section 338(h)(6)(B)(i) is con-sidered a target affiliate for all purposesof section 338. If a target affiliate is ac-quired in a qualified stock purchase, it isalso a target.

(19) 12–Month acquisition period. The12-month acquisition periodis the perioddescribed in section 338(h)(1), unless ex-tended pursuant to §1.338–8(j)(2).

(d) Time and manner of making elec-tion. The purchasing corporation makes asection 338 election for target by filing astatement of section 338 election on Form8023 in accordance with the instructionsto the form. The section 338 electionmust be made not later than the 15th dayof the 9th month beginning after themonth in which the acquisition date oc-curs. A section 338 election is irrevoca-ble. See §1.338(h)(10)–1T(c)(2) for sec-tion 338(h)(10) elections.

(e) Special rules for foreign corpora-tions or DISCs—(1) Elections by certainforeign purchasing corporations—(i)General rule. A qualifying foreign pur-chasing corporation is not required to filea statement of section 338 election for aqualifying foreign target before the earlierof 3 years after the acquisition date andthe 180th day after the close of the pur-chasing corporation’s taxable year withinwhich a triggering event occurs.

(ii) Qualifying foreign purchasing cor-poration. A purchasing corporation is aqualifying foreign purchasing corpora-tion only if, during the acquisition periodof a qualifying foreign target, all the cor-porations in the purchasing corporation’saffiliated group are foreign corporationsthat are not subject to United States tax.

(iii) Qualifying foreign target. A targetis a qualifying foreign targetonly if targetand its target affiliates are foreign corpo-rations that, during target’s acquisition pe-riod, are not subject to United States tax(and will not become subject to UnitedStates tax during such period because of asection 338 election). A target affiliate istaken into account for purposes of the pre-ceding sentence only if, during target’s12-month acquisition period, it is or be-comes a member of the affiliated group

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2000–4 I.R.B. 341 January 24, 2000

that includes the purchasing corporation.(iv) Triggering event. A triggering

eventoccurs in the taxable year of thequalifying foreign purchasing corporationin which either that corporation or anycorporation in its affiliated group be-comes subject to United States tax.

(v) Subject to United States tax. Forpurposes of this paragraph (e)(1), a for-eign corporation is considered subject toUnited States tax—

(A) For the taxable year for which thatcorporation is required under §1.6012–2(g)(other than §1.6012–2(g)(2)(i)(B)(2)) tofile a United States income tax return; or

(B) For the period during which thatcorporation is a controlled foreign corpo-ration, a passive foreign investment com-pany for which an election under section1295 is in effect, a foreign investmentcompany, or a foreign corporation thestock ownership of which is described insection 552(a)(2).

(2) Acquisition period. For purposes ofthis paragraph (e), the term acquisitionperiodmeans the period beginning on thefirst day of the 12-month acquisition pe-riod and ending on the acquisition date.

(3) Statement of section 338 electionmay be filed by United States sharehold-ers in certain cases.The United Statesshareholders (as defined in section951(b)) of a foreign purchasing corpora-tion that is a controlled foreign corpora-tion (as defined in section 957 (taking intoaccount section 953(c))) may file a state-ment of section 338 election on behalf ofthe purchasing corporation if the purchas-ing corporation is not required under§1.6012–2(g) (other than§1.6012–2(g)(2)(i)(B)(2)) to file a UnitedStates income tax return for its taxableyear that includes the acquisition date.Form 8023 must be filed as described inthe form and its instructions and also mustbe attached to the Form 5471 (informa-tion return with respect to a foreign cor-poration) filed with respect to the pur-chasing corporation by each United Statesshareholder for the purchasing corpora-tion’s taxable year that includes the acqui-sition date (or, if paragraph (e)(1)(i) ofthis section applies to the election, for thepurchasing corporation’s taxable yearwithin which it becomes a controlled for-eign corporation). The provisions of§1.964–1(c) (including §1.964–1(c)(7))do not apply to an election made by the

United States shareholders.(4) Notice requirement for U.S. persons

holding stock in foreign market—(i) Gen-eral rule. If a target subject to a section338 election was a controlled foreign cor-poration, a passive foreign investmentcompany, or a foreign personal holdingcompany at any time during the portion ofits taxable year that ends on its acquisitiondate, the purchasing corporation must de-liver written notice of the election (and acopy of Form 8023, its attachments andinstructions) to—

(A) Each U.S. person (other than amember of the affiliated group of whichthe purchasing corporation is a member(the purchasing group member)) that, onthe acquisition date of the foreign target,holds stock in the foreign target; and

(B) Each U.S. person (other than a pur-chasing group member) that sells stock inthe foreign target to a purchasing groupmember during the foreign target’s 12-month acquisition period.

(ii) Limitation. The notice requirementof this paragraph (e)(4) applies onlywhere the section 338 election for the for-eign target affects income, gain, loss, de-duction, or credit of the U.S. person de-scribed in paragraph (e)(4)(i) of thissection under section 551, 951, 1248, or1293.

(iii) Form of notice. The notice to U.S.persons must be identified prominently asa notice of section 338 election andmust—

(A) Contain the name, address, and em-ployer identification number (if any) of,and the country (and, if relevant, thelesser political subdivision) under thelaws of which is organized, the purchas-ing corporation and the relevant target(i.e., target the stock of which the particu-lar U.S. person held or sold under the cir-cumstances described in paragraph(e)(4)(i) of this section);

(B) Identify those corporations as thepurchasing corporation and the foreigntarget, respectively; and

(C) Contain the following declaration(or a substantially similar declaration):THIS DOCUMENT SERVES AS NO-TICE OF AN ELECTION UNDER SEC-TION 338 FOR THE ABOVE CITEDFOREIGN TARGET THE STOCK OFWHICH YOU EITHER HELD ORSOLD UNDER THE CIRCUM-STANCES DESCRIBED IN TREA-

SURY REGULATIONS SECTION1.338-2T(e)(4). FOR POSSIBLEUNITED STATES FEDERAL INCOMETAX CONSEQUENCES UNDER SEC-TION 551, 951, 1248, OR 1293 OF THEINTERNAL REVENUE CODE OF 1986THAT MAY APPLY TO YOU, SEETREASURY REGULATIONS SECTION1.338-9(b). YOU MAY BE REQUIREDTO ATTACH THE INFORMATION AT-TACHED TO THIS NOTICE TO CER-TAIN RETURNS.

(iv) Timing of notice. The notice re-quired by this paragraph (e)(4) must bedelivered to the U.S. person on or beforethe later of the 120th day after the acquisi-tion date of the particular target or the dayon which Form 8023 is filed. The noticeis considered delivered on the date it ismailed to the proper address (or an ad-dress similar enough to complete deliv-ery), unless the date it is mailed cannot bereasonably determined. The date of mail-ing will be determined under the rules ofsection 7502. For example, the date ofmailing is the date of U.S. postmark or theapplicable date recorded or marked by adesignated delivery service.

(v) Consequence of failure to comply.A statement of section 338 election is notvalid if timely notice is not given to oneor more U.S. persons described in thisparagraph (e)(4). If the form of noticefails to comply with all requirements ofthis paragraph (e)(4), the section 338election is valid, but the waiver rule of§1.338-10T(b)(1) does not apply.

(vi) Good faith effort to comply.Thepurchasing corporation will be consideredto have complied with this paragraph(e)(4), even though it failed to provide no-tice or provide timely notice to each per-son described in this paragraph (e)(4), ifthe Commissioner determines that thepurchasing corporation made a good faitheffort to identify and provide timely no-tice to those U.S. persons.§1.338-3T Qualification for the section338 election(temporary).

(a) Scope. This section provides ruleson whether certain acquisitions of stockare qualified stock purchases and on othermiscellaneous issues under section 338.

(b) Rules relating to qualified stockpurchases—(1) Purchasing corporationrequirement. An individual cannot makea qualified stock purchase of target. Sec-tion 338(d)(3) requires, as a condition of a

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qualified stock purchase, that a corpora-tion purchase the stock of target. If an in-dividual forms a corporation (new P) toacquire target stock, new P can make aqualified stock purchase of target if new Pis considered for tax purposes to purchasethe target stock. Facts that may indicatethat new P does not purchase the targetstock include new P’s merging down-stream into target, liquidating, or other-wise disposing of the target stock follow-ing the purported qualified stockpurchase.

(2) Purchase—(i) Definition. The termpurchasehas the same meaning as in sec-tion 338(h)(3).

(ii) Purchase of target.[Reserved](iii) Purchase of target affiliate. Stock

in a target affiliate acquired by new targetin the deemed asset sale of target’s assetsis considered purchased if, under generalprinciples of tax law, new target is consid-ered to own stock of the target affiliatemeeting the requirements of section1504(a)(2), notwithstanding that noamount may be allocated to target’s stockin the target affiliate.

(3) Acquisitions of stock from relatedcorporations—(i) In general. Stock ac-quired by a purchasing corporation from arelated corporation (R) is generally notconsidered acquired by purchase. Seesection 338(h)(3)(A)(iii).

(ii) Time for testing relationship. Forpurposes of section 338(h)(3)(A)(iii), apurchasing corporation is treated as re-lated to another person if the relationshipspecified in section 338(h)(3)(A)(iii) ex-ists—

(A) In the case of a single transaction,immediately after the purchase of Targetstock;

(B) In the case of a series of acquisi-tions otherwise constituting a qualifiedstock purchase within the meaning of sec-tion 338(d)(3), immediately after the lastacquisition in such series; and

(C) In the case of a series of transac-tions effected pursuant to an integratedplan to dispose of Target stock, immedi-ately after the last transaction in such se-ries.

(iii) Cases where section338(h)(3)(C)applies—acquisitions treated as pur-chases. If section 338(h)(3)(C) appliesand the purchasing corporation is treatedas acquiring stock by purchase from R,solely for purposes of determining when

the stock is considered acquired, targetstock acquired from R is considered tohave been acquired by the purchasing cor-poration on the day on which the purchas-ing corporation is first considered to ownthat stock under section 318(a) (other thansection 318(a)(4)).

(iv) Examples. The following exam-ples illustrate this paragraph (b)(3):

Example 1. (i) S is the parent of a group of corpo-rations that are engaged in various businesses. Priorto January 1, Year 1, S decided to discontinue its in-volvement in one line of business. To accomplishthis, S forms a new corporation, Newco, with a nom-inal amount of cash. Shortly thereafter, on January 1,Year 1, S transfers all the stock of the subsidiary con-ducting the unwanted business (Target) to Newco inexchange for 100 shares of Newco common stockand a Newco promissory note. Prior to January 1,Year 1, S and Underwriter (U) had entered into abinding agreement pursuant to which U would pur-chase 60 shares of Newco common stock from S andthen sell those shares in an Initial Public Offering(IPO). On January 6, Year 1, the IPO closes.

(ii) Newco’s acquisition of Target stock is one ofa series of transactions undertaken pursuant to oneintegrated plan. The series of transactions ends withthe closing of the IPO and the transfer of all theshares of stock in accordance with the agreements.Immediately after the last transaction effected pur-suant to the plan, S owns 40 percent of Newco,which does not give rise to a relationship describedin section 338(h)(3)(A)(ii i). See§1.338–2T(b)(3)(ii)(C). Accordingly, S and Newcoare not related for purposes of section338(h)(3)(A)(iii).

(iii) Further, because Newco’s basis in the Targetstock is not determined by reference to S’s basis inthe Target stock and because the transaction is not anexchange to which section 351, 354, 355, or 356 ap-plies, Newco’s acquisition of the Target stock is apurchase within the meaning of section 338(h)(3).

Example 2. (i) On January 1 of Year 1, P pur-chases 75 percent in value of the R stock. On thatdate, R owns 4 of the 100 shares of T stock. On June1 of Year 1, R acquires an additional 16 shares of Tstock. On December 1 of Year 1, P purchases 70shares of T stock from an unrelated person and 12 ofthe 20 shares of T stock held by R.

(ii) Of the 12 shares of T stock purchased by Pfrom R on December 1 of Year 1, 3 of those sharesare deemed to have been acquired by P on January 1of Year 1, the date on which 3 of the 4 shares of Tstock held by R on that date were first consideredowned by P under section 318(a)(2)(C) (i.e., 4 ( .75).The remaining 9 shares of T stock purchased by Pfrom R on December 1 of Year 1, are deemed tohave been acquired by P on June 1 of Year 1, thedate on which an additional 12 of the 20 shares of Tstock owned by R on that date were first consideredowned by P under section 318(a)(2)(C) (i.e., (20 (.75) -3). Because stock acquisitions by P sufficientfor a qualified stock purchase of T occur within a12-month period (i.e., 3 shares constructively onJanuary 1 of Year 1, 9 shares constructively on June1 of Year 1, and 70 shares actually on December 1 ofYear 1), a qualified stock purchase is made on De-cember 1 of Year 1.

Example 3. (i) On February 1 of Year 1, P acquires25 percent in value of the R stock from B (the soleshareholder of P). That R stock is not acquired bypurchase. See section 338(h)(3)(A)(iii). On that date,R owns 4 of the 100 shares of T stock. On June 1 ofYear 1, P purchases an additional 25 percent in valueof the R stock, and on January 1 of Year 2, P pur-chases another 25 percent in value of the R stock. OnJune 1 of Year 2, R acquires an additional 16 shares ofthe T stock. On December 1 of Year 2, P purchases68 shares of the T stock from an unrelated person and12 of the 20 shares of the T stock held by R.

(ii) Of the 12 shares of the T stock purchased by Pfrom R on December 1 of Year 2, 2 of those sharesare deemed to have been acquired by P on June 1 ofYear 1, the date on which 2 of the 4 shares of the Tstock held by R on that date were first consideredowned by P under section 318(a)(2)(C) (i.e., 4 ( .5).For purposes of this attribution, the R stock need notbe acquired by P by purchase. See section 338(h)(1).(By contrast, the acquisition of the T stock by P fromR does not qualify as a purchase unless P has ac-quired at least 50 percent in value of the R stock bypurchase. Section 338(h)(3)(C)(i).) Of the remain-ing 10 shares of the T stock purchased by P from Ron December 1 of Year 2, 1 of those shares is deemedto have been acquired by P on January 1 of Year 2,the date on which an additional 1 share of the 4shares of the T stock held by R on that date was firstconsidered owned by P under section 318(a)(2)(C)(i.e., (4 ( .75) –2). The remaining 9 shares of the Tstock purchased by P from R on December 1 of Year2, are deemed to have been acquired by P on June 1of Year 2, the date on which an additional 12 sharesof the T stock held by R on that date were first con-sidered owned by P under section 318(a)(2)(C) (i.e.,(20 ( .75) –3). Because a qualified stock purchase ofT by P is made on December 1 of Year 2, only if all12 shares of the T stock purchased by P from R onthat date are considered acquired during a 12-monthperiod ending on that date (so that, in conjunctionwith the 68 shares of the T stock P purchased on thatdate from the unrelated person, 80 of T’s 100 sharesare acquired by P during a 12-month period) and be-cause 2 of those 12 shares are considered to havebeen acquired by P more than 12 months before De-cember 1 of Year 2 (i.e., on June 1 of Year 1), a qual-ified stock purchase is not made. (Under§1.338–8(j)(2), for purposes of applying the consis-tency rules, P is treated as making a qualified stockpurchase of T if, pursuant to an arrangement, P pur-chases T stock satisfying the requirements of section1504(a)(2) over a period of more than 12 months.)

Example 4.Assume the same facts as in Example3, except that on February 1 of Year 1, P acquires 25percent in value of the R stock by purchase. The re-sult is the same as in Example 3.

(4) Acquisition date for tiered targets—(i) Stock sold in deemed asset sale. If anelection under section 338 is made for tar-get, old target is deemed to sell target’sassets and new target is deemed to acquirethose assets. Under section 338(h)(3)(B),new target’s deemed purchase of stock ofanother corporation is a purchase for pur-poses of section 338(d)(3) on the acquisi-tion date of target. If new target’s deemedpurchase causes a qualified stock pur-

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chase of the other corporation and if asection 338 election is made for the othercorporation, the acquisition date for theother corporation is the same as the acqui-sition date of target. However, thedeemed sale and purchase of the othercorporation’s assets is considered to takeplace after the deemed sale and purchaseof target’s assets.

(ii) Examples. The following examplesillustrate this paragraph (b)(4):

Example 1.A owns all of the T stock. T owns 50of the 100 shares of X stock. The other 50 shares ofX stock are owned by corporation Y, which is unre-lated to A, T, or P. On January 1 of Year 1, P makes aqualified stock purchase of T from A and makes asection 338 election for T. On December 1 of Year 1,P purchases the 50 shares of X stock held by Y. Aqualified stock purchase of X is made on December 1of Year 1, because the deemed purchase of 50 sharesof X stock by new T because of the section 338 elec-tion for T and the actual purchase of 50 shares of Xstock by P are treated as purchases made by one cor-poration. Section 338(h)(8). For purposes of deter-mining whether those purchases occur within a 12-month acquisition period as required by section338(d)(3), T is deemed to purchase its X stock on T’sacquisition date, i.e., January 1 of Year 1.

Example 2. On January 1 of Year 1, P makes aqualified stock purchase of T and makes a section338 election for T. On that day, T sells all of thestock of T1 to A. Although T held all of the T1 stockon T’s acquisition date, T is not considered to havepurchased the T1 stock because of the section 338election for T. In order for T to be treated as pur-chasing the T1 stock, T must hold the T1 stock whenT’s deemed asset sale occurs. The deemed asset saleis considered the last transaction of old T at the closeof T’s acquisition date. Accordingly, the T1 stockactually disposed of by T on the acquisition date isnot included in the deemed asset sale. Thus, T doesnot make a qualified stock purchase of T1.

(5) Effect of redemptions—(i) Generalrule. Except as provided in this para-graph (b)(5), a qualified stock purchase ismade on the first day on which the per-centage ownership requirements of sec-tion 338(d)(3) are satisfied by reference totarget stock that is both—

(A) Held on that day by the purchasingcorporation; and

(B) Purchased by the purchasing corpo-ration during the 12-month period endingon that day.

(ii) Redemptions from persons unre-lated to the purchasing corporation. Tar-get stock redemptions from persons unre-lated to the purchasing corporation thatoccur during the 12-month acquisition pe-riod are taken into account as reductionsin target’s outstanding stock for purposesof determining whether target stock pur-chased by the purchasing corporation in

the 12-month acquisition period satisfiesthe percentage ownership requirements ofsection 338(d)(3).

(iii) Redemptions from the purchasingcorporation or related persons during 12-month acquisition period—(A) Generalrule. For purposes of the percentageownership requirements of section338(d)(3), a redemption of target stockduring the 12-month acquisition periodfrom the purchasing corporation or fromany person related to the purchasing cor-poration is not taken into account as a re-duction in target’s outstanding stock.

(B) Exception for certain redemptionsfrom related corporations. A redemptionof target stock during the 12-month acqui-sition period from a corporation related tothe purchasing corporation is taken intoaccount as a reduction in target’s out-standing stock to the extent that the re-deemed stock would have been consid-ered purchased by the purchasingcorporation (because of section338(h)(3)(C)) during the 12-month acqui-sition period if the redeemed stock hadbeen acquired by the purchasing corpora-tion from the related corporation on theday of the redemption. See paragraph(b)(3) of this section.

(iv) Examples. The following exam-ples illustrate this paragraph (b)(5):

Example 1. QSP on stock purchase date; re-demption from unrelated person during 12-monthperiod. A owns all 100 shares of T stock. On Janu-ary 1 of Year 1, P purchases 40 shares of the T stockfrom A. On July 1 of Year 1, T redeems 25 sharesfrom A. On December 1 of Year 1, P purchases 20shares of the T stock from A. P makes a qualifiedstock purchase of T on December 1 of Year 1, be-cause the 60 shares of T stock purchased by P withinthe 12-month period ending on that date satisfy the80-percent ownership requirements of section338(d)(3) (i.e., 60/75 shares), determined by takinginto account the redemption of 25 shares.

Example 2. QSP on stock redemption date; re-demption from unrelated person during 12-month pe-riod. The facts are the same as in Example 1, exceptthat P purchases 60 shares of T stock on January 1 ofYear 1 and none on December 1 of Year 1. P makes aqualified stock purchase of T on July 1 of Year 1, be-cause that is the first day on which the T stock pur-chased by P within the preceding 12-month periodsatisfies the 80-percent ownership requirements ofsection 338(d)(3) (i.e., 60/75 shares), determined bytaking into account the redemption of 25 shares.

Example 3. Redemption from purchasing corpo-ration not taken into account.On December 15 ofYear 1, T redeems 30 percent of its stock from P.The redeemed stock was held by P for several yearsand constituted P’s total interest in T. On December1 of Year 2, P purchases the remaining T stock fromA. P does not make a qualified stock purchase of Ton December 1 of Year 2. For purposes of the 80-

percent ownership requirements of section338(d)(3), the redemption of P’s T stock on Decem-ber 15 of Year 1 is not taken into account as a reduc-tion in T’s outstanding stock.

Example 4. Redemption from related persontaken into account.On January 1 of Year 1, P pur-chases 60 of the 100 shares of X stock. On that date,X owns 40 of the 100 shares of T stock. On April 1of Year 1, T redeems X’s T stock and P purchases theremaining 60 shares of T stock from an unrelatedperson. For purposes of the 80-percent ownershiprequirements of section 338(d)(3), the redemption ofthe T stock from X (a person related to P) is takeninto account as a reduction in T’s outstanding stock.If P had purchased the 40 redeemed shares from Xon April 1 of Year 1, all 40 of the shares would havebeen considered purchased (because of section338(h)(3)(C)(i)) during the 12-month period endingon April 1 of Year 1 (24 of the 40 shares would havebeen considered purchased by P on January 1 ofYear 1 and the remaining 16 shares would have beenconsidered purchased by P on April 1 of Year 1).See paragraph (b)(3) of this section. Accordingly, Pmakes a qualified stock purchase of T on April 1 ofYear 1, because the 60 shares of T stock purchasedby P on that date satisfy the 80-percent ownershiprequirements of section 338(d)(3) (i.e., 60/60shares), determined by taking into account the re-demption of 40 shares.

(c) Effect of post-acquisition events oneligibility for section 338 election— (1)Post-acquisition elimination of target. (i)The purchasing corporation may make anelection under section 338 for target eventhough target is liquidated on or after theacquisition date. If target liquidates on theacquisition date, the liquidation is consid-ered to occur on the following day and im-mediately after new target’s deemed pur-chase of assets. The purchasingcorporation may also make an electionunder section 338 for target even thoughtarget is merged into another corporation,or otherwise disposed of by the purchasingcorporation provided that, under the factsand circumstances, the purchasing corpo-ration is considered for tax purposes as thepurchaser of the target stock.

(ii) The following examples illustratethis paragraph (c)(1):

Example 1.On January 1 of Year 1, P purchases100 percent of the outstanding common stock of T.On June 1 of Year 1, P sells the T stock to an unre-lated person. Assuming that P is considered for taxpurposes as the purchaser of the T stock, P remainseligible, after June 1 of Year 1, to make a section 338election for T that results in a deemed asset sale ofT’s assets on January 1 of Year 1.

Example 2. On January 1 of Year 1, P makes aqualified stock purchase of T. On that date, T ownsthe stock of T1. On March 1 of Year 1, T sells theT1 stock to an unrelated person. On April 1 of Year1, P makes a section 338 election for T. Notwith-standing that the T1 stock was sold on March 1 ofYear 1, the section 338 election for T on April 1 ofYear 1 results in a qualified stock purchase by T of

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T1 on January 1 of Year 1. See paragraph (b)(4)(i)of this section.

(2) Post-acquisition elimination of thepurchasing corporation. An electionunder section 338 may be made for targetafter the acquisition of assets of the pur-chasing corporation by another corpora-tion in a transaction described in section381(a), provided that the purchasing cor-poration is considered for tax purposes asthe purchaser of the target stock. The ac-quiring corporation in the section 381(a)transaction may make an election undersection 338 for target.

(3) Consequences of post-acquisitionelimination of target—(i) Scope. Therules of this paragraph (c)(3) apply to thetransfer of target assets to the purchasingcorporation (or another member of thesame affiliated group as the purchasingcorporation) (the transferee) following aqualified stock purchase of target stock, ifthe purchasing corporation does not makea section 338 election for target.Notwithstanding the rules of this para-graph (c)(3), section 354(a) (and so muchof section 356 as relates to section 354)cannot apply to any person other than thepurchasing corporation or another mem-ber of the same affiliated group as thepurchasing corporation unless the transferof target assets is pursuant to a reorgani-zation as determined without regard tothis paragraph (c)(3).

(ii) Continuity of interest. By virtue ofsection 338, in determining whether thecontinuity of interest requirement of§1.368-1(b) is satisfied on the transfer ofassets from target to the transferee, thepurchasing corporation’s target stock ac-quired in the qualified stock purchase rep-resents an interest on the part of a personwho was an owner of the target’s businessenterprise prior to the transfer that can becontinued in a reorganization.

(iii) Control requirement. By virtue ofsection 338, the acquisition of target stockin the qualified stock purchase will notprevent the purchasing corporation fromqualifying as a shareholder of the targettransferor for the purpose of determiningwhether, immediately after the transfer oftarget assets, a shareholder of the trans-feror is in control of the corporation towhich the assets are transferred within themeaning of section 368(a)(1)(D).

(iv) Example. The following exampleillustrates this paragraph (c)(3):

Example. (i) Facts. P, T, and X are domestic cor-

porations. T and X each operate a trade or business.A and K, individuals unrelated to P, own 85 and 15percent, respectively, of the stock of T. P owns all ofthe stock of X. The total adjusted basis of T’s prop-erty exceeds the sum of T’s liabilities plus theamount of liabilities to which T’s property is subject.P purchases all of A’s T stock for cash in a qualifiedstock purchase. P does not make an election undersection 338(g) with respect to its acquisition of Tstock. Shortly after the acquisition date, and as partof the same plan, T merges under applicable statelaw into X in a transaction that, but for the questionof continuity of interest, satisfies all the require-ments of section 368(a)(1)(A). In the merger, all ofT’s assets are transferred to X. P and K receive Xstock in exchange for their T stock. P intends to re-tain the stock of X indefinitely.

(ii) Status of transfer as a reorganization. Byvirtue of section 338, for the purpose of determiningwhether the continuity of interest requirement of§1.368–1(b) is satisfied, P’s T stock acquired in thequalified stock purchase represents an interest on thepart of a person who was an owner of T’s businessenterprise prior to the transfer that can be continuedin a reorganization through P’s continuing owner-ship of X. Thus, the continuity of interest require-ment is satisfied and the merger of T into X is a reor-ganization within the meaning of section368(a)(1)(A). Moreover, by virtue of section 338,the requirement of section 368(a)(1)(D) that a targetshareholder control the transferee immediately afterthe transfer is satisfied because P controls X imme-diately after the transfer. In addition, all of T’s as-sets are transferred to X in the merger and P and Kreceive the X stock exchanged therefor in pursuanceof the plan of reorganization. Thus, the merger of Tinto X is also a reorganization within the meaning ofsection 368(a)(1)(D).

(iii) Treatment of T and X.Under section 361(a),T recognizes no gain or loss in the merger. Undersection 362(b), X’s basis in the assets received in themerger is the same as the basis of the assets in T’shands. X succeeds to and takes into account theitems of T as provided in section 381.

(iv) Treatment of P. By virtue of section 338, thetransfer of T assets to X is a reorganization. Pur-suant to that reorganization, P exchanges its T stocksolely for stock of X, a party to the reorganization.Because P is the purchasing corporation, section 354applies to P’s exchange of T stock for X stock in themerger of T into X. Thus, P recognizes no gain orloss on the exchange. Under section 358, P’s basisin the X stock received in the exchange is the sameas the basis of P’s T stock exchanged therefor.

(v) Treatment of K. Because K is not the pur-chasing corporation (or an affiliate thereof), section354 cannot apply to K’s exchange of T stock for Xstock in the merger of T into X unless the transfer ofT’s assets is pursuant to a reorganization as deter-mined without regard to this paragraph (c)(3).Under general principles of tax law applicable to re-organizations, the continuity of interest requirementis not satisfied because P’s stock purchase and themerger of T into X are pursuant to an integratedtransaction in which A, the owner of 85 percent ofthe stock of T, received solely cash in exchange forA’s T stock. See, e.g., Yoc Heating v. Commissioner,61 T.C. 168 (1973); Kass v. Commissioner, 60 T.C.218 (1973), aff ’d, 491 F.2d 749 (3d Cir. 1974).Thus, the requisite continuity of interest under

§1.368–1(b) is lacking and section 354 does notapply to K’s exchange of T stock for X stock. K rec-ognizes gain or loss, if any, pursuant to section1001(c) with respect to its T stock.

§§1.338–4 and 1.338–5 [Redesignatedas §§1.338–8 and 1.338–9]

Par. 5. Sections 1.338–4 and 1.338–5are redesignated as §§1.338–8 and1.338–9, respectively.

Par. 6. New §§1.338–4T and 1.338–5Tare added to read as follows:§1.338–4T Aggregate deemed sale price;various aspects of taxation of the deemedasset sale (temporary).

(a) Scope. This section provides rulesunder section 338(a)(1) to determine theaggregate deemed sale price (ADSP) fortarget. ADSP is the amount for which oldtarget is deemed to have sold all of its as-sets in the deemed asset sale. ADSP is al-located among target’s assets in accor-dance with §1.338–6T to determine theamount for which each asset is deemed tohave been sold. When an increase or de-crease with respect to an element of ADSPis required, under general principles of taxlaw, after the close of new target’s firsttaxable year, redetermined ADSP is allo-cated among target’s assets in accordancewith §1.338–7T. This section also pro-vides rules regarding the recognition ofgain or loss on the deemed sale of targetaffiliate stock. Notwithstanding section338(h)(6)(B)(ii), stock held by a target af-filiate in a foreign corporation or in a cor-poration that is a DISC or that is describedin section 1248(e) is not excluded fromthe operation of section 338.

(b) Determination of ADSP—(1) Gen-eral rule. ADSP is the sum of—

(i) The grossed-up amount realized onthe sale to the purchasing corporation ofthe purchasing corporation’s recently pur-chased target stock (as defined in section338(b)(6)(A)); and

(ii) The liabilities of old target.(2) Time and amount of ADSP—(i)

Original determination.ADSP is initiallydetermined at the beginning of the dayafter the acquisition date of target. Gen-eral principles of tax law apply in deter-mining the timing and amount of the ele-ments of ADSP.

(ii) Redetermination of ADSP. ADSP isredetermined at such time and in suchamount as an increase or decrease would berequired, under general principles of taxlaw, for the elements of ADSP. For exam-

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ple, ADSP is redetermined because of anincrease or decrease in the amount realizedfor recently purchased stock or because lia-bilities not originally taken into account indetermining ADSP are subsequently takeninto account. An increase or decrease toone element of ADSP may cause an in-crease or decrease to the other element ofADSP. For example, if an increase in theamount realized for recently purchasedstock of target is taken into account afterthe acquisition date, any increase in the taxliability of target for the deemed sale gain isalso taken into account when ADSP is rede-termined. Increases or decreases with re-spect to the elements of ADSP that aretaken into account before the close of newtarget’s first taxable year are taken into ac-count for purposes of determining ADSPand the deemed sale gain as if they hadbeen taken into account at the beginning ofthe day after the acquisition date. Increasesor decreases with respect to the elements ofADSP that are taken into account after theclose of new target’s first taxable year re-sult in the reallocation of ADSP among tar-get’s assets under §1.338–7T.

(iii) Example. The following exampleillustrates this paragraph (b)(2):

Example. In Year 1, T, a manufacturer, purchasesa customized delivery truck from X with purchasemoney indebtedness having a stated principalamount of $100,000. P acquires all of the stock of Tin Year 3 for $700,000 and makes a section 338 elec-tion for T. Assume T has no liabilities other than itspurchase money indebtedness to X. In Year 4, whenT is neither insolvent nor in a title 11 case, T and Xagree to reduce the amount of the purchase moneyindebtedness to $80,000. Assume further that the re-duction would be a purchase price reduction undersection 108(e)(5). T and X’s agreement to reducethe amount of the purchase money indebtednesswould not, under general principles of tax law thatwould apply if the deemed asset sale had actuallyoccurred, change the amount of liabilities of old tar-get taken into account in determining its amount re-alized. Accordingly, ADSP is not redetermined atthe time of the reduction. See §1.338–5T(b)(2)(iii)Example 1 for the effect on AGUB.

(c) Grossed-up amount realized on thesale to the purchasing corporation of thepurchasing corporation’s recently pur-chased target stock—(1) Determinationof amount. The grossed-up amount real-ized on the sale to the purchasing corpora-tion of the purchasing corporation’s re-cently purchased target stock is anamount equal to—

(i) The amount realized on the sale tothe purchasing corporation of the pur-chasing corporation’s recently purchasedtarget stock determined as if old target

were the selling shareholder and the in-stallment method were not available anddetermined without regard to the sellingcosts taken into account in paragraph(c)(1)(iii) of this section;

(ii) Divided by the percentage of targetstock (by value, determined on the acqui-sition date) attributable to that recentlypurchased target stock;

(iii) Less the selling costs incurred bythe selling shareholders in connectionwith the sale to the purchasing corpora-tion of the purchasing corporation’s re-cently purchased target stock that reducetheir amount realized on the sale of thestock (e.g., brokerage commissions andany similar costs to sell the stock).

(2) Example. The following exampleillustrates this paragraph (c):

Example. T has two classes of stock outstanding,voting common stock and preferred stock not takeninto account for purposes of section 1504(a)(2). OnMarch 1 of Year 1, P purchases 40 percent of theoutstanding T stock from S1 for $500, 20 percent ofthe outstanding T stock from S2 for $225, and 20percent of the outstanding T stock from S3 for $275.On that date, the fair market value of all the T votingcommon stock is $1,250 and the preferred stock$750. S1, S2, and S3 respectively incur $40, $35,and $25 of selling costs. S1 continues to own the re-maining 20 percent of the outstanding T stock. Thegrossed-up amount realized on the sale to P of P’srecently purchased T stock is calculated as follows:The total amount realized (without regard to sellingcosts) is $1,000 (500 + 225 + 275). The percentageof T stock by value on the acquisition date attribut-able to the recently purchased T stock is 50%(1,000/(1,250 + 750)). The selling costs are $100(40 + 35 + 25). The grossed-up amount realized is$1,900 (1,000/.5 å100).

(d) Liabilities of old target—(1) In gen-eral. The liabilities of old target are the li-abilities of target (and the liabilities towhich target’s assets are subject) as of thebeginning of the day after the acquisitiondate (other than liabilities that were neitherliabilities of old target nor liabilities towhich old target’s assets were subject). Inorder to be taken into account in ADSP, aliability must be a liability of target that isproperly taken into account in amount real-ized under general principles of tax lawthat would apply if old target had sold itsassets to an unrelated person for considera-tion that included that person’s assumptionof, or taking subject to, the liability. Thus,ADSP takes into account both tax credit re-capture liability arising because of thedeemed asset sale and the tax liability forthe deemed sale gain unless the tax liabilityis borne by some person other than the tar-get. For example, ADSP would not take

into account the tax liability for thedeemed sale gain when a section338(h)(10) election is made for a target Scorporation because the S corporationshareholders bear that liability. However,if a target S corporation is subject to a taxunder section 1374 or 1375, the liabilityfor tax imposed by those sections is a lia-bility of target taken into account in ADSP(unless the S corporation shareholders ex-pressly assume that liability).

(2) Time and amount of liabilities. Thetime for taking into account liabilities ofold target in determining ADSP and theamount of the liabilities taken into ac-count is determined as if old target hadsold its assets to an unrelated person forconsideration that included the unrelatedperson’s assumption of or taking subjectto the liabilities. For example, if noamount of a target liability is properlytaken into account in amount realized asof the beginning of the day after the ac-quisition date, the liability is not initiallytaken into account in determining ADSP(although it may be taken into account atsome later date). As a further example, anincrease or decrease in a liability that doesnot affect the amount of old target’s basis,deductions, or noncapital nondeductibleitems arising from the incurrence of the li-ability is not taken into account in redeter-mining ADSP.

(3) Interaction with deemed sale gain.Though deemed sale gain increases or de-creases ADSP by creating or reducing atax liability, the amount of the tax liabilityitself is a function of the size of thedeemed sale gain. Thus, the determina-tion of ADSP may require trial and errorcomputations.

(e) Calculation of deemed sale gain.Deemed sale gain on each asset is com-puted by reference to the ADSP allocatedto that asset.

(f) Other rules apply in determiningADSP. ADSP may not be applied in sucha way as to contravene other applicablerules. For example, a capital loss cannotbe applied to reduce ordinary income incalculating the tax liability on the deemedsale for purposes of determining ADSP.

(g) Examples. The following examplesillustrate this section. For purposes of theexamples in this paragraph (g), unless oth-erwise stated, T is a calendar year taxpayerthat files separate returns and that has noloss, tax credit, or other carryovers to Year

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1. Depreciation for Year 1 is not taken intoaccount. T has no liabilities other than theFederal income tax liability resulting fromthe deemed asset sale, and the T sharehold-ers have no selling costs. Assume that T’stax rate for any ordinary income or netcapital gain resulting from the deemed saleof assets is 34 percent and that any capitalloss is offset by capital gain. On July 1 ofYear 1, P purchases all of the stock of Tand makes a section 338 election for T.The examples are as follows:

Example 1. One class. (i) On July 1 of Year 1,T’s only asset is an item of section 1245 propertywith an adjusted basis to T of $50,400, a recomputedbasis of $80,000, and a fair market value of$100,000. P purchases all of the T stock for$75,000, which also equals the amount realized forthe stock determined as if old target were the sellingshareholder.

(ii) ADSP is determined as follows (In the fol-lowing formula, G is the grossed-up amount realizedon the sale to P of P’s recently purchased T stock, Lis T’s liabilities other than T’s tax liability for thedeemed sale gain, TR is the applicable tax rate, andB is the adjusted basis of the asset deemed sold):

ADSP = G + L + TR x (ADSP - B)ADSP = ($75,000/1) + $0 + .34 x (ADSP -$50,400)ADSP = $75,000 + .34ADSP - $17,136.66ADSP = $57,864ADSP = $87,672.72(iii) Because ADSP for T ($87,672.72) does not

exceed the fair market value of T’s asset ($100,000),a Class V asset, T’s entire ADSP is allocated to thatasset. Thus, T has deemed sale gain of $37,272.72(consisting of $29,600 of ordinary income and$7,672.72 of capital gain).

(iv) The facts are the same as in paragraph (i) ofthis Example 1, except that on July 1 of Year 1, Ppurchases only 80 of the 100 shares of T stock for$60,000. The grossed-up amount realized on the

sale to P of P’s recently purchased T stock (G) is$75,000 ($60,000/.8). Consequently, ADSP anddeemed sale gain are the same as in paragraphs (ii)and (iii) of this Example 1.

(v) The facts are the same as in paragraph (i) ofthis Example 1, except that T also has goodwill (aClass VII asset) with an appraised value of $10,000.The results are the same as in paragraphs (ii) and (iii)of this Example 1. Because ADSP does not exceedthe fair market value of the Class V asset, no amountis allocated to the Class VII asset (goodwill).

Example 2. More than one class.(i) P purchasesall of the T stock for $140,000, which also equals theamount realized for the stock determined as if oldtarget were the selling shareholder. On July 1 ofYear 1, T has liabilities (not including the tax liabil-ity for the deemed sale gain) of $50,000, cash (aClass I asset) of $10,000, actively traded securities(a Class II asset) with a basis of $4,000 and a fairmarket value of $10,000, goodwill (a Class VIIasset) with a basis of $3,000, and the followingClass V assets:

January 24, 2000 346 2000–4 I.R.B.

Asset Basis FMV Ratio of

asset fmv

to total

Class V

fmv

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$ 5,000 $ 35,000 .14

Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10,000 50,000 .20

Equipment A (Recomputed basis $80,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5,000 90,000 .36

Equipment B (Recomputed basis $20,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10,000 75,000 .30

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$ 30,000 $ 250,000 1.00

(ii) ADSP exceeds $20,000. Thus, $10,000 ofADSP is allocated to the cash and $10,000 to the ac-tively traded securities. The amount allocated to anasset (other than a Class VII asset) cannot exceed itsfair market value (however, the fair market value ofany property subject to nonrecourse indebtedness istreated as being not less than the amount of such in-debtedness; see §1.338–6T(a)(2)). See§1.338–6T(c)(1) (relating to fair market value limi-tation).

(iii) The portion of ADSP allocable to the Class Vassets is preliminarily determined as follows (in theformula, the amount allocated to the Class I assets isreferred to as I and the amount allocated to the Class

II assets as II):ADSPV = (G - (I + II)) + L + TR ( [(II - BII) +(ADSPV - BV)]ADSPV = ($140,000 - ($10,000 + $10,000)) +$50,000 + .34 ( [($10,000 - $4,000) + (ADSPV -($5,000 + $10,000 + $5,000 + $10,000))]ADSPV = $161,840 + .34 ADSPV.66 ADSPV = $161,840ADSPV = $245,212.12(iv) Because, under the preliminary calculations of

ADSP, the amount to be allocated to the Class I, II, III,IV, V, and VI assets does not exceed their aggregatefair market value, no ADSP amount is allocated togoodwill. Accordingly, the deemed sale of the good-

will results in a capital loss of $3,000. The portion ofADSP allocable to the Class V assets is finally deter-mined by taking into account this loss as follows:

ADSPV = (G å (I + II)) + L + TR ( [(II å BII) +(ADSPV å BV) + (ADSPVII å BVII )]ADSPV = ($140,000 å ($10,000 + $10,000)) +$50,000 + .34 ( [($10,000 å $4,000) + (ADSPV å$30,000) + ($0 å $3,000)]ADSPV = $160,820 + .34 ADSPV.66 ADSPV = $160,820ADSPV = $243,666.67(v) The allocation of ADSPV among the Class V

assets is in proportion to their fair market values, asfollows:

Asset ADSP Gain

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$ 34,113.33 $ 29,113.33

(capital gain)

Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48,733.34 38,733.34

(capital gain)

Equipment A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .87,720.00 82,720.00

(75,000 ordinary income

7,720 capital gain)

Equipment B . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .73,100.00 63,100.00

(10,000 ordinary income

53,100 capital gain)

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$ 243,666.67 $ 213,666.67

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Example 3. More than one class.(i) The factsare the same as in Example 2, except that P pur-chases the T stock for $150,000, rather than$140,000. The amount realized for the stock deter-mined as if old target were the selling shareholder isalso $150,000.

(ii) As in Example 2, ADSP exceeds $20,000.Thus, $10,000 of ADSP is allocated to the cash and$10,000 to the actively traded securities.

(iii) The portion of ADSP allocable to the Class Vassets as preliminarily determined under the formulaset forth in paragraph (ii i) of Example 2is$260,363.64. The amount allocated to the Class Vassets cannot exceed their aggregate fair marketvalue ($250,000). Thus, preliminarily, the ADSPamount allocated to Class V assets is $250,000.

(iv) Based on the preliminary allocation, theADSP is determined as follows (in the formula, theamount allocated to the Class I assets is referred toas I, the amount allocated to the Class II assets as II,and the amount allocated to the Class V assets as V):

ADSP = G + L + TR ( [(II - BII) + (V - BV) +(ADSP - (I + II + V+ BVII ))]ADSP = $150,000 + $50,000 + .34 ( [($10,000 -$4,000) + ($250,000 - $30,000) + (ADSP -($10,000 + $10,000 + $250,000 + $3,000))]ADSP = $200,000 + .34ADSP - $15,980.66ADSP = $184,020ADSP = $278,818.18(v) Because ADSP as determined exceeds the ag-

gregate fair market value of the Class I, II, III, IV, V,and VI assets, the $250,000 amount preliminarily al-located to the Class V assets is appropriate. Thus,the amount of ADSP allocated to Class V assetsequals their aggregate fair market value ($250,000),and the allocated ADSP amount for each Class Vasset is its fair market value. Further, because thereare no Class VI assets, the allocable ADSP amountfor the Class VII asset (goodwill) is $8,818.18 (theexcess of ADSP over the aggregate ADSP amountsfor the Class I, II, III, IV, V and VI assets).

Example 4. Amount allocated to T1 stock. (i)The facts are the same as in Example 2,except that Towns all of the T1 stock (instead of the building),and T1’s only asset is the building. The T1 stockand the building each have a fair market value of$50,000, and the building has a basis of $10,000. Asection 338 election is made for T1 (as well as T),and T1 has no liabilities other than the tax liabilityfor the deemed sale gain. T is the common parent ofa consolidated group filing a final consolidated re-turn described in §1.338–10T(a)(1).

(ii) ADSP exceeds $20,000. Thus, $10,000 ofADSP is allocated to the cash and $10,000 to the ac-tively traded securities.

(iii) Because T does not recognize any gain onthe deemed sale of the T1 stock under paragraph(h)(2) of this section, appropriate adjustments mustbe made to reflect accurately the fair market valueof the T and T1 assets in determining the allocationof ADSP among T’s Class V assets (including theT1 stock). In preliminarily calculating ADSPV inthis case, the T1 stock can be disregarded and, be-cause T owns all of the T1 stock, the T1 asset canbe treated as a T asset. Under this assumption,ADSPV is $243,666.67. See paragraph (iv) of Ex-ample 2.

(iv) Because the portion of the preliminary ADSPallocable to Class V assets ($243,666.67) does not ex-ceed their fair market value ($250,000), no amount is

allocated to Class VII assets for T. Further, thisamount ($243,666.67) is allocated among T’s Class Vassets in proportion to their fair market values. Seeparagraph (v) of Example 2. Tentatively, $48,733.34of this amount is allocated to the T1 stock.

(v) The amount tentatively allocated to the T1stock, however, reflects the tax incurred on thedeemed sale of the T1 asset equal to $13,169.34 (.34 (($48,733.34 å $10,000)). Thus, the ADSP allocable tothe Class V assets of T, and the ADSP allocable to theT1 stock, as preliminarily calculated, each must be re-duced by $13,169.34. Consequently, these amounts,respectively, are $230,497.33 and $35,564.00. In de-termining ADSP for T1, the grossed-up amount real-ized on the deemed sale to new T of new T’s recentlypurchased T1 stock is $35,564.00.

(vi) The facts are the same as in paragraph (i) ofthis Example 4, except that the T1 building has a$12,500 basis and a $62,500 value, all of the out-standing T1 stock has a $62,500 value, and T owns80 percent of the T1 stock. In preliminarily calculat-ing ADSPV, the T1 stock can be disregarded but, be-cause T owns only 80 percent of the T1 stock, only80 percent of T1 asset basis and value should betaken into account in calculating T’s ADSP. By tak-ing into account 80 percent of these amounts, the re-maining calculations and results are the same as inparagraphs (ii), (iii), (iv), and (v) of thisExample 4,except that the grossed-up amount realized on thesale of the recently purchased T1 stock is$44,455.00 ($35,564.00/0.8).

(h) Deemed sale of target affiliate stock—(1) Scope. This paragraph (h) prescribesrules relating to the treatment of gain or lossrealized on the deemed sale of stock of a tar-get affiliate when a section 338 election (butnot a section 338(h)(10) election) is madefor the target affiliate. For purposes of thisparagraph (h), the definition of domestic cor-poration in §1.338–2T(c)(9) is applied with-out the exclusion therein for DISCs, corpo-rations described in section 1248(e), andcorporations to which an election under sec-tion 936 applies.

(2) In general. Except as otherwiseprovided in this paragraph (h), if a section338 election is made for target, target rec-ognizes no gain or loss on the deemedsale of stock of a target affiliate havingthe same acquisition date and for which asection 338 election is made if—

(i) Target directly owns stock in the tar-get affiliate satisfying the requirements ofsection 1504(a)(2);

(ii) Target and the target affiliate aremembers of a consolidated group filing afinal consolidated return described in§1.338-10T(a)(1); or

(iii) Target and the target affiliate file acombined return under §1.338–10T(a)(4).

(3) Deemed sale of foreign target affili-ate by a domestic target.A domestic tar-get recognizes gain or loss on the deemed

sale of stock of a foreign target affiliate.For the proper treatment of such gain orloss, see, e.g., sections 1246, 1248, 1291et seq., and 338(h)(16) and §1.338–9.

(4) Deemed sale producing effectivelyconnected income.A foreign target rec-ognizes gain or loss on the deemed sale ofstock of a foreign target affiliate to the ex-tent that such gain or loss is effectivelyconnected (or treated as effectively con-nected) with the conduct of a trade orbusiness in the United States.

(5) Deemed sale of insurance companytarget affiliate electing under section953(d). A domestic target recognizes gain(but not loss) on the deemed sale of stockof a target affiliate that has in effect an elec-tion under section 953(d) in an amountequal to the lesser of the gain realized or theearnings and profits described in section953(d)(4)(B).

(6) Deemed sale of DISC target affiliate.A foreign or domestic target recognizesgain (but not loss) on the deemed sale ofstock of a target affiliate that is a DISC or aformer DISC (as defined in section 992(a))in an amount equal to the lesser of the gainrealized or the amount of accumulatedDISC income determined with respect tosuch stock under section 995(c). Such gainis included in gross income as a dividend asprovided in sections 995(c)(2) and 996(g).

(7) Anti-stuffing rule. If an asset the ad-justed basis of which exceeds its fair mar-ket value is contributed or transferred to atarget affiliate as transferred basis property(within the meaning of section7701(a)(43)) and a purpose of such transac-tion is to reduce the gain (or increase theloss) recognized on the deemed sale of suchtarget affiliate’s stock, the gain or loss rec-ognized by target on the deemed sale ofstock of the target affiliate is determined asif such asset had not been contributed ortransferred.

(8) Examples. The following examplesillustrate this paragraph (h):

Example 1. (i) P makes a qualified stock purchaseof T and makes a section 338 election for T. T’s soleasset, all of the T1 stock, has a basis of $50 and a fairmarket value of $150. T’s deemed purchase of the T1stock results in a qualified stock purchase of T1 and asection 338 election is made for T1. T1’s assets have abasis of $50 and a fair market value of $150.

(ii) T realizes $100 of gain on the deemed sale ofthe T1 stock, but the gain is not recognized becauseT directly owns stock in T1 satisfying the require-ments of section 1504(a)(2) and a section 338 elec-tion is made for T1.

(iii) T1 recognizes gain of $100 on the deemedsale of its assets.

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Example 2.The facts are the same as in Example1, except that P does not make a section 338 electionfor T1. Because a section 338 election is not madefor T1, the $100 gain realized by T on the deemedsale of the T1 stock is recognized.

Example 3. (i) P makes a qualified stock pur-chase of T and makes a section 338 election for T. Towns all of the stock of T1 and T2. T’s deemed pur-chase of the T1 and T2 stock results in a qualifiedstock purchase of T1 and T2 and section 338 elec-tions are made for T1 and T2. T1 and T2 each own50 percent of the vote and value of T3 stock. Thedeemed purchases by T1 and T2 of the T3 stock re-sult in a qualified stock purchase of T3 and a section338 election is made for T3. T is the common parentof a consolidated group and all of the deemed assetsales are reported on the T group’s final consolidatedreturn. See §1.338–10T(a)(1).

(ii) Because T, T1, T2 and T3 are members of aconsolidated group filing a final consolidated return,no gain or loss is recognized by T, T1 or T2 on theirrespective deemed sales of target affiliate stock.

Example 4.(i) T’s sole asset, all of the FT1 stock,has a basis of $25 and a fair market value of $150.FT1’s sole asset, all of the FT2 stock, has a basis of$75 and a fair market value of $150. FT1 and FT2each have $50 of accumulated earnings and profits forpurposes of section 1248(c) and (d). FT2’s assetshave a basis of $125 and a fair market value of $150,and their sale would not generate subpart F incomeunder section 951. The sale of the FT2 stock or assetswould not generate income effectively connectedwith the conduct of a trade or business within theUnited States. FT1 does not have an election in effectunder section 953(d) and neither FT1 nor FT2 is apassive foreign investment company.

(ii) P makes a qualified stock purchase of T andmakes a section 338 election for T. T’s deemed pur-chase of the FT1 stock results in a qualified stockpurchase of FT1 and a section 338 election is madefor FT1. Similarly, FT1’s deemed purchase of theFT2 stock results in a qualified stock purchase ofFT2 and a section 338 election is made for FT2.

(iii) T recognizes $125 of gain on the deemedsale of the FT1 stock under paragraph (h)(3) of thissection. FT1 does not recognize $75 of gain on thedeemed sale of the FT2 stock under paragraph (h)(2)of this section. FT2 recognizes $25 of gain on thedeemed sale of its assets. The $125 gain T recog-nizes on the deemed sale of the FT1 stock is in-cluded in T’s income as a dividend under section1248, because FT1 and FT2 have sufficient earningsand profits for full recharacterization ($50 of accu-mulated earnings and profits in FT1, $50 of accumu-lated earnings and profits in FT2, and $25 of deemedsale earnings and profits in FT2). §1.338–9(b). Forpurposes of sections 901 through 908, the sourceand foreign tax credit limitation basket of $25 of therecharacterized gain on the deemed sale of the FT1stock is determined under section 338(h)(16).

§1.338–5T Adjusted grossed-up basis(temporary).

(a) Scope. This section provides rulesunder section 338(b) to determine the ad-justed grossed-up basis (AGUB) for tar-get. AGUB is the amount for which newtarget is deemed to have purchased all ofits assets in the deemed purchase under

section 338(a)(2). AGUB is allocatedamong target’s assets in accordance with§1.338–6T to determine the price atwhich the assets are deemed to have beenpurchased. When an increase or decreasewith respect to an element of AGUB is re-quired, under general principles of taxlaw, after the close of new target’s firsttaxable year, redetermined AGUB is allo-cated among target’s assets in accordancewith §1.338–7T.

(b) Determination of AGUB—(1) Gen-eral rule. AGUB is the sum of—

(i) The grossed-up basis in the purchas-ing corporation’s recently purchased tar-get stock;

(ii) The purchasing corporation’s basisin nonrecently purchased target stock; and

(iii) The liabilities of new target.(2) Time and amount of AGUB—(i)

Original determination. AGUB is ini-tially determined at the beginning of theday after the acquisition date of target.General principles of tax law apply in de-termining the timing and amount of theelements of AGUB.

(ii) Redetermination of AGUB. AGUBis redetermined at such time and in suchamount as an increase or decrease would berequired, under general principles of taxlaw, with respect to an element of AGUB.For example, AGUB is redetermined be-cause of an increase or decrease in theamount paid or incurred for recently pur-chased stock or nonrecently purchasedstock or because liabilities not originallytaken into account in determining AGUBare subsequently taken into account. An in-crease or decrease to an element of ADSPmay cause an increase or decrease to an el-ement of AGUB. For example, if an in-crease in the amount realized for recentlypurchased stock of target is taken into ac-count after the acquisition date, any in-crease in tax liability of target for thedeemed sale gain is also taken into accountwhen AGUB is redetermined. An increaseor decrease to one element of AGUB mayalso cause an increase or decrease to an-other element of AGUB. For example, ifthere is an increase in the amount paid orincurred for recently purchased stock afterthe acquisition date, any increase in thebasis of nonrecently purchased stock be-cause a gain recognition election was madeis also taken into account when AGUB isredetermined. Increases or decreases withrespect to the elements of AGUB that are

taken into account before the close of newtarget’s first taxable year are taken into ac-count for purposes of determining AGUBand the basis of target’s assets as if they hadbeen taken into account at the beginning ofthe day after the acquisition date. Increasesor decreases with respect to the elements ofAGUB that are taken into account after theclose of new target’s first taxable year re-sult in the reallocation of AGUB amongtarget’s assets under §1.338–7T.

(iii) Examples. The following exam-ples illustrate this paragraph (b)(2):

Example 1. In Year 1, T, a manufacturer, pur-chases a customized delivery truck from X with pur-chase money indebtedness having a stated principalamount of $100,000 . P acquires all of the stock of Tin Year 3 for $700,000 and makes a section 338 elec-tion for T. Assume T has no liabilities other than itspurchase money indebtedness to X. In Year 4, whenT is neither insolvent nor in a title 11 case, T and Xagree to reduce the amount of the purchase moneyindebtedness to $80,000. Assume that the reductionwould be a purchase price reduction under section108(e)(5). T and X’s agreement to reduce theamount of the purchase money indebtedness would,under general principles of tax law that would applyif the deemed asset sale had actually occurred,change the amount of liabilities of old target takeninto account in determining its basis. Accordingly,AGUB is redetermined at the time of the reduction.See paragraph (e)(2) of this section. Thus the pur-chase price reduction affects the basis of the truckonly indirectly, through the mechanism of§§1.338–6T and 1.338–7T. See§1.338–4T(b)(2)(iii) Examplefor the effect onADSP.

Example 2. T, an accrual basis taxpayer, is achemical manufacturer. In Year 1, T is obligated toremediate environmental contamination at the site ofone of its plants. Assume that all the events have oc-curred that establish the fact of the liability and theamount of the liability can be determined with rea-sonable accuracy but economic performance has notoccurred with respect to the liability within themeaning of section 461(h). P acquires all of thestock of T in Year 1 and makes a section 338 elec-tion for T. Assume that, if a corporation unrelated toT had actually purchased T’s assets and assumed T’sobligation to remediate the contamination, the cor-poration would not satisfy the economic perfor-mance requirements until Year 5. Under section461(h), the assumed liability would not be treated asincurred and taken into account in basis until thattime. The incurrence of the liability in Year 5 underthe economic performance rules is an increase in theamount of liabilities properly taken into account inbasis and results in the redetermination of AGUB.(Respecting ADSP, compare §1.461–4(d)(5), whichprovides that economic performance occurs for oldT as the amount of the liability is properly taken intoaccount in amount realized on the deemed asset sale.Thus ADSP is not redetermined when new T satis-fies the economic performance requirements.)

(c) Grossed-up basis of recently pur-chased stock.The purchasing corpora-tion’s grossed-up basis of recently pur-

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chased target stock (as defined in section338(b)(6)(A)) is an amount equal to—

(1) The purchasing corporation’s basisin recently purchased target stock at thebeginning of the day after the acquisitiondate determined without regard to the ac-quisition costs taken into account in para-graph (c)(3) of this section;

(2) Multiplied by a fraction, the numer-ator of which is 100 percent minus thepercentage of target stock (by value, de-termined on the acquisition date) attribut-able to the purchasing corporation’s non-recently purchased target stock, and thedenominator of which is the percentage oftarget stock (by value, determined on theacquisition date) attributable to the pur-chasing corporation’s recently purchasedtarget stock;

(3) Plus the acquisition costs the pur-chasing corporation incurred in connec-tion with its purchase of the recently pur-chased stock that are capitalized in thebasis of such stock (e.g., brokerage com-missions and any similar costs incurredby the purchasing corporation to acquirethe stock).

(d) Basis of nonrecently purchasedstock; gain recognition election—(1) Nogain recognition election. In the absenceof a gain recognition election under sec-tion 338(b)(3) and this section, the pur-chasing corporation retains its basis in thenonrecently purchased stock.

(2) Procedure for making gain recogni-tion election. A gain recognition electionmay be made for nonrecently purchasedstock of target (or a target affiliate) only ifa section 338 election is made for target(or the target affiliate). The gain recogni-tion election is made by attaching a gainrecognition statement to a timely filedForm 8023 for target. The gain recogni-tion statement must contain the informa-tion specified in the form and its instruc-tions. The gain recognition election isirrevocable. If a section 338(h)(10) elec-tion is made for target, see§1.338(h)(10)–1T(d)(1) (providing thatthe purchasing corporation is automati-cally deemed to have made a gain recog-nition election for its nonrecently pur-chased T stock).

(3) Effect of gain recognitionelection—(i) In general. If the purchas-ing corporation makes a gain recognitionelection, then for all purposes of the Inter-nal Revenue Code—

(A) The purchasing corporation istreated as if it sold on the acquisition datethe nonrecently purchased target stock forthe basis amount determined under para-graph (d)(3)(ii) of this section; and

(B) The purchasing corporation’s basison the acquisition date in nonrecently pur-chased target stock immediately follow-ing the deemed sale in paragraph(d)(3)(i)(A) of this section is the basisamount.

(ii) Basis amount. The basis amount isequal to the amount in paragraph (c)(1) ofthis section (the purchasing corporation’sbasis in recently purchased target stock atthe beginning of the day after the acquisi-tion date determined without regard to theacquisition costs taken into account inparagraph (c)(3) of this section) multi-plied by a fraction the numerator of whichis the percentage of target stock (by value,determined on the acquisition date) attrib-utable to the purchasing corporation’snonrecently purchased target stock andthe denominator of which is 100 percentminus the numerator amount. Thus, iftarget has a single class of outstandingstock, the purchasing corporation’s basisin each share of nonrecently purchasedtarget stock after the gain recognitionelection is equal to the average price pershare of the purchasing corporation’s re-cently purchased target stock.

(iii) Losses not recognized.Only gains(unreduced by losses) on the nonrecentlypurchased target stock are recognized.

(iv) Stock subject to election. The gainrecognition election applies to—

(A) All nonrecently purchased targetstock; and

(B) Any nonrecently purchased stock ina target affiliate having the same acquisi-tion date as target if such target affiliatestock is held by the purchasing corpora-tion on such date.

(e) Liabilities of new target—(1) Ingeneral. The liabilities of new target arethe liabilities of target (and the liabilitiesto which target’s assets are subject) as ofthe beginning of the day after the acquisi-tion date (other than liabilities that wereneither liabilities of old target nor liabili-ties to which old target’s assets were sub-ject). In order to be taken into account inAGUB, a liability must be a liability oftarget that is properly taken into accountin basis under general principles of taxlaw that would apply if new target had ac-

quired its assets from an unrelated personfor consideration that included the as-sumption of, or taking subject to, the lia-bility. See §1.338–4T(d)(1) for examplesof when tax liabilities are considered lia-bilities assumed by new target.

(2) Time and amount of liabilities. Thetime for taking into account liabilities ofold target in determining AGUB and theamount of the liabilities taken into ac-count is determined as if new target hadacquired its assets from an unrelated per-son for consideration that included the as-sumption of, or taking subject to, the lia-bilities. For example, an increase ordecrease in a liability that does not affectthe amount of new target’s basis arisingfrom the assumption of, or taking subjectto, the liability is not taken into account inredetermining AGUB.

(3) Interaction with deemed sale gain.See §1.338–4T(d)(3).

(f) Adjustments by the Internal RevenueService. In connection with the examina-tion of a return, the District Director mayincrease (or decrease) AGUB under theauthority of section 338(b)(2) and allocatesuch amounts to target’s assets under theauthority of section 338(b)(5) so thatAGUB and the basis of target’s assetsproperly reflect the cost to the purchasingcorporation of its interest in target’s as-sets. Such items may include distribu-tions from target to the purchasing corpo-ration, capital contributions from thepurchasing corporation to target duringthe 12-month acquisition period, or acqui-sitions of target stock by the purchasingcorporation after the acquisition date fromminority shareholders.

(g) Examples. The following examplesillustrate this section. For purposes of theexamples in this paragraph (g), T has noliabilities other than the tax liability forthe deemed sale gain, T shareholdersincur no costs in selling the T stock, and Pincurs no costs in acquiring the T stock.The examples are as follows:

Example 1. (i) Before July 1 of Year 1, P pur-chases 10 of the 100 shares of T stock for $5,000.On July 1 of Year 2, P purchases 80 shares of T stockfor $60,000 and makes a section 338 election for T.As of July 1 of Year 2, T’s only asset is raw land withan adjusted basis to T of $50,400 and a fair marketvalue of $100,000. T has no loss or tax credit carry-overs to Year 2. T’s marginal tax rate for any ordi-nary income or net capital gain resulting from thedeemed asset sale is 34 percent. The 10 shares pur-chased before July 1 of Year 1 constitute nonrecentlypurchased T stock with respect to P’s qualified stock

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purchase of T stock on July 1 of Year 2.(ii) The ADSP formula as applied to these facts is

the same as in §1.338–4T(g) Example 1. Accord-ingly, the ADSP for T is $87,672.72. The existenceof nonrecently purchased T stock is irrelevant forpurposes of the ADSP formula, because that formulatreats P’s nonrecently purchased T stock in the samemanner as T stock not held by P.

(iii) The total tax liability resulting from T’sdeemed asset sale, as calculated under the ADSPformula, is $12,672.72.

(iv) If P does not make a gain recognition elec-tion, the AGUB of new T’s assets is $85,172.72, de-termined as follows (In the following formulabelow, GRP is the grossed-up basis in P’s recentlypurchased T stock, BNP is P’s basis in nonrecentlypurchased T stock, L is T’s liabilities, and X is P’sacquisition costs for the recently purchased T stock):

AGUB = GRP + BNP + L + XAGUB = $60,000 ( [(1 - .1)/.8] + $5,000 +$12,672.72 + 0AGUB = $85,172.72(v) If P makes a gain recognition election, the

AGUB of new T’s assets is $87,672.72, determinedas follows:

AGUB = $60,000 ( [(1 - .1)/.8] + $60,000 ( [(1 -.1)/.8] ( [.1/(1 - .1)] + $12,672.72AGUB = $87,672.72(vi) The calculation of AGUB if P makes a gain

recognition election may be simplified as follows:AGUB = $60,000/.8 + $12,672.72AGUB = $87,672.72(vii) As a result of the gain recognition election,

P’s basis in its nonrecently purchased T stock is in-creased from $5,000 to $7,500 (i.e., $60,000 ( [(1 å.1)/.8] ( [.1/(1 å .1)]). Thus, P recognizes a gain inYear 2 with respect to its nonrecently purchased Tstock of $2,500 (i.e., $7,500 å $5,000).

Example 2. On January 1 of Year 1, P purchasesone-third of the T stock. On March 1 of Year 1, Tdistributes a dividend to all of its shareholders. OnApril 15 of Year 1, P purchases the remaining Tstock and makes a section 338 election for T. In ap-propriate circumstances, the District Director maydecrease the AGUB of T to take into account thepayment of the dividend and properly reflect the fairmarket value of T’s assets deemed purchased.

Example 3.(i) T’s sole asset is a building worth$100,000. At this time, T has 100 shares of stockoutstanding. On August 1 of Year 1, P purchases 10of the 100 shares of T stock for $8,000. On June 1of Year 2, P purchases 50 shares of T stock for$50,000. On June 15 of Year 2, P contributes a tractof land to the capital of T and receives 10 additionalshares of T stock as a result of the contribution.Both the basis and fair market value of the land atthat time are $10,800. On June 30 of Year 2, P pur-chases the remaining 40 shares of T stock for$40,000 and makes a section 338 election for T. TheAGUB of T is $108,800.

(ii) To prevent the shifting of basis from the con-tributed property to other assets of T, the District Di-rector may allocate $10,800 of the AGUB to theland, leaving $98,000 to be allocated to the building.See paragraph (f) of this section. Otherwise, apply-ing the allocation rules of §1.338–6T would, onthese facts, result in an allocation to the recentlycontributed land of an amount less than its value of$10,800, with the difference being allocated to thebuilding already held by T.

Par. 7. Sections 1.338–6T and1.338–7T are added to read as follows:§1.338–6T Allocation of ADSP andAGUB among target assets(temporary).

(a) Scope—(1) In general. This sectionprescribes rules for allocating ADSP andAGUB among the acquisition date assetsof a target for which a section 338 elec-tion is made.

(2) Fair market value—(i) In general.Generally, the fair market value of an asset isits gross fair market value (i.e., fair marketvalue determined without regard to mort-gages, liens, pledges, or other liabilities).However, for purposes of determining theamount of old target’s deemed sale gain, thefair market value of any property subject to anonrecourse indebtedness will be treated asbeing not less than the amount of such in-debtedness. (For purposes of the precedingsentence, a liability that was incurred be-cause of the acquisition of the property isdisregarded to the extent that such liabilitywas not taken into account in determiningold target’s basis in such property.)

(ii) Transaction costs.Transactioncosts are not taken into account in allocat-ing ADSP or AGUB to assets in thedeemed sale (except indirectly throughtheir effect on the total ADSP or AGUB tobe allocated).

(iii) Internal Revenue Service author-ity. In connection with the examination ofa return, the Internal Revenue Servicemay challenge the taxpayer’s determina-tion of the fair market value of any assetby any appropriate method and take intoaccount all factors, including any lack ofadverse tax interests between the parties.For example, in certain cases the InternalRevenue Service may make an indepen-dent showing of the value of goodwill andgoing concern value as a means of callinginto question the validity of the taxpayer’svaluation of other assets.

(b) General rule for allocating ADSPand AGUB—(1) Reduction in the amountof consideration for Class I assets. BothADSP and AGUB, in the respective allo-cation of each, are first reduced by theamount of Class I acquisition date assets.Class I assets are cash and general depositaccounts (including savings and checkingaccounts) other than certificates of de-posit held in banks, savings and loan as-sociations, and other depository institu-tions. If the amount of Class I assetsexceeds AGUB, new target will immedi-

ately realize ordinary income in anamount equal to such excess. The amountof ADSP or AGUB remaining after the re-duction is to be allocated to the remainingacquisition date assets.

(2) Other assets—(i) In general. Sub-ject to the limitations and other rules ofparagraph (c) of this section, ADSP andAGUB (as reduced by the amount ofClass I assets) are allocated among ClassII acquisition date assets of target in pro-portion to the fair market values of suchClass II assets at such time, then amongClass III assets so held in such proportion,then among Class IV assets so held insuch proportion, then among Class V as-sets so held in such proportion, thenamong Class VI assets so held in suchproportion, and finally to Class VII assets.

(ii) Class II assets.Class II assets are ac-tively traded personal property within themeaning of section 1092(d)(1) and§1.1092(d)–1 (determined without regardto section 1092(d)(3)). In addition, Class IIassets include certificates of deposit andforeign currency even if they are not ac-tively traded personal property. Examplesof Class II assets include U.S. governmentsecurities and publicly traded stock.

(iii) Class III assets. Class III assets areaccounts receivable, mortgages, and creditcard receivables from customers whicharise in the ordinary course of business.

(iv) Class IV assets. Class IV assets arestock in trade of the taxpayer or otherproperty of a kind which would properlybe included in the inventory of taxpayer ifon hand at the close of the taxable year, orproperty held by the taxpayer primarilyfor sale to customers in the ordinarycourse of its trade or business.

(v) Class V assets. Class V assets areall assets other than Class I, II, III, IV, VI,and VII assets.

(vi) Class VI assets. Class VI assetsare all section 197 intangibles, as definedin section 197, except goodwill and goingconcern value.

(vii) Class VII assets. Class VII assetsare goodwill and going concern value(whether or not the goodwill or goingconcern value qualifies as a section 197intangible).

(3) Other items designated by the Inter-nal Revenue Service.Similar items may beadded to any class described in this para-graph (b) by designation in the Internal Rev-enue Bulletin by the Internal Revenue Ser-

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vice (see §601.601(d)(2) of this Chapter).(c) Certain limitations and other rules

for allocation to an asset—(1) Allocationnot to exceed fair market value. Theamount of ADSP or AGUB allocated toan asset (other than Class VII assets) can-not exceed the fair market value of thatasset at the beginning of the day after theacquisition date.

(2) Allocation subject to other rules.Theamount of ADSP or AGUB allocated to anasset is subject to other provisions of the In-ternal Revenue Code or general principlesof tax law in the same manner as if suchasset were transferred to or acquired froman unrelated person in a sale or exchange.For example, if the deemed asset sale is atransaction described in section 1056(a)(relating to basis limitation for player con-tracts transferred in connection with thesale of a franchise), the amount of AGUBallocated to a contract for the services of anathlete cannot exceed the limitation im-posed by that section. As another example,the amount of AGUB allocated to an amor-tizable section 197 intangible resultingfrom an assumption-reinsurance transac-tion is determined under section 197(f)(5).

(3) Special rule for allocating AGUBwhen purchasing corporation has nonre-cently purchased stock—(i) Scope. Thisparagraph (c)(3) applies if at the beginning

of the day after the acquisition date—(A) The purchasing corporation holds

nonrecently purchased stock for which again recognition election under section338(b)(3) and §1.338–5T(d) is not made;and

(B) The hypothetical purchase price de-termined under paragraph (c)(3)(ii) of thissection exceeds the AGUB determinedunder §1.338–5T(b).

(ii) Determination of hypothetical pur-chase price. Hypothetical purchase priceis the AGUB that would result if a gainrecognition election were made.

(iii) Allocation of AGUB. Subject tothe limitations in paragraphs (c)(1) and(2) of this section, the portion of AGUB(after reduction by the amount of Class Iassets) to be allocated to each Class II, III,IV, V, VI, and VII asset of target held atthe beginning of the day after the acquisi-tion date is determined by multiplying—

(A) The amount that would be allo-cated to such asset under the general rulesof this section were AGUB equal to thehypothetical purchase price; by

(B) A fraction, the numerator of whichis actual AGUB (after reduction by theamount of Class I assets) and the denomi-nator of which is the hypothetical pur-chase price (after reduction by the amountof Class I assets).

(4) Liabilities taken into account in de-termining amount realized on subsequentdisposition. In determining the amountrealized on a subsequent sale or other dis-position of property deemed purchased bynew target, the entire amount of any lia-bility taken into account in AGUB is con-sidered to be an amount taken into ac-count in determining new target’s basis inproperty that secures the liability for pur-poses of applying §1.1001–2(a). Thus, ifa liability is taken into account in AGUB,§1.1001–2(a)(3) does not prevent theamount of such liability from beingtreated as discharged within the meaningof §1.1001–2(a)(4) as a result of new tar-get’s sale or disposition of the propertywhich secures such liability.

(d) Examples. The following examplesillustrate §§1.338–4T, 1.338–5T, and thissection:

Example 1. (i) T owns 90 percent of the outstandingT1 stock. P purchases 100 percent of the outstanding Tstock for $2,000. There are no acquisition costs. Pmakes a section 338 election for T and, as a result, T1 isconsidered acquired in a qualified stock purchase. Asection 338 election is made for T1. The grossed-upbasis of the T stock is $2,000 (i.e., $2,000 ( 1/1).

(ii) The liabilities of T as of the beginning of theday after the acquisition date (including the tax lia-bility for the deemed sale gain) that would, undergeneral principles of tax law, be properly taken intoaccount before the close of new T’s first taxableyear, are as follows:

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Liabilities (nonrecourse mortgage plus unsecured liabilities) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 700

Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,000

(iii) The AGUB of T is determined as follows:

Grossed-up basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

AGUB . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,000

(iv) Assume that ADSP is also $3,000.

(v) Assume that, at the beginning of the day after the acquisition date, T’s cash and the fair market values of T’s Class II, III, IV, and V assets

are as follows:

Asset Asset FairClass market

value

I Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 200*

II Portfolio of actively traded securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

III Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

IV Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

V Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800

V Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

V Investment in T1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,850

*Amount.

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(vi) Under paragraph (b)(1) of this section, theamount of ADSP and AGUB allocable to T’s ClassII, III, IV, and V assets is reduced by the amount ofcash to $2,800, i.e., $3,000 å $200. $300 of ADSPand of AGUB is then allocated to actively traded se-curities. $600 of ADSP and of AGUB is then allo-cated to accounts receivable. $300 of ADSP and ofAGUB is then allocated to the inventory. Since theremaining amount of ADSP and of AGUB is $1,600(i.e., $3,000 å ($200 + $300 + $600 + $300)), anamount which exceeds the sum of the fair marketvalues of T’s Class V assets, the amount of ADSPand of AGUB allocated to each Class V asset is itsfair market value:

Building . . . . . . . . . . . . . . . . . . 800Land . . . . . . . . . . . . . . . . . . . . . 200Investment in T1 . . . . . . . . . . . . 450Total . . . . . . . . . . . . . . . . . . . . . $ 1,450(vii) T has no Class VI assets. The amount of

ADSP and of AGUB allocated to T’s Class VII as-sets (goodwill and going concern value) is $150, i.e.,$1,600 - $1,450.

(viii) The grossed-up basis of the T1 stock is$500, i.e., $450 ( 1/.9.

(ix) The liabilities of T as of the beginning of theday after the acquisition date (including the tax lia-bility for the deemed sale gain) that would, undergeneral principles of tax law, be properly taken intoaccount before the close of new T’s first taxableyear, are as follows:

General Liabilities . . . . . . . . . . . $ 100Taxes Payable . . . . . . . . . . . . . . 20

Total . . . . . . . . . . . . . . . . . . . $ 120(x) The AGUB of T1 is determined as follows:Grossed-up basis of T1 Stock . . $ 500Liabilities . . . . . . . . . . . . . . . . . 120AGUB . . . . . . . . . . . . . . . . . . . . $ 620(xi) Assume that ADSP is also $620.(xii) Assume that at the beginning of the day after

the acquisition date, T1’s cash and the fair market

values of its Class IV and VI assets are as follows:Asset Asset Fair Class Market

Value

I Cash . . . . . . . . . . . . . . $ 50*

IV Inventory . . . . . . . . . . 200

VI Patent . . . . . . . . . . . . . 350

Total . . . . . . . . . . . . $ 600

* Amount.(xiii) The amount of ADSP and of AGUB alloca-

ble to T1’s Class IV and VI assets is first reduced bythe $50 of cash.

(xiv) Because the remaining amount of ADSPand of AGUB ($570) is an amount which exceedsthe fair market value of T1’s only Class IV asset, theinventory, the amount allocated to the inventory isits fair market value ($200). After that, the remain-ing amount of ADSP and of AGUB ($370) exceedsthe fair market value of T1’s only Class VI asset, thepatent. Thus, the amount of ADSP and of AGUB al-located to the patent is its fair market value ($350).

(xv) The amount of ADSP and of AGUB allo-cated to T1’s Class VII assets (goodwill and goingconcern value) is $20, i.e., $570 å $550.

Example 2. (i) Assume that the facts are the sameas in Example 1except that P has, for five years,owned 20 percent of T’s stock, which has a basis inP’s hands at the beginning of the day after the acqui-sition date of $100, and P purchases the remaining80 percent of T’s stock for $1,600. P does not makea gain recognition election under section 338(b)(3).

(ii) Under §1.338–5T(c), the grossed-up basis ofrecently purchased T stock is $1,600, i.e., $1,600 ((1 - .2)/.8.

(iii) The AGUB of T is determined as follows:

Grossed-up basis of recently purchased stock as determined under §1.338–5T(c) ($1,600 x

(1 - .2)/.8) . . . . . . . . . . . . . . . . . . . . . $ 1,600

Basis of nonrecently purchased stock . . . . . . . . . . . . . . . . . . . . . . . . . 100

Liabilities . . . . . . . . . . . . . . . . . . . . . 1,000

AGUB . . . . . . . . . . . . . . . . . . . . . $ 2,700(iv) Since P holds nonrecently purchased stock,

the hypothetical purchase price of the T stock mustbe computed and is determined as follows:

Grossed-up basis of recently purchased stock as determined under §1.338–5T(c) ($1,600 ( (1 - .2)/.8) . . . . . . . . . . . . $ 1,600

Basis of nonrecently purchased stock as if the gain recognition election under §1.338–5T(d)(2) had been made ($1,600 ( .2/(1 å .2)) . . . . . . . . . . . . . . . . . . . 400

Liabilities . . . . . . . . . . . . . . . . . . . . . 1,000

Total . . . . . . . . . . . . . . . . . . . . . . $ 3,000(v) Since the hypothetical purchase price

($3,000) exceeds the AGUB ($2,700) and no gainrecognition election is made under section338(b)(3), AGUB is allocated under paragraph(c)(3) of this section.

(vi) First, an AGUB amount equal to the hypo-thetical purchase price ($3,000) is allocated amongthe assets under the general rules of this section.The allocation is set forth in the column below enti-tled Original Allocation. Next, the allocation toeach asset in Class II through Class VII is multipliedby a fraction having a numerator equal to the actualAGUB reduced by the amount of Class I assets($2,700 å $200 = $2,500) and a denominator equalto the hypothetical purchase price reduced by theamount of Class I assets ($3,000 å $200 = $2,800),or 2,500/2,800. This produces the Final Allocation:

January 24, 2000 352 2000–4 I.R.B.

Class Asset Original FinalAllocation Allocation

I Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 200 $ 200II Portfolio of actively traded securities . . . . . . . . . . . . . . . . . . . . . . 300 268*III Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 536IV Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 268V Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800 714V Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 178V Investment in T1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450 402VII Goodwill and going concern value . . . . . . . . . . . . . . . . . . . . . . . . 150 134

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,000 $ 2,700

* All numbers rounded for convenience.

§1.338–7T Allocation of redeterminedADSP and AGUB among target assets(temporary).

(a) Scope.ADSP and AGUB are rede-termined at such time and in such amountas an increase or decrease would be re-quired under general principles of tax lawfor the elements of ADSP or AGUB. Thissection provides rules for allocating rede-termined ADSP or AGUB when increasesor decreases with respect to the elementsof ADSP or AGUB are required after theclose of new target’s first taxable year.

For determining and allocating ADSP orAGUB when increases or decreases arerequired with respect to the elements ofADSP or AGUB before the close of newtarget’s first taxable year, see §§1.338–4T,1.338–5T, and 1.338–6T.

(b) Allocation of redetermined ADSPand AGUB. When ADSP or AGUB is re-determined, a new allocation of ADSP orAGUB is made by allocating the redeter-mined ADSP or AGUB amount under therules of §1.338–6T. If the allocation ofthe redetermined ADSP or AGUB amount

under §1.338–6T to a given asset is differ-ent from the original allocation to it, thedifference is added to or subtracted fromthe original allocation to the asset, as ap-propriate. Amounts allocable to an acqui-sition date asset (or with respect to a dis-posed-of acquisition date asset) aresubject to all the asset allocation rules (forexample, the fair market value limitationin §1.338–6T(c)(1)) as if the redeter-mined ADSP or AGUB were the ADSP orAGUB on the acquisition date.

(c) Special rules for ADSP—(1) In-

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creases or decreases in deemed sale gaintaxable notwithstanding old target ceasesto exist. To the extent general principlesof tax law would require a seller in an ac-tual asset sale to account for events relat-ing to the sale that occur after the saledate, target must make such an account-ing. Target is not precluded from realiz-ing additional deemed sale gain becausethe target is treated as a new corporationafter the acquisition date.

(2) Procedure for transactions in whichsection 338(h)(10) is not elected— (i)Deemed sale gain included in new target’sreturn. If an election under section338(h)(10) is not made, any additionaldeemed sale gain of old target resultingfrom an increase or decrease in the ADSPis included in new target’s income tax re-turn for new target’s taxable year in whichthe increase or decrease is taken into ac-count. For example, if after the acquisi-tion date there is an increase in the alloca-ble ADSP of section 1245 property forwhich the recomputed basis (but not theadjusted basis) exceeds the portion of theADSP allocable to that particular asset onthe acquisition date, the additional gain istreated as ordinary income to the extent itdoes not exceed such excess amount. Seeparagraph (c)(2)(ii) of this section for thespecial treatment of old target’s carry-overs and carrybacks. Although includedin new target’s income tax return, thedeemed sale gain is separately accountedfor as an item of old target and may not beoffset by income, gain, deduction, loss,credit, or other amount of new target. Theamount of tax on income of old target re-sulting from an increase or decrease in theADSP is determined as if such deemedsale gain had been recognized in old tar-get’s taxable year ending at the close ofthe acquisition date.

(ii) Carryovers and carrybacks—(A)Loss carryovers to new target taxableyears. A net operating loss or net capitalloss of old target may be carried forwardto a taxable year of new target, under theprinciples of section 172 or 1212, as ap-plicable, but is allowed as a deductiononly to the extent of any recognized in-come of old target for such taxable year,as described in paragraph (c)(2)(i) of thissection. For this purpose, however, tax-able years of new target are not taken intoaccount in applying the limitations in sec-tion 172(b)(1) or 1212(a)(1)(B) (or other

similar limitations). In applying sections172(b) and 1212(a)(1), only income, gain,loss, deduction, credit, and other amountsof old target are taken into account. Thus,if old target has an unexpired net operat-ing loss at the close of its taxable year inwhich the deemed asset sale occurred thatcould be carried forward to a subsequenttaxable year, such loss may be carried for-ward until it is absorbed by old target’s in-come.

(B) Loss carrybacks to taxable years ofold target. An ordinary loss or capitalloss accounted for as a separate item ofold target under paragraph (c)(2)(i) of thissection may be carried back to a taxableyear of old target under the principles ofsection 172 or 1212, as applicable. Forthis purpose, taxable years of new targetare not taken into account in applying thelimitations in section 172(b) or 1212(a)(or other similar limitations).

(C) Credit carryovers and carrybacks.The principles described in paragraphs(c)(2)(ii)(A) and (B) of this section applyto carryovers and carrybacks of amountsfor purposes of determining the amount ofa credit allowable under part IV, subchap-ter A, chapter 1 of the Internal RevenueCode. Thus, for example, credit carry-overs of old target may offset only in-come tax attributable to items describedin paragraph (c)(2)(i) of this section.

(3) Procedure for transactions in whichsection 338(h)(10) is elected. If an elec-tion under section 338(h)(10) is made,any additional deemed sale gain resultingfrom an increase or decrease in the ADSPis accounted for in determining the tax-able income (or other amount) of themember of the selling consolidated group,the selling affiliate, or the S corporationshareholders to which such income, loss,or other amount is attributable for the tax-able year in which such increase or de-crease is taken into account.

(d) Special rules for AGUB—(1) Effectof disposition or depreciation of acquisi-tion date assets.If an acquisition dateasset has been disposed of, depreciated,amortized, or depleted by new target be-fore an amount is added to the original al-location to the asset, the increased amountotherwise allocable to such asset is takeninto account under general principles oftax law that apply when part of the cost ofan asset not previously taken into accountin basis is paid or incurred after the asset

has been disposed of, depreciated, amor-tized, or depleted. A similar rule applieswhen an amount is subtracted from theoriginal allocation to the asset. For pur-poses of the preceding sentence, an assetis considered to have been disposed of tothe extent that its allocable portion of thedecrease in AGUB would reduce its basisbelow zero.

(2) Section 38 property. Section1.47–2(c) applies to a reduction in basisof section 38 property under this section.

(e) Examples. The following examplesillustrate this section. Any amount de-scribed in the following examples is ex-clusive of interest. For rules characteriz-ing deferred contingent payments asprincipal or interest, see §§1.483–4,1.1274–2(g), and 1.1275–4(c). The ex-amples are as follows:

Example 1. (i)(A) T’s assets other than goodwilland going concern value, and their fair market val-ues at the beginning of the day after the acquisitiondate, are as follows:Asset Asset Fair Class Market

Value

V Building . . . . . . . . . . . . . $ 100

V Stock of X (not a target) . 200

Total . . . . . . . . . . . . . . $ 300(B) T has no liabilities other than a contingent li-

ability that would not be taken into account undergeneral principles of tax law in an asset sale betweenunrelated parties when the buyer assumed the liabil-ity or took property subject to it.

(ii)(A) On September 1, 2000, P purchases all ofthe outstanding stock of T for $270 and makes a sec-tion 338 election for T. The grossed-up basis of theT stock and T’s AGUB are both $270. The AGUB isratably allocated among T’s Class V assets in pro-portion to their fair market values as follows:Asset Basis

Building ($270 ( 100/300) . . . . . . . . $ 90

Stock ($270 ( 200/300) . . . . . . . . . . . 180

Total . . . . . . . . . . . . . . . . . . . . . . . $270(B) No amount is allocated to the Class VII as-

sets. New T is a calendar year taxpayer. Assumethat the X stock is a capital asset in the hands of newT.

(iii) On January 1, 2001, new T sells the X stockand uses the proceeds to purchase inventory.

(iv) Pursuant to events on June 30, 2002, thecontingent liability of old T is at that time properlytaken into account under general principles of taxlaw. The amount of the liability is $60.

(v) T’s AGUB increases by $60 from $270 to$330. This $60 increase in AGUB is first allocatedamong T’s acquisition date assets in accordance withthe provisions of §1.338–6T. Because the redeter-mined AGUB for T ($330) exceeds the sum of thefair market values at the beginning of the day afterthe acquisition date of the Class V acquisition dateassets ($300), AGUB allocated to those assets is lim-ited to those fair market values under §1.338-

2000–4 I.R.B. 353 January 24, 2000

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6T(c)(1). As there are no Class VI assets, the re-maining AGUB of $30 is allocated to goodwill andgoing concern value (Class VII assets). The amountof increase in AGUB allocated to each acquisitiondate asset is determined as follows:Asset Original Redetermined Increase

AGUB AGUB

Building . . . . $ 90 $ 100 $ 10

X Stock . . . . . 180 200 20

Goodwill and going concern value . . . . . . . 0 30 30

Total . . . . . . $ 270 $ 330 $ 60(vi) Since the X stock was disposed of before the

contingent liability was properly taken into accountfor tax purposes, no amount of the increase inAGUB attributable to such stock may be allocated toany T asset. Rather, such amount ($20) is allowedas a capital loss to T for the taxable year 2002 underthe principles of Arrowsmith v. Commissioner, 344U.S. 6 (1952). In addition, the $10 increase inAGUB allocated to the building and the $30 in-crease in AGUB allocated to the goodwill and goingconcern value are treated as basis redeterminationsin 2002. See paragraph (d)(1) of this section.

Example 2. (i) On January 1, 2002, P purchasesall of the outstanding stock of T and makes a section338 election for T. Assume that ADSP and AGUBof T are both $500 and are allocated among T’s ac-quisition date assets as follows:Asset Asset BasisClass

V Machinery . . . . . . . . . . . . . . $ 150

V Land . . . . . . . . . . . . . . . . . . 250

VII Goodwill and going. . . . . . . concern value . . . . . . . . . . . 100

Total . . . . . . . . . . . . . . . $ 500(ii) On September 30, 2004, P filed a claim

against the selling shareholders of T in a court of ap-propriate jurisdiction alleging fraud in the sale of theT stock.

(iii) On January 1, 2007, the former shareholdersrefund $140 of the purchase price to P in a settle-ment of the lawsuit. Assume that, under generalprinciples of tax law, both the seller and the buyerproperly take into account such refund when paid.Assume also that the refund has no effect on the taxliability for the deemed sale gain. This refund re-sults in a decrease of T’s ADSP and AGUB of $140,from $500 to $360.

(iv) The redetermined ADSP and AGUB of $360is allocated among T’s acquisition date assets. Be-

cause ADSP and AGUB do not exceed the fair mar-ket value of the Class V assets, the ADSP andAGUB amounts are allocated to the Class V assetsin proportion to their fair market values at the begin-ning of the day after the acquisition date. Thus,$135 ($150 ( ($360/($150 + $250))) is allocated tothe machinery and $225 ($250 ( ($360/($150 +$250))) is allocated to the land. Accordingly, thebasis of the machinery is reduced by $15 ($150 orig-inal allocation å $135 redetermined allocation) andthe basis of the land is reduced by $25 ($250 origi-nal allocation å $225 redetermined allocation). Noamount is allocated to the Class VII assets. Accord-ingly, the basis of the goodwill and going concernvalue is reduced by $100 ($100 original allocation å$0 redetermined allocation).

(v) Assume that, as a result of deductions undersection 168, the adjusted basis of the machinery im-mediately before the decrease in AGUB is zero. Themachinery is treated as if it were disposed of beforethe decrease is taken into account. In 2007, T recog-nizes income of $15, the character of which is deter-mined under the principles of Arrowsmith v. Com-missioner, 344 U.S. 6 (1952), and the tax benefitrule. No adjustment to the basis of T’s assets ismade for any tax paid on this amount. Assume alsothat, as a result of amortization deductions, the ad-justed basis of the goodwill and going concern valueimmediately before the decrease in AGUB is $40. Asimilar adjustment to income is made in 2007 withrespect to the $60 of previously amortized goodwilland going concern value.

(vi) In summary, the basis of T’s acquisition dateassets, as of January 1, 2007, is as follows:Asset Basis

Machinery . . . . . . . . . . . . . . . . . . . . $ 0

Land . . . . . . . . . . . . . . . . . . . . . . . . . 225

Goodwill and goingconcern value . . . . . . . . . . . . . . . . . . 0

Example 3. (i) Assume that the facts are the sameas §1.338–6T(d) Example 2except that the recentlypurchased stock is acquired for $1,600 plus addi-tional payments that are contingent upon T’s futureearnings. Assume that, under general principles oftax law, such later payments are properly taken intoaccount when paid. Thus, T’s AGUB, determined asof the beginning of the day after the acquisition date(after reduction by T’s cash of $200), is $2,500 andis allocated among T’s acquisition date assets under§1.338–6T(c)(3)(iii) as follows:Class Asset Final

Allocation

I Cash . . . . . . . . . . . . . . . $ 200

II Portfolio of actively

traded securities . . . . . . 268*

III Accounts receivable . . 536

IV Inventory . . . . . . . . . . . 268

V Building . . . . . . . . . . . . 714

V Land . . . . . . . . . . . . . . . 178

V Investment in T1 . . . . . 402

VII Goodwill and goingconcern value . . . . . . . . 134

Total . . . . . . . . . . . . . $ 2,700

* All numbers rounded for convenience.(ii) After the close of new target’s first taxable

year, P pays an additional $200 for its recently pur-chased T stock. Assume that the additional consid-eration paid would not increase T’s tax liability forthe deemed sale gain.

(iii) T’s AGUB increases by $200, from $2,700 to$2,900. This $200 increase in AGUB is accountedfor in accordance with the provisions of§1.338–6T(c)(3)(iii).

(iv) The hypothetical purchase price of the Tstock is redetermined as follows:

Grossed-up basis of recently purchased stock as determined under §1.338–5T(c) ($1,800 ( (1 - .2)/.8) . . . . . . . . . . . . . . . . . . $ 1,800Basis of nonrecently purchased stock as if the gain recognition election under §1.338–5T(d)(2) had been made ($1,800 ( .2/(1 å .2)) . . . . . . . . . . . . . . . . . . 450Liabilities . . . . . . . . . . . . . . . . . . . . 1,000Total . . . . . . . . . . . . . . . . . . . . . . . . $ 3,250(v) Since the redetermined hypothetical purchase

price ($3,250) exceeds the redetermined AGUB($2,900) and no gain recognition election was madeunder section 338(b)(3), the rules of§1.338–6T(c)(3)(iii) are reapplied using the redeter-mined hypothetical purchase price and the redeter-mined AGUB.

(vi) First, an AGUB amount equal to the redeter-mined hypothetical purchase price ($3,250) is allo-cated among the assets under the general rules of§1.338–6T. The allocation is set forth in the columnbelow entitled Hypothetical Allocation. Next, theallocation to each asset in Class II through Class VIIis multiplied by a fraction with a numerator equal tothe actual redetermined AGUB reduced by theamount of Class I assets ($2,900 å $200 = $2,700)and a denominator equal to the redetermined hypo-thetical purchase price reduced by the amount ofClass I assets ($3,250 å $200 = $3,050), or2,700/3,050. This produces the Final Allocation:

January 24, 2000 354 2000–4 I.R.B.

Class Asset Hypothetical FinalAllocation Allocation

I Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 200 $ 200II Portfolio of actively traded securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 266*III Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 531IV Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 266V Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800 708V Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 177V Investment in T1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450 398VII Goodwill and going concern value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400 354

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,250 $ 2900

* All numbers rounded for convenience.

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(vii) As illustrated by this example, reapplying§1.338–6T(c)(3) results in a basis increase for

some assets and a basis decrease for other assets.The amount of redetermined AGUB allocated to

each acquisition date asset is determined as fol-lows:

2000–4 I.R.B. 355 January 24, 2000

Asset Original Redetermined Increase (c)(3) (c)(3) (decrease)

allocation allocationPortfolio of actively traded securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 268 $ 266 $ (2)Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 536 531 (5)Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268 266 (2)Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 714 708 (6)Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178 177 (1)Investment in T1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 402 398 (4)Goodwill and going concern value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134 354 220

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,500 $ 2,700 $ 200

Example 4. (i) On January 1, 2001, P purchasesall of the outstanding T stock and makes a section338 election for T. P pays $700 of cash andpromises also to pay a maximum $300 of contingentconsideration at various times in the future. Assumethat, under general principles of tax law, such laterpayments are properly taken into account by P whenpaid. Assume also, however, that the current fairmarket value of the contingent payments is reason-ably ascertainable. The fair market value of T’s as-sets (other than goodwill and going concern value)as of the beginning of the following day is as fol-lows:Asset Assets FairClass market

value

V Equipment . . . . . . . . . . . . . $ 200

V Non-actively tradedsecurities . . . . . . . . . . . . . . 100

V Building. . . . . . . . . . . . . . . 500

Total . . . . . . . . . . . . . . . 800(ii) T has no liabilities. The AGUB is $700. In

calculating ADSP, assume that, under §1.1001–1,the current amount realized attributable to the con-tingent consideration is $200. ADSP is therefore$900 ($700 cash plus $200).

(iii) (A) The AGUB of $700 is ratably allocatedamong T’s Class V acquisition date assets in propor-tion to their fair market values as follows:Asset Basis

Equipment ($700 ( 200/800) . . . . . . . $175.00

Non-actively traded securities ($700 ( 100/800) . . . . . . . . . . . . . . . . . 87.50

Building ($700 ( 500/800) . . . . . . . . . 437.50

Total . . . . . . . . . . . . . . . . . . . . . . . . $700.00(B) No amount is allocated to goodwill or going

concern value.(iv) (A) The ADSP of $900 is ratably allocated

among T’s Class V acquisition date assets in propor-tion to their fair market values as follows:Asset Basis

Equipment . . . . . . . . . . . . . . . . . . . . . $200

Non-actively traded securities . . . . . . 100

Building . . . . . . . . . . . . . . . . . . . . . . . 500

Total . . . . . . . . . . . . . . . . . . . . . . . . . . $800(B) The remaining ADSP, $100, is allocated to

goodwill and going concern value (Class VII).(v) P and T file a consolidated return for 2001

and each following year with P as the common par-ent of the affiliated group.

(vi) In 2004, a contingent amount of $120 is paidby P. Assume that, under general principles of taxlaw, the payment is properly taken into account by Pat the time made. In 2004, there is an increase in T’sAGUB of $120. The amount of the increase allo-cated to each acquisition date asset is determined asfollows:

Asset Original Redetermined IncreaseAGUB AGUB

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 175.00 $ 200.00 $ 25.00Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87.50 100.00 12.50Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 437.50 500.00 62.50Goodwill and going concern value . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.00 20.00 20.00

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 700.00 $ 820.00 $ 120.00

Par. 8. Section 1.338–10T is added toread as follows:§1.338–10T Filing of returns (tempo-rary).

(a) Returns including tax liability fromdeemed asset sale—(1) In general. Ex-cept as provided in paragraphs (a)(2) and(3) of this section, any deemed sale gainis reported on the final return of old targetfiled for old target’s taxable year that endsat the close of the acquisition date. If oldtarget is the common parent of an affili-ated group, the final return may be a con-solidated return (any such consolidatedreturn must also include any deemed salegain of any members of the consolidatedgroup that are acquired by the purchasingcorporation on the same acquisition dateas old target).

(2) Old target’s final taxable year oth-erwise included in consolidated return of

selling group—(i) General rule. If theselling group files a consolidated returnfor the period that includes the acquisitiondate, old target is disaffiliated from thatgroup immediately before the deemedasset sale and must file a deemed sale re-turn separate from the group that includesonly the deemed sale gain and the carry-over items specified in paragraph(a)(2)(iii) of this section. The deemedasset sale occurs at the close of the acqui-sition date and is the last transaction ofold target. Any transactions of old targetoccurring on the acquisition date otherthan the deemed asset sale are included inthe selling group’s consolidated return. Adeemed sale return includes a combineddeemed sale return as defined in para-graph (a)(4) of this section.

(ii) Separate taxable year. The deemedasset sale included in the deemed sale re-

turn under this paragraph (a)(2) occurs ina separate taxable year, except that oldtarget’s taxable year of the sale and theconsolidated year of the selling group thatincludes the acquisition date are treated asthe same year for purposes of determiningthe number of years in a carryover or car-ryback period.

(iii) Carryover and carryback of tax at-tributes. Target’s attributes may be car-ried over to, and carried back from, thedeemed sale return under the rules applic-able to a corporation that ceases to be amember of a consolidated group.

(iv) Old target is a component memberof purchasing corporation’s controlledgroup. For purposes of its deemed salereturn, target is a component member ofthe controlled group of corporations in-cluding the purchasing corporation unlesstarget is treated as an excluded member

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under section 1563(b)(2).(3) Old target is an S corporation. If

target is an S corporation for the periodthat ends on the day before the acquisitiondate, old target must file a deemed sale re-turn as a C corporation. For this purpose,the principles of paragraph (a)(2) of thissection apply. This paragraph (a)(3) doesnot apply if an election under section338(h)(10) is made for the S corporation.

(4) Combined deemed sale return—(i)General rule. Under section 338(h)(15),a combined deemed sale return (com-bined return) may be filed for all targetsfrom a single selling consolidated group(as defined in §1.338(h)(10)–1T(b)(3))that are acquired by the purchasing corpo-ration on the same acquisition date andthat otherwise would be required to fileseparate deemed sale returns. The com-bined return must include all such targets.For example, T and T1 may be includedin a combined return if—

(A) T and T1 are directly owned sub-sidiaries of S;

(B) S is the common parent of a consol-idated group; and

(C) P makes qualified stock purchasesof T and T1 on the same acquisition date.

(ii) Gain and loss offsets. Gains andlosses recognized on the deemed assetsales by targets included in a combinedreturn are treated as the gains and lossesof a single target. In addition, loss carry-overs of a target that were not subject tothe separate return limitation year restric-tions (SRLY restrictions) of the consoli-dated return regulations while that targetwas a member of the selling consolidatedgroup may be applied without limitationto the gains of other targets included inthe combined return. If, however, a targethas loss carryovers that were subject tothe SRLY restrictions while that targetwas a member of the selling consolidatedgroup, the use of those losses in the com-bined return continues to be subject tothose restrictions, applied in the samemanner as if the combined return were aconsolidated return. A similar rule ap-plies, when appropriate, to other tax at-tributes.

(iii) Procedure for filing a combined re-turn. A combined return is made by filinga single corporation income tax return inlieu of separate deemed sale returns for alltargets required to be included in the com-bined return. The combined return re-

flects the deemed asset sales of all targetsrequired to be included in the combinedreturn. If the targets included in the com-bined return constitute a single affiliatedgroup within the meaning of section1504(a), the income tax return is signedby an officer of the common parent of thatgroup. Otherwise, the return must besigned by an officer of each target in-cluded in the combined return. Rulessimilar to the rules in §1.1502–75(j) applyfor purposes of preparing the combinedreturn. The combined return must includean attachment prominently identified asan “ELECTION TO FILE A COMBINEDRETURN UNDER SECTION338(h)(15).” The attachment must—

(A) Contain the name, address, and em-ployer identification number of each tar-get required to be included in the com-bined return;

(B) Contain the following declaration(or a substantially similar declaration):EACH TARGET IDENTIFIED IN THISELECTION TO FILE A COMBINEDRETURN CONSENTS TO THE FILINGOF A COMBINED RETURN;

(C) For each target, be signed by a per-son who states under penalties of perjurythat he or she is authorized to act on be-half of such target.

(iv) Consequences of filing a combinedreturn. Each target included in a com-bined return is severally liable for any taxassociated with the combined return. See§1.338–1T(b)(3).

(5) Deemed sale excluded from pur-chasing corporation’s consolidated re-turn. Old target may not be considered amember of any affiliated group that in-cludes the purchasing corporation with re-spect to its deemed asset sale.

(6) Due date for old target’s final re-turn—(i) General rule. Old target’s finalreturn is generally due on the 15th day ofthe third calendar month following themonth in which the acquisition date oc-curs. See section 6072 (time for filing in-come tax returns).

(ii) Application of §1.1502–76(c)—(A)In general. Section 1.1502–76(c) appliesto old target’s final return if old target wasa member of a selling group that did notfile consolidated returns for the taxableyear of the common parent that precedesthe year that includes old target’s acquisi-tion date. If the selling group has notfiled a consolidated return that includes

old target’s taxable period that ends on theacquisition date, target may, on or beforethe final return due date (including exten-sions), either—

(1) File a deemed sale return on the as-sumption that the selling group will filethe consolidated return; or

(2) File a return for so much of old tar-get’s taxable period as ends at the close ofthe acquisition date on the assumptionthat the consolidated return will not befiled.

(B) Deemed extension. For purposes ofapplying §1.1502–76(c)(2), an extensionof time to file old target’s final return isconsidered to be in effect until the lastdate for making the election under section338.

(C) Erroneous filing of deemed sale re-turn. If, under this paragraph (a)(6)(ii),target files a deemed sale return but theselling group does not file a consolidatedreturn, target must file a substituted returnfor old target not later than the due date(including extensions) for the return ofthe common parent with which old targetwould have been included in the consoli-dated return. The substituted return is forso much of old target’s taxable year asends at the close of the acquisition date.Under §1.1502–76(c)(2), the deemed salereturn is not considered a return for pur-poses of section 6011 (relating to the gen-eral requirement of filing a return) if asubstituted return must be filed.

(D) Erroneous filing of return for regu-lar tax year. If, under this paragraph(a)(6)(ii), target files a return for so muchof old target’s regular taxable year as endsat the close of the acquisition date but theselling group files a consolidated return,target must file an amended return for oldtarget not later than the due date (includ-ing extensions) for the selling group’sconsolidated return. (The amended returnis a deemed sale return.)

(E) Last date for payment of tax.If ei-ther a substituted or amended final returnof old target is filed under this paragraph(a)(6)(ii), the last date prescribed for pay-ment of tax is the final return due date (asdefined in paragraph (a)(6)(i) of this sec-tion).

(7) Examples.The following examplesillustrate this paragraph (a):

Example 1. (i) S is the common parent of a con-solidated group that includes T. The S group filescalendar year consolidated returns. At the close ofJune 30 of Year 1, P makes a qualified stock pur-chase of T from S. P makes a section 338 electionfor T, and T’s deemed asset sale occurs as of the

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close of T’s acquisition date (June 30).(ii) T is considered disaffiliated for purposes of

reporting the deemed sale gain. Accordingly, T isincluded in the S group’s consolidated returnthrough T’s acquisition date except that the tax lia-bility for the deemed sale gain is reported in a sepa-rate deemed sale return of T. Provided that T is nottreated as an excluded member under section1563(b)(2), T is a component member of P’s con-trolled group for the taxable year of the deemedasset sale, and the taxable income bracket amountsavailable in calculating tax on the deemed sale re-turn must be limited accordingly.

(iii) If P purchased the stock of T at 10 a.m. onJune 30 of Year 1, the results would be the same.See paragraph (a)(2)(i) of this section.

Example 2.The facts are the same as in Example1, except that the S group does not file consolidatedreturns. T must file a separate return for its taxableyear ending on June 30 of Year 1, which return in-cludes the deemed asset sale.

(b) Waiver—(1) Certain additions totax. An addition to tax or additionalamount (addition) under subchapter A ofchapter 68 of the Internal Revenue Codearising on or before the last day for mak-ing the election under section 338 becauseof circumstances that would not exist butfor an election under section 338, iswaived if—

(i) Under the particular statute the addi-tion is excusable upon a showing of rea-sonable cause; and

(ii) Corrective action is taken on or be-fore the last day.

(2) Notification. The Internal RevenueService should be notified at the time ofcorrection (e.g., by attaching a statementto a return that constitutes corrective ac-tion) that the waiver rule of this paragraph(b) is being asserted.

(3) Elections or other actions requiredto be specified on a timely filed return—(i) In general. If paragraph (b)(1) of thissection applies or would apply if therewere an underpayment, any election orother action that must be specified on atimely filed return for the taxable periodcovered by the late filed return describedin paragraph (b)(1) of this section is con-sidered timely if specified on a late-filedreturn filed on or before the last day formaking the election under section 338.

(ii) New target in purchasing corpora-tion’s consolidated return. If new targetis includible for its first taxable year in aconsolidated return filed by the affiliatedgroup of which the purchasing corpora-tion is a member on or before the last dayfor making the election under section 338,any election or other action that must bespecified in a timely filed return for new

target’s first taxable year (but which is notspecified in the consolidated return) isconsidered timely if specified in anamended return filed on or before suchlast day, at the place where the consoli-dated return was filed.

(4) Examples. The following examplesillustrate this paragraph (b):

Example 1. T is an unaffiliated corporation witha tax year ending March 31. At the close of Septem-ber 20 of Year 1, P makes a qualified stock purchaseof T. P does not join in filing a consolidated return.P makes a section 338 election for T on or beforeJune 15 of Year 2, which causes T’s taxable year toend as of the close of September 20 of Year 1. Anincome tax return for T’s taxable period ending onSeptember 20 of Year 1 was due on December 15 ofYear 1. Additions to tax for failure to file a returnand to pay tax shown on a return will not be imposedif T’s return is filed and the tax paid on or beforeJune 15 of Year 2. (This waiver applies even if theacquisition date coincides with the last day of T’sformer taxable year, i.e., March 31 of Year 2.) Inter-est on any underpayment of tax for old T’s short tax-able year ending September 20 of Year 1 runs fromDecember 15 of Year 1. A statement indicating thatthe waiver rule of this paragraph is being assertedshould be attached to T’s return.

Example 2.Assume the same facts as in Example1. Assume further that new T adopts the calendaryear by filing, on or before June 15 of Year 2, its firstreturn (for the period beginning on September 21 ofYear 1 and ending on December 31 of Year 1) indicat-ing that a calendar year is chosen. See §1.338-1T(b)(1). Any additions to tax or amounts describedin this paragraph (b) that arise because of the late fil-ing of a return for the period ending on December 31of Year 1 are waived, because they are based on cir-cumstances that would not exist but for the section338 election. Notwithstanding this waiver, however,the return is still considered due March 15 of Year 2,and interest on any underpayment runs from that date.

Example 3. Assume the same facts as in Example2, except that T’s former taxable year ends on Octo-ber 31. Although prior to the election old T had a re-turn due on January 15 of Year 2 for its year endingOctober 31 of Year 1, that return need not be filedbecause a timely election under section 338 wasmade. Instead, old T must file a final return for theperiod ending on September 20 of Year 1, which isdue on December 15 of Year 1.

§§1.338(b)–1, 1.338(b)–2T,1.338(b)–3T, and 1.338(h)(10)–1[Removed]

Par. 9. Sections 1.338(b)–1,1.338(b)–2T, and 1.338(b)–3T, and1.338(h)(10)–1 are removed.

Par. 10. Section 1.338(h)(10)–1T isadded to read as follows:§1.338(h)(10)–1T Deemed asset sale andliquidation (temporary).

(a) Scope. This section prescribes rulesfor qualification for a section 338(h)(10)election and for making a section

338(h)(10) election. This section also pre-scribes the consequences of such election.The rules of this section are in addition tothe rules of §§1.338–0T through1.338–7T, 1.338–8, 1.338–9, 1.338–10T,and 1.338(i)–1T and, in appropriate cases,apply instead of the rules of §§1.338–0Tthrough 1.338–7T, 1.338–8, 1.338–9,1.338–10T, and 1.338(i)–1T.

(b) Definitions—(1) Consolidated tar-get. A consolidated targetis a target thatis a member of a consolidated groupwithin the meaning of §1.1502–1(h) onthe acquisition date and is not the com-mon parent of the group on that date.

(2) Selling consolidated group.A sell-ing consolidated groupis the consoli-dated group of which the consolidated tar-get is a member on the acquisition date.

(3) Selling affiliate; affiliated target. Aselling affiliate is a domestic corporationthat owns on the acquisition date anamount of stock in a domestic target,which amount of stock is described insection 1504(a)(2), and does not join infiling a consolidated return with the tar-get. In such case, the target is an affili-ated target.

(4) S corporation target. An S corpo-ration targetis a target that is an S corpo-ration immediately before the acquisitiondate.

(5) S corporation shareholders. S cor-poration shareholdersare the S corpora-tion target’s shareholders. Unless other-wise indicated, a reference to Scorporation shareholders refers both to Scorporation shareholders who do andthose who do not sell their target stock.

(6) Liquidation. Any reference in thissection to a liquidation is treated as a ref-erence to the transfer described in para-graph (d)(4) of this section notwithstand-ing its ultimate characterization forFederal income tax purposes.

(c) Section 338(h)(10) election—(1) Ingeneral . A section 338(h)(10) electionmay be made for T if P acquires stockmeeting the requirements of section1504(a)(2) from a selling consolidatedgroup, a selling affiliate, or the S corpora-tion shareholders in a qualified stock pur-chase.

(2) Simultaneous joint election require-ment. A section 338(h)(10) election ismade jointly by P and the selling consoli-dated group (or the selling affiliate or theS corporation shareholders) on Form

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8023 in accordance with the instructionsto the form. S corporation shareholderswho do not sell their stock must also con-sent to the election. The section338(h)(10) election must be made notlater than the 15th day of the 9th monthbeginning after the month in which theacquisition date occurs.

(3) Irrevocability. A section 338(h)(10)election is irrevocable. If a section338(h)(10) election is made for T, a sec-tion 338 election is deemed made for T.

(4) Effect of invalid election. If a sec-tion 338(h)(10) election for T is not valid,the section 338 election for T is also notvalid.

(d) Certain consequences of section338(h)(10) election. For purposes of sub-title A of the Internal Revenue Code (ex-cept as provided in §1.338–1T(b)(2)), theconsequences to the parties of making asection 338(h)(10) election for T are asfollows:

(1) P. P is automatically deemed tohave made a gain recognition election forits nonrecently purchased T stock, if any.The effect of a gain recognition electionincludes a taxable deemed sale by P onthe acquisition date of any nonrecentlypurchased target stock. See§1.338–5T(d).

(2) New T. The AGUB for new T’s as-sets is determined under §1.338–5T and isallocated among the acquisition date as-sets under §§1.338–6T and 1.338–7T.Notwithstanding paragraph (d)(4) of thissection (deemed liquidation of old T),new T remains liable for the tax liabilitiesof old T (including the tax liability for thedeemed sale gain). For example, new Tremains liable for the tax liabilities of themembers of any consolidated group thatare attributable to taxable years in whichthose corporations and old T joined in thesame consolidated return. See§1.1502–6(a).

(3) Old T—deemed sale—(i) In gen-eral. Old T is treated as transferring all ofits assets to an unrelated person in ex-change for consideration that includes theassumption of or taking subject to liabili-ties in a single transaction at the close ofthe acquisition date (but before thedeemed liquidation). See §1.338–1T(a)regarding the tax characterization of thedeemed asset sale. ADSP for old T is de-termined under §1.338–4T and allocatedamong the acquisition date assets under

§§1.338–6T and 1.338–7T. Old T real-izes the deemed sale gain from thedeemed asset sale before the close of theacquisition date while old T is a memberof the selling consolidated group (orowned by the selling affiliate or owned bythe S corporation shareholders). If T is anaffiliated target, or an S corporation tar-get, the principles of §§1.338–2T(c)(10)and 1.338–10T(a)(1), (5), and (6)(i) applyto the return on which the deemed salegain is reported. When T is an S corpora-tion target, T’s S election continues in ef-fect through the close of the acquisitiondate (including the time of the deemedasset sale and the deemed liquidation)notwithstanding section 1362(d)(2)(B).Also, when T is an S corporation target,any direct and indirect subsidiaries of Twhich T has elected to treat as qualifiedsubchapter S subsidiaries under section1361(b)(3) remain qualified subchapter Ssubsidiaries through the close of the ac-quisition date. No similar rule applieswhen a qualified subchapter S subsidiary,as opposed to the S corporation that is itsowner, is the target the stock of which isactually purchased.

(ii) Tiered targets. In the case of par-ent-subsidiary chains of corporationsmaking elections under section338(h)(10), the deemed asset sale of aparent corporation is considered to pre-cede that of its subsidiary. See§1.338–3T(4)(i).

(4) Old T and selling consolidatedgroup, selling affiliate, or S corporationshareholders—deemed liquidation; taxcharacterization—(i) In general. Old T istreated as if, before the close of the acqui-sition date, after the deemed asset sale inparagraph (d)(3) of this section, and whileold T is a member of the selling consoli-dated group (or owned by the selling affil-iate or owned by the S corporation share-holders), it transferred all of its assets tomembers of the selling consolidatedgroup, the selling affiliate, or S corpora-tion shareholders and ceased to exist. Thetransfer from old T is characterized forFederal income tax purposes in the samemanner as if the parties had actually en-gaged in the transactions deemed to occurbecause of this section and taking into ac-count other transactions that actually oc-curred or are deemed to occur. For exam-ple, the transfer may be treated as adistribution in pursuance of a plan of reor-

ganization, a distribution in complete can-cellation or redemption of all its stock,one of a series of distributions in com-plete cancellation or redemption of all itsstock in accordance with a plan of liqui-dation, or part of a circular flow of cash.In most cases, the transfer will be treatedas a distribution in complete liquidation towhich section 336 or 337 applies.

(ii) Tiered targets. In the case of par-ent-subsidiary chains of corporationsmaking elections under section338(h)(10), the deemed liquidation of asubsidiary corporation is considered toprecede the deemed liquidation of its par-ent.

(5) Selling consolidated group, sellingaffiliate, or S corporation shareholders—(i) In general. If T is an S corporation tar-get, S corporation shareholders (whetheror not they sell their stock) take their prorata share of the deemed sale gain into ac-count under section 1366 and increase ordecrease their basis in T stock under sec-tion 1367. Members of the selling con-solidated group, the selling affiliate, or Scorporation shareholders are treated as if,after the deemed asset sale in paragraph(d)(3) of this section and before the closeof the acquisition date, they received theassets transferred by old T in the transac-tion described in paragraph (d)(4)(i) ofthis section. In most cases, the transferwill be treated as a distribution in com-plete liquidation to which section 331 or332 applies.

(ii) Basis and holding period of T stocknot acquired. A member of the sellingconsolidated group (or the selling affiliateor an S corporation shareholder) retainingT stock is treated as acquiring the stock soretained on the day after the acquisitiondate for its fair market value. The holdingperiod for the retained stock starts on theday after the acquisition date. For pur-poses of this paragraph, the fair marketvalue of all of the T stock equals thegrossed-up amount realized on the sale toP of P’s recently purchased target stock.See §1.338–4T(c).

(iii) T stock sale. Members of the sell-ing consolidated group (or the selling af-filiate or S corporation shareholders) rec-ognize no gain or loss on the sale orexchange of T stock included in the quali-fied stock purchase (although they mayrecognize gain or loss on the T stock inthe deemed liquidation).

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(6) Nonselling minority shareholdersother than nonselling S corporationshareholders—(i) In general. This para-graph (d)(6) describes the treatment ofshareholders of old T other than the fol-lowing: members of the selling consoli-dated group, the selling affiliate, S corpo-ration shareholders (whether or not theysell their stock), and P. For a descriptionof the treatment of S corporation share-holders, see paragraph (d)(5) of this sec-tion. A shareholder to which this para-graph (d)(6) applies is called a minorityshareholder.

(ii) T stock sale. A minority share-holder recognizes gain or loss on theshareholder’s sale or exchange of T stockincluded in the qualified stock purchase.

(iii) T stock not acquired. A minorityshareholder does not recognize gain orloss under this section with respect toshares of T stock retained by the share-holder. The shareholder’s basis and hold-ing period for that T stock is not affectedby the section 338(h)(10) election.

(7) Consolidated return of selling con-solidated group.If P acquires T in a qual-ified stock purchase from a selling con-solidated group—

(i) The selling consolidated group mustfile a consolidated return for the taxableperiod that includes the acquisition date;

(ii) A consolidated return for the sellingconsolidated group for that period maynot be withdrawn on or after the day that asection 338(h)(10) election is made for T;and

(iii) Permission to discontinue filingconsolidated returns cannot be grantedfor, and cannot apply to, that period orany of the immediately preceding taxableperiods during which consolidated returnscontinuously have been filed.

(8) Availability of the section 453 in-stallment method. Solely for purposes ofapplying sections 453, 453A, and 453B,and the regulations thereunder (the in-stallment method) to determine the conse-quences to old T in the deemed asset saleand to old T (and its shareholders, if rele-vant) in the deemed liquidation, the rulesin paragraphs (d)(1) through (7) of thissection are modified as follows:

(i) In deemed asset sale. Old T istreated as receiving in the deemed assetsale new T installment obligations, theterms of which are identical (except as tothe obligor) to P installment obligations

issued in exchange for recently purchasedstock of T. Old T is treated as receiving incash all other consideration in the deemedasset sale other than the assumption of, ortaking subject to, old T liabilities. For ex-ample, old T is treated as receiving incash any amounts attributable to thegrossing-up of amount realized under§1.338–4T(c). The amount realized forrecently purchased stock taken into ac-count in determining ADSP is adjusted(and, thus, ADSP is redetermined) to re-flect the amounts paid under an install-ment obligation for the stock when thetotal payments under the installmentobligation are greater or less than theamount realized.

(ii) In deemed liquidation. Old T istreated as distributing in the deemed liqui-dation the new T installment obligationsthat it is treated as receiving in thedeemed asset sale. The members of theselling consolidated group, the selling af-filiate, or the S corporation shareholdersare treated as receiving in the deemed liq-uidation the new T installment obligationsthat correspond to the P installment oblig-ations they actually received individuallyin exchange for their recently purchasedstock. The new T installment obligationsmay be recharacterized under other rules.See for example §1.453–11(a)(2) which,in certain circumstances, treats the new Tinstallment obligations deemed distrib-uted by old T as if they were issued bynew T in exchange for the members’ ofthe selling consolidated group, the sellingaffiliate’s, or the S corporation sharehold-ers’ stock in old T. The members of theselling consolidated group, the selling af-filiate, or the S corporation shareholdersare treated as receiving all other consider-ation in the deemed liquidation in cash.

(9) Treatment consistent with an actualasset sale. Old T may not assert any pro-vision in section 338(h)(10) or this sec-tion to obtain a tax result that would notbe obtained if the parties had actually en-gaged in the transactions deemed to occurbecause of this section and taking into ac-count other transactions that actually oc-curred or are deemed to occur.

(e) Examples. The following examplesillustrate this section:

Example 1. (i) S1 owns all of the T stock and Towns all of the stock of T1 and T2. S1 is the com-mon parent of a consolidated group that includes T,T1, and T2. P makes a qualified stock purchase ofall of the T stock from S1. S1 joins with P in making

a section 338(h)(10) election for T and for thedeemed purchase of T1. A section 338 election isnot made for T2.

(ii) S1 does not recognize gain or loss on the saleof the T stock and T does not recognize gain or losson the sale of the T1 stock because section338(h)(10) elections are made for T and T1. Thus,for example, gain or loss realized on the sale of the Tor T1 stock is not taken into account in earnings andprofits. However, because a section 338 election isnot made for T2, T must recognize any gain or lossrealized on the deemed sale of the T2 stock. See§1.338–4T(h).

(iii) The results would be the same if S1, T, T1,and T2 are not members of any consolidated group,because S1 and T are selling affiliates.

Example 2. (i) S and T are solvent corporations.S owns all of the outstanding stock of T. S and Pagree to undertake the following transaction: T willdistribute half its assets to S, and S will assume halfof T’s liabilities. Then, P will purchase the stock of Tfrom S. S and P will jointly make a section338(h)(10) election with respect to the sale of T. Thecorporations then complete the transaction as agreed.

(ii) Under section 338(a), the assets present in Tat the close of the acquisition date are deemed soldby old T to new T. Under paragraph (d)(4) of thissection, the transactions described in paragraph (d)of this section are treated in the same manner as ifthey had actually occurred. Because S and P hadagreed that, after T’s actual distribution to S of partof its assets, S would sell T to P pursuant to an elec-tion under section 338(h)(10), and because para-graph (d)(4) of this section deems T subsequently tohave transferred all its assets to its shareholder, T isdeemed to have adopted a plan of complete liquida-tion under section 332. T’s actual transfer of assetsto S is treated as a distribution pursuant to that planof complete liquidation.

Example 3. (i) S1 owns all of the outstandingstock of both T and S2. All three are corporations.S1 and P agree to undertake the following transac-tion. T will transfer substantially all of its assets andliabilities to S2, with S2 issuing no stock in ex-change therefor, and retaining its other assets and li-abilities. Then, P will purchase the stock of T fromS1. S1 and P will jointly make a section 338(h)(10)election with respect to the sale of T. The corpora-tions then complete the transaction as agreed.

(ii) Under section 338(a), the assets present in Tat the close of the acquisition date are deemed soldby old T to new T. Under paragraph (d)(4) of thissection, the transactions described in this section aretreated in the same manner as if they had actuallyoccurred. Because old T transferred substantially allof its assets to S2, and is deemed to have distributedall its remaining assets and gone out of existence,the transfer of assets to S2, taking into account therelated transfers, deemed and actual, qualifies as areorganization under section 368(a)(1)(D). Section361(c)(1) and not section 332 applies to T’s deemedliquidation.

Example 4. (i) T owns two assets: an activelytraded security (Class II) with a fair market value of$100 and an adjusted basis of $100, and inventory(Class IV) with a fair market value of $100 and anadjusted basis of $100. T has no liabilities. S is ne-gotiating to sell all the stock in T to P for $100 cashand contingent consideration. Assume that undergenerally applicable tax accounting rules, P’s ad-

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justed basis in the T stock immediately after the pur-chase would be $100, because the contingent con-sideration is not taken into account. Thus, under therules of §1.338–5T, AGUB would be $100. Underthe allocation rules of §1.338–6T, the entire $100would be allocated to the Class II asset, the activelytraded security, and no amount would be allocated tothe inventory. P, however, plans immediately tocause T to sell the inventory, but not the activelytraded security, so it requests that, prior to the stocksale, S cause T to create a new subsidiary, Newco,and contribute the actively traded security to thecapital of Newco. Because the stock in Newco,which would not be actively traded, is a Class Vasset, under the rules of §1.338–6T $100 of AGUBwould be allocated to the inventory and no amountof AGUB would be allocated to the Newco stock.Newco’s own AGUB, $0 under the rules of§1.338–5T, would be allocated to the actively traded

security. When P subsequently causes T to sell theinventory, T would realize no gain or loss instead ofrealizing gain of $100.

(ii) Assume that, if the T stock had not itself beensold but T had instead sold both its inventory and theNewco stock to P, T would for tax purposes bedeemed instead to have sold both its inventory andactively traded security directly to P, with P deemedthen to have created Newco and contributed the ac-tively traded security to the capital of Newco. Sec-tion 338, if elected, generally recharacterizes a stocksale as a deemed sale of assets. The tax results ofthe deemed sale of assets should, where possible, belike those of an actual asset sale. Hence, the deemedsale of assets under section 338(h)(10) should betreated as one of the inventory and actively tradedsecurity themselves, not of the inventory and Newcostock. That is the substance of the transaction. Theanti-abuse rule of §1.338–1T(c) does not apply, be-

cause the substance of the deemed sale of assets is asale of the inventory and the actively traded securitythemselves, not of the inventory and the Newcostock. Otherwise, the anti-abuse rule might apply.

Example 5. (i) T, a member of a selling consoli-dated group, has only one class of stock, all of whichis owned by S1. On March 1 of Year 2, S1 sells its Tstock to P for $80,000, and joins with P in making asection 338(h)(10) election for T. There are no sell-ing costs or acquisition costs. On March 1 of Year 2,T owns land with a $50,000 basis and $75,000 fairmarket value and equipment with a $30,000 adjustedbasis, $70,000 recomputed basis, and $60,000 fairmarket value. T also has a $40,000 liability. S1pays old T’s allocable share of the selling group’sconsolidated tax liability for Year 2 including the taxliability for the deemed sale gain (a total of$13,600).

(ii) ADSP of $120,000 ($80,000 + $40,000 + 0)

January 24, 2000 360 2000–4 I.R.B.

is allocated to each asset as follows:Assets Basis FMV Fraction Allocable

ADSP

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 50,000 $ 75,000 5/9 $ 66,667

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 60,000 4/9 53,333

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$ 80,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$ 135,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$ 120,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

(iii) Under paragraph (d)(3) of this section, old Thas gain on the deemed sale of $40,000 (consistingof $16,667 of capital gain and $23,333 of ordinaryincome).

(iv) Under paragraph (d)(5)(iii) of this section,S1 recognizes no gain or loss upon its sale of the oldT stock to P. S1 also recognizes no gain or loss uponthe deemed liquidation of T. See paragraph (d)(4) ofthis section and section 332.

(v) P’s basis in new T stock is P’s cost for thestock, $80,000. See section 1012.

(vi) Under §1.338–5T, the AGUB for new T is$120,000, i.e., P’s cost for the old T stock ($80,000)plus T’s liability ($40,000). This AGUB is allocatedas basis among the new T assets under §§1.338–6Tand 1.338–7T.

Example 6. (i) The facts are the same as in Ex-ample 5, except that S1 sells 80 percent of the old Tstock to P for $64,000, rather than 100 percent of theold T stock for $80,000.

(ii) The consequences to P, T, and S1 are the sameas in Example 5, except that:

(A) P’s basis for its 80-percent interest in the newT stock is P’s $64,000 cost for the stock. See section1012.

(B) Under §1.338–5T, the AGUB for new T is$120,000 (i.e., $64,000/.8 + $40,000 + $0).

(C) Under paragraph (d)(4) of this section, S1recognizes no gain or loss with respect to the re-tained stock in T. See section 332.

(D) Under paragraph (d)(5)(ii) of this section, thebasis of the T stock retained by S1 is $16,000 (i.e.,$120,000 å $40,000 (the ADSP amount for the old Tassets over the sum of new T’s liabilities immedi-ately after the acquisition date) ( .20 (the proportionof T stock retained by S1)).

Example 7. (i) The facts are the same as in Ex-ample 6, except that K, a shareholder unrelated to T

or P, owns the 20 percent of the T stock that is notacquired by P in the qualified stock purchase. K’sbasis in its T stock is $5,000.

(ii) The consequences to P, T, and S1 are the sameas in Example 6.

(iii) Under paragraph (d)(6)(iii) of this section, Krecognizes no gain or loss, and K’s basis in its Tstock remains at $5,000.

Example 8. (i) The facts are the same as in Ex-ample 5, except that the equipment is held by T1, awholly–owned subsidiary of T, and a section338(h)(10) election is also made for T1. The T1stock has a fair market value of $60,000. T1 has noassets other than the equipment and no liabilities.S1 pays old T’s and old T1’s allocable shares of theselling group’s consolidated tax liability for Year 2including the tax liability for T and T1’s deemed salegain.

(ii) ADSP for T is $120,000, allocated $66,667 tothe land and $53,333 to the stock. Old T’s deemedsale gain is $16,667 (the capital gain on its deemedsale of the land). Under paragraph (d)(5)(iii) of thissection, old T does not recognize gain or loss on itsdeemed sale of the T1 stock. See section 332.

(iii) ADSP for T1 is $53,333 (i.e., $53,333 + $0 +$0). On the deemed sale of the equipment, T1 rec-ognizes ordinary income of $23,333.

(iv) Under paragraph (d)(5)(iii) of this section,S1 does not recognize gain or loss upon its sale ofthe old T stock to P.

Example 9. (i) The facts are the same as in Ex-ample 8, except that P already owns 20 percent ofthe T stock, which is nonrecently purchased stockwith a basis of $6,000, and that P purchases the re-maining 80 percent of the T stock from S1 for$64,000.

(ii) The results are the same as in Example 8, ex-cept that under paragraph (d)(1) of this section and§1.338-5T(d), P is deemed to have made a gainrecognition election for its nonrecently purchased Tstock. As a result, P recognizes gain of $10,000 andits basis in the nonrecently purchased T stock is in-creased from $6,000 to $16,000. P’s basis in all theT stock is $80,000 (i.e., $64,000 + $16,000). The

computations are as follows:(A) P’s grossed-up basis for the recently pur-

chased T stock is $64,000 (i.e., $64,000 (the basis ofthe recently purchased T stock) ( (1 å .2)/(.8) (thefraction in section 338(b)(4))).

(B) P’s basis amount for the nonrecently pur-chased T stock is $16,000 (i.e., $64,000 (thegrossed-up basis in the recently purchased T stock) ((.2)/(1.0 å .2) (the fraction in section 338(b)(3)(B))).

(C) The gain recognized on the nonrecently pur-chased stock is $10,000 (i.e., $16,000 å $6,000).

Example 10. (i) T is an S corporation whose soleclass of stock is owned 40 percent each by A and Band 20 percent by C. T, A, B, and C all use the cashmethod of accounting. A and B each has an adjustedbasis of $10,000 in the stock. C has an adjustedbasis of $5,000 in the stock. A, B, and C hold no in-stallment obligations to which section 453A applies.On March 1 of Year 1, A sells its stock to P for$40,000 in cash and B sells its stock to P for a$25,000 note issued by P and real estate having afair market value of $15,000. The $25,000 note, duein full in Year 7, is not publicly traded and bears ad-equate stated interest. A and B have no selling ex-penses. T’s sole asset is real estate, which has avalue of $110,000 and an adjusted basis of $35,000.Also, T’s real estate is encumbered by long-out-standing purchase-money indebtedness of $10,000.The real estate does not have built-in gain subject tosection 1374. A, B, and C join with P in making asection 338(h)(10) election for T.

(ii) Solely for purposes of application of sections453, 453A, and 453B, old T is considered in itsdeemed asset sale to receive back from new T the$25,000 note (considered issued by new T) and$75,000 of cash (total consideration of $80,000 paidfor all the stock sold, which is then divided by .80 inthe grossing-up, with the resulting figure of$100,000 then reduced by the amount of the install-ment note). Absent an election under section453(d), gain is reported by old T under the install-ment method.

(iii) In applying the installment method to old T’sdeemed asset sale, the contract price for old T’s as-

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sets deemed sold is $100,000, the $110,000 sellingprice reduced by the indebtedness of $10,000 towhich the assets are subject. (The $110,000 sellingprice is itself the sum of the $80,000 grossed-up inparagraph (ii) above to $100,000 and the $10,000 li-ability.) Gross profit is $75,000 ($110,000 sellingprice å old T’s basis of $35,000). Old T’s grossprofit ratio is 0.75 (gross profit of $75,000 â$100,000 contract price). Thus, $56,250 (0.75 ( the$75,000 cash old T is deemed to receive in Year 1) isYear 1 gain attributable to the sale, and $18,750($75,000 å $56,250) is recovery of basis.

(iv) In its liquidation, old T is deemed to distrib-ute the $25,000 note to B, since B actually sold thestock partly for that consideration. To the extent ofthe remaining liquidating distribution to B, it isdeemed to receive, along with A and C, the balanceof old T’s liquidating assets in the form of cash.Under section 453(h), B, unless it makes an electionunder section 453(d), is not required to treat the re-ceipt of the note as a payment for the T stock; P’spayment of the $25,000 note in Year 7 to B is a pay-ment for the T stock. Because section 453(h) ap-plies to B, old T’s deemed liquidating distribution ofthe note is, under section 453B(h), not treated as ataxable disposition by old T.

(v) Under section 1366, A reports 40 percent, or$22,500, of old T’s $56,250 gain recognized in Year1. Under section 1367, this increases A’s $10,000adjusted basis in the T stock to $32,500. Next, inold T’s deemed liquidation, A is considered to re-ceive $40,000 for its old T shares, causing it to rec-ognize an additional $7,500 gain in Year 1.

(vi) Under section 1366, B reports 40 percent, or$22,500, of old T’s $56,250 gain recognized in Year1. Under section 1367, this increases B’s $10,000adjusted basis in its T stock to $32,500. Next, in oldT’s deemed liquidation, B is considered to receivethe $25,000 note and $15,000 of other consideration.Applying section 453, including section 453(h), tothe deemed liquidation, B’s selling price and con-tract price are both $40,000. Gross profit is $7,500($40,000 selling price å B’s basis of $32,500). B’sgross profit ratio is 0.1875 (gross profit of $7,500 â$40,000 contract price). Thus, $2,812.50 (0.1875 ($15,000) is Year 1 gain attributable to the deemedliquidation. In Year 7, when the $25,000 note ispaid, B has $4,687.50 (0.1875 ( $25,000) of addi-tional gain.

(vii) Under section 1366, C reports 20 percent, or$11,250, of old T’s $56,250 gain recognized in Year1. Under section 1367, this increases C’s $5,000 ad-justed basis in its T stock to $16,250. Next, in oldT’s deemed liquidation, C is considered to receive$20,000 for its old T shares, causing it to recognizean additional $3,750 gain in Year 1. Finally, underparagraph (d)(5)(ii) of this section, C is consideredto acquire its stock in T on the day after the acquisi-tion date for $20,000 (fair market value = grossed-up amount realized of $100,000 ( 20%). C’s holdingperiod in the stock deemed received in new T beginsat that time.

(f) Inapplicability of provisions. Theprovisions of section 6043, §1.331– 1(d),and §1.332–6 (relating to information re-turns and recordkeeping requirements forcorporate liquidations) do not apply to thedeemed liquidation of old T under para-graph (d)(4) of this section.

(g) Required information. The Com-missioner may exercise the authoritygranted in section 338(h)(10)(C)(iii) to re-quire provision of any informationdeemed necessary to carry out the provi-sions of section 338(h)(10) by requiringsubmission of information on any tax re-porting form.

§1.338(i)–1 [Removed]

Par. 11. Section 1.338(i)–1 is removed.Par. 12. Section 1.338(i)–1T is added

to read as follows:§1.338(i)–1T Effective dates (temporary).

The provisions of §§1.338–0T through1.338–7T, 1.338–10T and1.338(h)(10)–1T apply to any qualifiedstock purchase occurring after January 5,2000. For rules applicable to qualifiedstock purchases on or before January 5,2000, see §§1.338–0 through 1.338–5,1.338(b)–1, 1.338(b)–2T, 1.338(b)–3T,1.338(h)(10)–1, and 1.338(i)–1 in effectprior to January 6, 2000 (see 26 CFR part1 revised April 1, 1999).

Par. 13. Section 1.1060–1T is revisedto read as follows:§1.1060–1T Special allocation rules forcertain asset acquisitions(temporary).

(a) Scope—(1) In general. This sectionprescribes rules relating to the require-ments of section 1060, which, in the caseof an applicable asset acquisition, re-quires the transferor (the seller) and thetransferee (the purchaser) each to allocatethe consideration paid or received in thetransaction among the assets transferredin the same manner as amounts are allo-cated under section 338(b)(5) (relating tothe allocation of adjusted grossed-upbasis among the assets of the target corpo-ration when a section 338 election ismade). In the case of an applicable assetacquisition described in paragraph (b)(1)of this section, sellers and purchasersmust allocate the consideration under theresidual method as described in§§1.338–6T and 1.338–7T in order to de-termine, respectively, the amount realizedfrom, and the basis in, each of the trans-ferred assets. For rules relating to distrib-utions of partnership property or transfersof partnership interests which are subjectto section 1060(d), see §1.755–2T.

(2) Effective date. The provisions ofthis section apply to any asset acquisitionoccurring after January 5, 2000. For rulesapplicable to asset acquisitions on or be-

fore January 5, 2000, see §1.1060–1T ineffect prior to January 6, 2000 (see 26CFR part 1 revised April 1, 1999).

(3) Outline of topics. In order to facili-tate the use of this section, this paragraph(a)(3) lists the major paragraphs in thissection as follows:(a) Scope.(1) In general.(2) Effective date.(3) Outline of topics.(b) Applicable asset acquisition.(1) In general.(2) Assets constituting a trade or business.(i) In general.(ii) Goodwill or going concern value.(iii) Factors indicating goodwill or goingconcern value.(3) Examples.(4) Asymmetrical transfers of assets.(5) Related transactions.(6) More than a single trade or business.(7) Covenant entered into by the seller.(8) Partial non-recognition exchanges.(c) Allocation of consideration among as-sets under the residual method.(1) Consideration.(2) Allocation of consideration among as-sets.(3) Certain costs.(4) Effect of agreement between parties.(d) Examples.(e) Reporting requirements.(1) Applicable asset acquisitions.(i) In general.(ii) Time and manner of reporting.(A) In general.(B) Additional reporting requirement.(2) Transfers of interests in partnerships.

(b) Applicable asset acquisition—(1)In general. An applicable asset acquisi-tion is any transfer, whether direct or indi-rect, of a group of assets if the assetstransferred constitute a trade or businessin the hands of either the seller or the pur-chaser and, except as provided in para-graph (b)(8) of this section, the pur-chaser’s basis in the transferred assets isdetermined wholly by reference to thepurchaser’s consideration.

(2) Assets constituting a trade or busi-ness—(i) In general. For purposes of thissection, a group of assets constitutes atrade or business if—

(A) The use of such assets would con-stitute an active trade or business undersection 355; or

(B) Its character is such that goodwill

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or going concern value could under anycircumstances attach to such group.

(ii) Goodwill or going concern value.Goodwill is the value of a trade or busi-ness attributable to the expectancy of con-tinued customer patronage. This ex-pectancy may be due to the name orreputation of a trade or business or anyother factor. Going concern value is theadditional value that attaches to propertybecause of its existence as an integral partof an ongoing business activity. Goingconcern value includes the value attribut-able to the ability of a trade or business(or a part of a trade or business) to con-tinue functioning or generating incomewithout interruption notwithstanding achange in ownership. It also includes thevalue that is attributable to the immediateuse or availability of an acquired trade orbusiness, such as, for example, the use ofthe revenues or net earnings that other-wise would not be received during anyperiod if the acquired trade or businesswere not available or operational.

(iii) Factors indicating goodwill orgoing concern value.In making the de-termination in this paragraph (b)(2), allthe facts and circumstances surroundingthe transaction are taken into account.Whether sufficient consideration is avail-able to allocate to goodwill or going con-cern value after the residual method is ap-plied is not relevant in determiningwhether goodwill or going concern valuecould attach to a group of assets. Factorsto be considered include—

(A) The presence of any intangible as-sets (whether or not those assets are sec-tion 197 intangibles), provided, however,that the transfer of such an asset in the ab-sence of other assets will not be a trade orbusiness for purposes of section 1060;

(B) The existence of an excess of thetotal consideration over the aggregatebook value of the tangible and intangi-ble assets purchased (other than good-will and going concern value) as shownin the financial accounting books andrecords of the purchaser; and

(C) Related transactions, includinglease agreements, licenses, or other sim-ilar agreements between the purchaserand seller (or managers, directors, own-ers, or employees of the seller) in con-nection with the transfer.

(3) Examples. The following exam-ples illustrate paragraphs (b)(1) and (2)

of this section:Example 1. S is a high grade machine shop that

manufactures microwave connectors in limitedquantities. It is a successful company with a reputa-tion within the industry and among its customers formanufacturing unique, high quality products. Itstangible assets consist primarily of ordinary machin-ery for working metal and plating. It has no secretformulas or patented drawings of value. P is a com-pany that designs, manufactures, and markets elec-tronic components. It wants to establish an immedi-ate presence in the microwave industry, an area inwhich it previously has not been engaged. P is ac-quiring assets of a number of smaller companies andhopes that these assets will collectively allow it tooffer a broad product mix. P acquires the assets of Sin order to augment its product mix and to promoteits presence in the microwave industry. P will notuse the assets acquired from S to manufacture mi-crowave connectors. The assets transferred are as-sets that constitute a trade or business in the hands ofthe seller. Thus, P’s purchase of S’s assets is an ap-plicable asset acquisition. The fact that P will notuse the assets acquired from S to continue the busi-ness of S does not affect this conclusion.

Example 2. S, a sole proprietor who operates acar wash, both leases the building housing the carwash and sells all of the car wash equipment to P. S’suse of the building and the car wash equipment con-stitute a trade or business. P begins operating a carwash in the building it leases from S. Because theassets transferred together with the asset leased areassets which constitute a trade or business, P’s pur-chase of S’s assets is an applicable asset acquisition.

Example 3. S, a corporation, owns a retail storebusiness in State X and conducts activities in con-nection with that business enterprise that meet theactive trade or business requirement of section 355.P is a minority shareholder of S. S distributes to Pall the assets of S used in S’s retail business in StateX in complete redemption of P’s stock in S held byP. The distribution of S’s assets in redemption of P’sstock is treated as a sale or exchange under sections302(a) and 302(b)(3), and P’s basis in the assets dis-tributed to it is determined wholly by reference tothe consideration paid, the S stock. Thus, S’s distri-bution of assets constituting a trade or business to Pis an applicable asset acquisition.

Example 4. S is a manufacturing company withan internal financial bookkeeping department. P isin the business of providing a financial bookkeepingservice on a contract basis. As part of an agreementfor P to begin providing financial bookkeeping ser-vices to S, P agrees to buy all of the assets associatedwith S’s internal bookkeeping operations and pro-vide employment to any of S’s bookkeeping depart-ment employees who choose to accept a positionwith P. In addition to selling P the assets associatedwith its bookkeeping operation, S will enter into along term contract with P for bookkeeping services.Because assets transferred from S to P, along withthe related contract for bookkeeping services, are atrade or business in the hands of P, the sale of thebookkeeping assets from S to P is an applicable assetacquisition.

(4) Asymmetrical transfers of assets.If, under general principles of tax law, aseller is not treated as transferring thesame assets as the purchaser is treated as

acquiring, the assets acquired by thepurchaser constitute a trade or business,and, except as provided in paragraph(b)(8) of this section, the purchaser’sbasis in the transferred assets is deter-mined wholly by reference to the pur-chaser’s consideration, then the pur-chaser is subject to section 1060.

(5) Related transactions.Whether theassets transferred constitute a trade orbusiness is determined by aggregatingall transfers from the seller to the pur-chaser in a series of related transactions.Except as provided in paragraph (b)(8)of this section, all assets transferredfrom the seller to the purchaser in a se-ries of related transactions are includedin the group of assets among which theconsideration paid or received in suchseries is allocated under the residualmethod. The principles of §1.338–1T(c)are also applied in determining whichassets are included in the group of assetsamong which the consideration paid orreceived is allocated under the residualmethod.

(6) More than a single trade or busi-ness. If the assets transferred from aseller to a purchaser include more thanone trade or business, then, in applyingthis section, all of the assets transferred(whether or not transferred in one trans-action or a series of related transactionsand whether or not part of a trade orbusiness) are treated as a single trade orbusiness.

(7) Covenant entered into by theseller. If, in connection with an applica-ble asset acquisition, the seller entersinto a covenant (e.g., a covenant not tocompete) with the purchaser, thatcovenant is treated as an asset trans-ferred as part of a trade or business.

(8) Partial non-recognition exchanges.A transfer may constitute an applicableasset acquisition notwithstanding the factthat no gain or loss is recognized with re-spect to a portion of the group of assetstransferred. All of the assets transferred,including the non-recognition assets, aretaken into account in determining whetherthe group of assets constitutes a trade orbusiness. The allocation of considerationunder paragraph (c) of this section is donewithout taking into account either thenon-recognition assets or the amount ofmoney or other property that is treated astransferred in exchange for the non-recog

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nition assets (together, the non-recogni-tion exchange property). The basis in andgain or loss recognized with respect to thenon-recognition exchange property aredetermined under such rules as wouldotherwise apply to an exchange of suchproperty. The amount of the money andother property treated as exchanged fornon-recognition assets is the amount bywhich the fair market value of the non-recognition assets transferred by oneparty exceeds the fair market value of thenon-recognition assets transferred by theother (to the extent of the money and thefair market value of property transferredin the exchange). The money and otherproperty that are treated as transferred inexchange for the non-recognition assets(and which are not included among theassets to which section 1060 applies) areconsidered to come from the followingassets in the following order: first fromClass I assets, then from Class II assets,then from Class III assets, then fromClass IV assets, then from Class V assets,then from Class VI assets, and then fromClass VII assets. For this purpose, liabili-ties assumed (or to which a non-recogni-tion exchange property is subject) aretreated as Class I assets. See Example 1in paragraph (d) of this section for an ex-ample of the application of section 1060to a single transaction which is, in part, anon-recognition exchange.

(c) Allocation of consideration amongassets under the residual method — (1)Consideration.The seller’s considerationis the amount, in the aggregate, realizedfrom selling the assets in the applicableasset acquisition under section 1001(b).

The purchaser’s consideration is theamount, in the aggregate, of its cost ofpurchasing the assets in the applicableasset acquisition that is properly takeninto account in basis.

(2) Allocation of consideration amongassets. For purposes of determining theseller’s amount realized for each of theassets sold in an applicable asset acquisi-tion, the seller allocates consideration toall the assets sold by using the residualmethod under §§1.338–6T and 1.338–7T,substituting consideration for ADSP. Forpurposes of determining the purchaser’sbasis in each of the assets purchased in anapplicable asset acquisition, the purchaserallocates consideration to all the assetspurchased by using the residual methodunder §§1.338–6T and 1.338–7T, substi-tuting consideration for AGUB. In allo-cating consideration, the rules set forth inparagraphs (c)(3) and (4) of this sectionapply in addition to the rules in§§1.338–6T and 1.338–7T.

(3) Certain costs. The seller and pur-chaser each adjusts the amount allocatedto an individual asset to take into accountthe specific identifiable costs incurred intransferring that asset in connection withthe applicable asset acquisition (e.g., realestate transfer costs or security interestperfection costs). Costs so allocated in-crease, or decrease, as appropriate, thetotal consideration that is allocated underthe residual method. No adjustment ismade to the amount allocated to an indi-vidual asset for general costs associatedwith the applicable asset acquisition as awhole or with groups of assets includedtherein (e.g., non-specific appraisal fees

or accounting fees). These latter amountsare taken into account only indirectlythrough their effect on the total considera-tion to be allocated.

(4) Effect of agreement betweenparties. If, in connection with an applica-ble asset acquisition, the seller and pur-chaser agree in writing as to the allocationof any amount of consideration to, or as tothe fair market value of, any of the assets,such agreement is binding on them to theextent provided in this paragraph (c)(4).Nothing in this paragraph (c)(4) restrictsthe Commissioner’s authority to chal-lenge the allocations or values arrived atin an allocation agreement. This para-graph (c)(4) does not apply if the partiesare able to refute the allocation or valua-tion under the standards set forth in Com-missioner v. Danielson, 378 F.2d 771 (3dCir.), cert. denied, 389 U.S. 858 (1967) (aparty wishing to challenge the tax conse-quences of an agreement as construed bythe Commissioner must offer proof that,in an action between the parties to theagreement, would be admissible to alterthat construction or show its unenforce-ability because of mistake, undue influ-ence, fraud, duress, etc.).

(d) Examples.The following examplesillustrate this section:

Example 1. (i) On January 1, 2001, A transfersassets X, Y, and Z to B in exchange for assets D, E,and F plus $1,000 cash.

(ii) Assume the exchange of assets constitutes anexchange of like-kind property to which section1031 applies. Assume also that goodwill or goingconcern value could under any circumstances attachto each of the DEF and XYZ groups of assets and,therefore, each group constitutes a trade or businessunder section 1060.

(iii) Assume the fair market values of the assetsand the amount of money transferred are as follows:

2000–4 I.R.B. 363 January 24, 2000

By A By BAsset Fair Market Value Asset Fair Market Value

X . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 400 D . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 40

Y . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400 E . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Z . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 F . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Cash (amount) . . . . . . . . . . . . . . . . . 1,000

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,000 Total. . . . . . . . . . . . . . . . . . . . . . . $ 1,100

(iv) Under paragraph (b)(8) of this section, forpurposes of allocating consideration under para-graph (c) of this section, the like-kind assets ex-changed and any money or other property that aretreated as transferred in exchange for the like-kindproperty are excluded from the application of sec-tion 1060.

(v) Since assets X, Y, and Z are like-kind prop-erty, they are excluded from the application of thesection 1060 allocation rules.

(vi) Since assets D, E, and F are like-kind prop-erty, they are excluded from the application of thesection 1060 allocation rules. In addition, $900 ofthe $1,000 cash B gave to A for A’s like-kind assetsis treated as transferred in exchange for the like-kindproperty in order to equalize the fair market valuesof the like-kind assets. Therefore, $900 of the cashis excluded from the application of the section 1060allocation rules.

(vii) $100 of the cash is allocated under section

1060 and paragraph (c) of this section.(viii) A, as transferor of assets X, Y, and Z, re-

ceived $100 that must be allocated under section1060 and paragraph (c) of this section. Since Atransferred no Class I, II, III, IV, V, or VI assets towhich section 1060 applies, in determining itsamount realized for the part of the exchange towhich section 1031 does not apply, the $100 is allo-cated to Class VII assets (goodwill and going con-cern value).

IRB 2000-4 1/28/00 10:26 AM Page 363

(ix) A, as transferee of assets D, E, and F, gaveconsideration only for assets to which section 1031applies. Therefore, the allocation rules of section1060 and paragraph (c) of this section are not ap-plied to determine the bases of the assets A received.

(x) B, as transferor of assets D, E, and F, receivedconsideration only for assets to which section 1031applies. Therefore, the allocation rules of section1060 do not apply in determining B’s gain or loss.

(xi) B, as transferee of assets X, Y, and Z, gave A$100 that must be allocated under section 1060 andparagraph (c) of this section. Since B received fromA no Class I, II, III, IV, V, or VI assets to which sec-tion 1060 applies, the $100 consideration is allo-cated by B to Class VII assets (goodwill and goingconcern value).

Example 2.(i) On January 1, 2001, S, a sole pro-prietor, sells to P, a corporation, a group of assetsthat constitutes a trade or business under paragraph(b)(2) of this section. S, who plans to retire immedi-ately, also executes in P’s favor a covenant not tocompete. P pays S $3,000 in cash and assumes$1,000 in liabilities. Thus, the total consideration is$4,000.

(ii) On the purchase date, P and S also execute aseparate agreement that states that the fair marketvalues of the Class II, Class III, Class V, and ClassVI assets S sold to P are as follows:Asset Asset Fair Class Market

Value

II Actively traded securities . . . . . $ 500

Total Class II . . . . . . . . . . . 500

III Accounts receivable . . . . . . . . . 200

Total Class III . . . . . . . . . . . 200

V Furniture and fixtures . . . . . . . . 800

Building . . . . . . . . . . . . . . . . . . 800

Land . . . . . . . . . . . . . . . . . . . . . 200

Equipment . . . . . . . . . . . . . . . . . 400

Total Class V . . . . . . . . . . . 2,200

VI Covenant not to compete . . . . . 900

Total Class VI . . . . . . . . . . 900(iii) P and S each allocate the consideration in the

transaction among the assets transferred under para-graph (c) of this section in accordance with theagreed upon fair market values of the assets, so that$500 is allocated to Class II assets, $200 is allocatedto the Class III asset, $2,200 is allocated to Class Vassets, $900 is allocated to Class VI assets, and $200

($4,000 total consideration less $3,800 allocated toassets in Classes II, III, V, and VI) is allocated to theClass VII assets (goodwill and going concern value).

(iv) In connection with the examination of P’s re-turn, the District Director, in determining the fairmarket values of the assets transferred, may disre-gard the parties’ agreement. Assume that the Dis-trict Director correctly determines that the fair mar-ket value of the covenant not to compete was $500.Since the allocation of consideration among Class II,III, V, and VI assets results in allocation up to thefair market value limitation, the $600 of unallocatedconsideration resulting from the District Director’sredetermination of the value of the covenant not tocompete is allocated to Class VII assets (goodwilland going concern value).

(e) Reporting requirements—(1) Applic-able asset acquisitions—(i) In general.Unless otherwise excluded from this re-quirement by the Commissioner, the sellerand the purchaser in an applicable asset ac-quisition each must report information con-cerning the amount of consideration in thetransaction and its allocation among the as-sets transferred. They also must report in-formation concerning subsequent adjust-ments to consideration.

(ii) Time and manner of reporting—(A)In general. The seller and the purchasereach must file asset acquisition statementson Form 8594 with their income tax returnsor returns of income for the taxable yearthat includes the first date assets are soldpursuant to an applicable asset acquisition.This reporting requirement applies to allasset acquisitions described in this section.For reporting requirements relating to assetacquisitions occurring before January 6,2000, as described in paragraph (a)(2) ofthis section, see the temporary regulationsunder section 1060 in effect prior to Janu-ary 6, 2000 (§1.1060–1T as contained in 26CFR part 1 revised April 1, 1999).

(B) Additional reporting requirement.When an increase or decrease in considera-tion is taken into account after the close of

the first taxable year that includes the firstdate assets are sold in an applicable assetacquisition, the seller and the purchasereach must file a supplemental asset acquisi-tion statement on Form 8594 with the in-come tax return or return of income for thetaxable year in which the increase (or de-crease) is properly taken into account.

(2) Transfers of interests in partner-ships. For reporting requirements relatingto the transfer of a partnership interest,see §1.755–2T(c).

PART 602—OMB CONTROLNUMBERS UNDER PAPERWORKREDUCTION ACT

Par. 14. The authority citation for part602 continues to read as follows:

Authority: 26 U.S.C. 7805.Par. 15. In §602.101, paragraph (b) is

amended by removing the entries for§§1.338–1, 1.338(b)–1, 1.338(h)(10)–1,and 1.1060–1T from the tables and addingnew entries to the table in numerical orderto read as follows:§602.101 OMB Control numbers.* * * * *

(b) * * *

Robert E. Wenzel,Deputy Commissioner

of Internal Revenue.

Approved December 22, 1999.

Jonathan Talisman,Acting Assistant Secretary of the

Treasury.

(Filed by the Office of the Federal Register on Janu-ary 5, 2000, 8:45 a.m., and published in the issue ofthe Federal Register for January 7, 2000, 65 F.R.1235)

January 24, 2000 364 2000–4 I.R.B.

CFR part or section where Current OMBidentified and described control No.

* * * * *

1.338–2T . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-16581.338–5T . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-16581.338–10T . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-16581.338–(h)(10)–1T . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-1658

* * * * *

IRB 2000-4 1/28/00 10:26 AM Page 364

Section 832.—InsuranceCompany Taxable Income

26 CFR 1.832–4: Gross Income.

T.D. 8857

DEPARTMENT OF THE TREASURYInternal Revenue Service26 CFR Part 1

Determination of UnderwritingIncome

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document containsfinal regulations relating to the determina-tion of underwriting income by insurancecompanies other than life insurance com-panies. In computing underwriting in-come, non-life insurance companies arerequired to reduce by 20 percent their de-ductions for increases in unearned premi-ums. This requirement was enacted aspart of the Tax Reform Act of 1986.These regulations provide guidance tonon-life insurance companies for pur-poses of determining the amount of un-earned premiums that are subject to the 20percent reduction rule.

DATES: The regulations are effectiveJanuary 5, 2000.

FOR FURTHER INFORMATION CON-TACT: Gary Geisler, (202) 622-3970(not a toll-free number)

SUPPLEMENTARY INFORMATION:

Background

On January 2, 1997, the IRS publishedin the Federal Registera notice of pro-posed rulemaking (REG–209839–96,1997–1 C.B. 780 [62 F.R. 72]) proposingamendments to the Income Tax Regula-tions (26 CFR part 1) under section832(b) of the Internal Revenue Code.The IRS received a number of writtencomments on the proposed regulations.On April 30, 1997, the IRS held a publichearing on the proposed regulations.After consideration of all written and oral

comments regarding the proposed regula-tions, those regulations are adopted as re-vised by this Treasury decision.

Explanation of Revisions andSummary of Comments

Underwriting income

A non-life insurance company’s under-writing income equals its premiumsearned on insurance contracts during thetaxable year less its losses incurred on in-surance contracts and its expenses in-curred.1 Seesection 832(b)(3). To com-pute premiums earned, the company startswith the gross premiums written on insur-ance contracts during the taxable year,subtracts return premiums and premiumspaid for reinsurance, and makes an adjust-ment to reflect the change in its unearnedpremiums over the course of the taxableyear. Seesection 832(b)(4). This compu-tation results in premiums being recog-nized in underwriting income over theterm of the insurance contract, rather thanin the taxable year in which the premiumsare billed or received from the policy-holder.

Prior to 1987, 100 percent of thechange in unearned premiums during thetaxable year was taken into account as anincrease or decrease to written premiumsin computing premiums earned. Thistreatment “generally reflect[ed]” the ac-counting conventions (often referred toas “statutory accounting principles”)used to prepare a non-life insurancecompany’s annual statement for state in-surance regulatory purposes. See2 H.R.Conf. Rep. No. 841, 99th Cong., 2d Sess.II-354 (1986), 1986–3 C.B. (Vol. 4) 354;S. Rep. No. 313, 99th Cong., 2d Sess.495 (1986), 1986–3 C.B. (Vol. 3) 495,H.R. Rep. No. 426, 99th Cong., 1st Sess.668 (1985), 1986–3 C.B. (Vol. 2) 668.Because unearned premiums are com-puted on the basis of the gross premiumsfor an insurance contract, the amount ofunearned premiums reflects not only the

portion of the gross premium allocableto future insurance claims but also theportion allocable to the insurance com-pany’s expenses and profit on the insur-ance contract.

In 1986, Congress determined that de-ferring unearned premium income andcurrently deducting premium acquisitionexpenses attributable to unearned premi-ums resulted in a mismatch of an insur-ance company’s net income and expense.Congress decided to require a bettermeasurement of net income for Federalincome tax purposes. SeeH.R. Rep. No.426, 1986–3 C.B. (Vol. 2) at 669; S. Rep.No. 313, 1986–3 C.B. (Vol. 3) at 496.Rather than defer the deduction for pre-mium acquisition expenses attributableto unearned premiums, Congress re-duced by 20 percent the adjustment forunearned premiums. For taxable yearsbeginning on or after January 1, 1993, anon-life insurance company’s premiumsearned is an amount equal to: (1) itsgross premiums written, less both returnpremiums and premiums paid for rein-surance; plus (2) 80 percent of unearnedpremiums at the end of the prior taxableyear, less 80 percent of unearned premi-ums at the end of the current taxableyear. Section 832(b)(4). The accelera-tion of income that is typically generatedby the 20 percent reduction of unearnedpremiums is intended to be roughlyequivalent to denying current deductibil-ity for the portion of the insurance com-pany’s premium acquisition expenses al-locable to the unearned premiums. See2H.R. Conf. Rep. No. 841, 1986–3 C.B.(Vol. 4) at 354–55; S. Rep. No. 313,1986–3 C.B. (Vol. 3) at 495–98; H.R.Rep. No. 426, 1986–3 C.B. (Vol. 2) at668–70.

Role of the annual statement

The proposed regulations provide defi-nitions of the items used to determine pre-miums earned under section 832(b)(4)and timing rules for taking these itemsinto account for Federal income tax pur-poses. The treatment provided in the pro-posed regulations would apply regardlessof the classification or method of report-ing the items used on an insurance com-pany’s annual statement.

Several comments questioned whetherthere is legal authority to require an in-surance company to use a method to cal-

2000–4 I.R.B. 365 January 24, 2000

1For this purpose, expenses incurred generally refersto the expenses reported on the company’s annualstatement approved by the National Association ofInsurance Commissioners (NAIC) and filed for stateinsurance regulatory purposes, less expensesincurred which are not allowed as deductions undersection 832(c). Seesection 832(b)(6). Expensesincurred generally include premium acquisitionexpenses attributable to unearned premiums oninsurance contracts.

IRB 2000-4 1/28/00 10:26 AM Page 365

culate premiums earned for Federal in-come tax purposes that differs from themethod that the company is permitted touse to calculate premiums earned on itsannual statement. As noted in the pre-amble to the proposed regulations, theexisting regulations under§1.832–4(a)(2) state that the annualstatement “. . . insofar as it is not incon-sistent with the provisions of the Code . ..” will be recognized and used as a basisfor computing the net income of a non-life insurance company. Also, if statu-tory accounting principles permit alter-native practices, one or more of whichdo not clearly reflect income as definedby the Code, the company is required forFederal income tax purposes to use amethod that clearly reflects income.Section 446(b) and §1.446–1(a)(2).

Gross premiums written

The proposed regulations generally de-fine gross premiums written as the totalamounts payable for insurance coverageunder insurance or reinsurance contractsissued or renewed during the taxable year.The proposed regulations, however, donot address situations where the amountscharged for insurance coverage maychange due to increases or decreases incoverage limits, additions or deletions inproperty or risks covered, changes in lo-cation or status of insureds, or other simi-lar factors.

The final regulations define an insur-ance company’s “gross premiums writ-ten” on insurance contracts (which in-cludes premiums attr ibutable toreinsurance contracts) as amountspayable for insurance coverage for theeffective periods of the contracts. Thelabel placed on a payment in a contractdoes not determine whether an amountis a gross premiums written. The effec-tive period of a contract is the periodover which one or more rates for insur-ance coverage are guaranteed in the con-tract. If a new rate for insurance cover-age is guaranteed after the effective dateof an insurance contract, the making ofthe guarantee generally is treated as theissuance of a new insurance contractwith an effective period equal to the du-ration of the new guaranteed rate for in-surance coverage.

Under the final regulations, gross pre-miums written include: (1) additional

premiums resulting from increases inrisk exposure during the effective periodof an insurance contract; (2) amountssubtracted from a premium stabilizationreserve that are used to pay premiums;and (3) consideration for assuming in-surance liabilities under contracts not is-sued by the insurance company (that is,a payment or transfer of property in anassumption reinsurance transaction).Gross premiums written, however, donot include other items of gross incomedescribed in section 832(b)(1)(C). Tothe extent that amounts paid or payableto an insurance company with respect toan arrangement are not gross premiumswritten, the insurance company may nottreat amounts payable to customers withrespect to the applicable portion of sucharrangements as losses incurred de-scribed in section 832(b)(5).

Method of reporting gross premiumswritten

The proposed regulations provide that anon-life insurance company reports thefull amount of gross premiums written foran insurance contract for the earlier of thetaxable year which includes the effectivedate of the contract or the year in whichall or a portion of the premium for thecontract is received. A variety of com-ments were received with respect to theapplication of this timing rule to insur-ance contracts with installment premi-ums. In response to comments, the finalregulations provide a number of excep-tions from the general rule with respect towhen an insurance company reports grosspremiums written.

Advance premiums

Under the proposed regulations, a non-life insurance company that receives aportion of the premium for an insurancecontract prior to the effective date of thecontract includes the full amount of thepremium in gross premiums written forthe taxable year during which the portionof the premium was received.

Several comments addressed the treat-ment of advance premiums in the pro-posed regulations. One comment en-dorsed the proposed treatment of advancepremiums, noting that it is proper understatutory accounting principles to recordthe full amount of gross premiums writtenand expenses incurred with respect to a

casualty insurance policy for the year inwhich an advance premium is received.2

Other comments argued that since thepolicyholder may demand a refund of anadvance premium prior to the policy’s ef-fective date, the company should be per-mitted to treat an advance premium as anontaxable deposit until such time as cov-erage begins under the contract. Alterna-tively, these comments urged that thecompany be permitted to report only theadvance premium (rather than the entiregross premium for the contract) in grosspremiums written for the taxable year ofreceipt, and to report the remainder of thegross premium for the taxable year thatincludes the contract’s effective date.These comments also indicated that com-panies generally do not deduct the fullamount of premium acquisition expensesfor the contract in the taxable year inwhich they receive advance premiums.

In response to comments, the finalregulations permit an insurance companythat receives part of the gross premiumfor an insurance contract prior to the ef-fective date of the contract to report onlythe advance premium (rather than thefull amount of the gross premium writtenfor the contract) in gross premiums writ-ten for the taxable year of receipt. Theremainder of the gross premium for theinsurance contract is included in grosspremiums written for the taxable yearwhich includes the effective date of thecontract. This method of reporting grosspremiums written is available only if thecompany’s deduction for premium ac-quisition expenses attributable to thecontract does not exceed a limitationspecified in the regulations, which is in-tended to ensure that a company does notdeduct premium acquisition expenses at-tributable to an insurance contract morerapidly than the company includes pre-miums for the insurance contract in itsgross premiums written. Companies thatadopt this method of reporting gross pre-

January 24, 2000 366 2000–4 I.R.B.

2Prior to 1989, advance premiums were required tobe reported in written premiums and unearned pre-miums on a non-life insurance company’s annualstatement. However, statutory accounting principleswere later modified to permit advance premiums tobe accumulated in a suspense account and reportedas a write-in liability on the annual statement. Acompany electing to use this alternative treatmentwould not report advance premiums in either writtenpremiums or unearned premiums on its annual state-ment until the effective date of the underlying cov-erage.

IRB 2000-4 1/28/00 10:26 AM Page 366

miums written must use this method forall insurance contracts with advance pre-miums.

Accident and health insurancecontracts

The proposed regulations have no spe-cial rules for determining gross premiumswritten with respect to accident and healthinsurance contracts. Several commentsindicated that the longstanding practice ofinsurance companies that issue accidentand health insurance contracts with in-stallment premiums is to include amountsin gross premiums written for the taxableyear in which the installment premiumsbecome due under the contracts. Thesecomments also stated that companies gen-erally do not deduct premium acquisitionexpenses allocable to installment premi-ums not yet due or received with respectto accident and health insurance con-tracts.

In response to comments, the final reg-ulations permit a non- life insurance com-pany that either issues or proportionallyreinsures cancellable accident and healthinsurance contracts with installment pre-miums to report the installment premiumsin gross premiums written for the earlierof the taxable year in which the install-ment premiums become due under theterms of the contract or the taxable year inwhich the installment premiums are re-ceived. This method of reporting grosspremiums written for cancellable accidentand health insurance contracts with in-stallment premiums is available only ifthe company’s deduction for premium ac-quisition expenses attributable to thosecontracts does not exceed the matchinglimitation specified in the regulations.Companies that adopt this method of re-porting gross premiums written must useit for all cancellable accident and healthinsurance contracts with installment pre-miums.

Multi-year contracts with installmentpremiums

The final regulations also provide anexception with respect to the reportingof gross premiums written for a multi-year insurance contract for which thegross premium is payable in install-ments over the effective period of thecontract. Under the final regulations, acompany may treat this type of multi-

year insurance contract as a series ofseparate insurance contracts. The firstinsurance contract in the series will betreated as having an effective period of12 months. Subsequent insurance con-tracts in the series will be treated as hav-ing an effective period equal to thelesser of 12 months or the remainder ofthe period for which the rates for insur-ance coverage are guaranteed in themulti-year insurance contract.

This method of reporting gross pre-mium written for a multi-year insurancecontract with installment premiums isavailable only if the company’s deduc-tion for premium acquisition expensesattributable to the contract does not ex-ceed the matching limitation specified inthe regulations. Companies that adoptthis method of reporting gross premiumswritten for a multi-year insurance con-tract must use it for all multi-year con-tracts with installment premiums.

Contracts that give rise to lifeinsurance reserves

Some insurance companies that are tax-able under Part II of Subchapter L issue orreinsure risks relating to guaranteed re-newable accident and health insurancecontracts or other contracts that give riseto “life insurance reserves” (as defined insection 816(b)). For these companies,section 832(b)(4) provides that unearnedpremiums includes the amount of thecompany’s life insurance reserves, as de-termined under section 807. However,under section 832(b)(7), the unearnedpremiums for contracts giving rise to lifeinsurance reserves are not reduced by 20percent. Instead, an amount of otherwisedeductible expenses equal to a percentageof the net premiums for the contracts mustbe capitalized and amortized as specifiedpolicy acquisition expenses under section848.3 For purposes of determining theamount of specified policy acquisition ex-penses under section 848, a non-life in-surance company computes net premiumsfor the contracts in accordance with sec-tion 811(a). Seesection 848(d)(2). Thus,with respect to contracts described in sec-tion 832(b)(7), a non-life insurance com-pany does not take into account unpaidpremiums attributable to insurance cover-

age not yet provided (such as deferred anduncollected premium installments) in de-termining the amount of specified policyacquisition expenses required to be amor-tized under section 848. The proposedregulations do not provide special rulesfor determining gross premiums writtenwith respect to contracts described in sec-tion 832(b)(7). Under the final regula-tions, a non-life insurance company thatissues or reinsures the risks related to acontract described in section 832(b)(7)may report gross premiums written for thecontract in the manner required for life in-surance companies under sections 803and 811. This method of reporting grosspremiums written for contracts describedin section 832(b)(7) is available only ifthe company also determines its deduc-tion for premium acquisition expenses forthe contracts in accordance with section811(a), as adjusted by the amount re-quired to be amortized under section 848based on the net premiums of the con-tracts. Thus, the final regulations ensurethat the rules for determining premium in-come and amortizing premium acquisi-tion expenses for contracts described insection 832(b)(7) operate consistently,whether the issuing company is a non-lifeinsurance company or a life insurancecompany.

Fluctuating risk contracts

The method of reporting gross premi-ums written for certain insurance con-tracts covering fluctuating risks is re-served in the proposed regulations. Somecomments requested that the final regula-tions not address the method of reportinggross premiums written for insurancecontracts covering fluctuating risks, not-ing that the method of recording grosswritten premiums for these policies forannual statement reporting purposes wasbeing considered by the NAIC as part ofits project to codify statutory accountingprinciples. Subsequently, the NAIC is-sued guidance permitting an insurancecompany for annual statement purposes toreport written premiums on workers’compensation policies (but not on othercasualty contracts involving “fluctuatingrisks,” such as commercial automobile li-ability and product liability policies) ei-ther on the effective date of the insurancecontract or based on installment billingsto the policyholder. By contrast, with re-

2000–4 I.R.B. 367 January 24, 2000

3Under section 848(e)(5), a contract that reinsures acontract subject to section 848 is treated in the samemanner as the reinsured contract.

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spect to other types of casualty insurancepolicies, the NAIC reaffirmed the generalrule that gross premiums with respect tothese policies must be recorded on the an-nual statement on the effective date of theinsurance contract.

The final regulations do not permit anon-life insurance company to reportgross premiums written for a fluctuatingrisk contract based on installment billingsto the policyholder. Rather, the final reg-ulations require a company generally toreport the gross premiums written for thecontract for the earlier of the taxable yearwhich includes the effective date of thecontract or the year in which all or a por-tion of the premium for the contract is re-ceived, with special rules for advance pre-miums, cancellable accident and healthcontracts, multi-year insurance contracts,and contracts described in section832(b)(7). The company reports any ad-ditional premiums resulting from an in-crease in risk exposure in gross premiumswritten for the taxable year in which thechange in risk exposure occurs. Unlessthe increase in risk exposure is of tempo-rary duration, the company determinesthe additional premium resulting from achange in risk exposure based on the re-mainder of the effective period of the con-tract.

Return premiums

The proposed regulations define returnpremiums as amounts (other than policy-holder dividends or claims and benefitpayments) paid or credited to the policy-holder in accordance with the terms of aninsurance contract. Under the final regu-lations, return premiums are amounts pre-viously included in an insurance com-pany’s gross premiums written, which arerefundable to the policyholder (or the ced-ing company with respect of a reinsuranceagreement) if the amounts are fixed by theinsurance contract and do not depend onthe experience of the insurance companyor the discretion of its management. Thisrule incorporates a specific definition ofpolicyholder dividends.

The final regulations list a number ofitems which are included in return premi-ums, to the extent they have previouslybeen included in gross premiums written.These items include: (1) amounts that arerefundable due to policy cancellations ordecreases in risk exposure during the ef-

fective period of an insurance contract;(2) the unearned portion of unpaid premi-ums for an insurance contract that is can-celed or for which there is a decrease inrisk exposure during its effective period;and (3) amounts that are either refundableor that reflect the unearned portion of un-paid premiums for an insurance contract,arising from the redetermination of thepremium due to correction of posting orother similar errors.

In addition, the final regulation pro-vides timing rules for the deduction of re-turn premiums. If a contract is canceled,the return premium arising from that can-cellation is deducted in the taxable year inwhich the contract is canceled. If there isa reduction in risk exposure under an in-surance contract that gives rise to a returnpremium, such return premium is de-ductible in the taxable year in which thereduction in risk exposure occurs.

Retrospectively rated insurancecontracts

The proposed regulations provide thatgross written premiums include an insur-ance company’s estimate of additionalpremiums (retro debits) to be receivedwith regard to the expired portion of a ret-rospectively rated insurance or reinsur-ance contract. The proposed regulationsalso provide that return premiums includean insurance company’s estimate ofamounts to be refunded to policyholders(retro credits) with regard to the expiredportion of a retrospectively rated insur-ance or reinsurance contract. The pro-posed regulations, therefore, would mod-ify the treatment of retro credits under§1.832–4(a)(3)(ii) of the existing regula-tions, which treat retro credits as un-earned premiums. At the option of thetaxpayer, however, the proposed regula-tions permit a company to continue to in-clude gross retro credits (but not grossretro debits) in the amount of unearnedpremiums subject to the 20 percent reduc-tion under section 832(b)(4)(B).

A variety of comments were receivedwith respect to the treatment of retro deb-its and retro credits in the proposed regu-lations. Most comments approved of theproposed rule to modify the treatment ofretro credits in §1.832–4(a)(3)(ii) and, in-stead, to permit retro credits to be ac-counted for as part of return premiums.Some comments contended, however, that

the method of netting retro debits andretro credits as an adjustment to unearnedpremiums was required under NAIC ac-counting rules, prior case law, and theService’s published rulings interpreting§1.832–4(a)(3)(ii). These comments ar-gued that the enactment of the 20 percentreduction rule in 1986 did not authorizethe Service to change the items includedin unearned premiums, including the his-torical treatment of retro debits and retrocredits as part of unearned premiums.Other comments contended that retro deb-its (but not retro credits) should be dis-counted using the applicable discount fac-tors for unpaid losses under section 846.These comments argued that there is a di-rect correlation between amounts reportedby an insurance company as retro debitsand the company’s related liabilities forunpaid losses and unpaid loss adjustmentexpenses. Therefore, the comments urgedthat, to achieve proper matching of theseitems, a non-life insurance companyshould be permitted either to report retrodebits as a subtraction from unearned pre-miums or to discount the retro debitsusing the applicable discount factorsunder section 846 for the related line ofbusiness.

The treatment of retro debits and retrocredits in the proposed regulations waspremised on the assumptions that retro-spectively rated arrangements could qual-ify as insurance contracts for tax pur-poses, and that all amounts payable undersuch arrangements could be considered tohave been paid for insurance coverage.The final regulations provide that grosspremiums are amounts paid for insurancecoverage. Similarly, unearned premiumsand return premiums only includeamounts included in gross written premi-ums. The final regulations also providethat retro credits are not included in un-earned premiums, and retro debits cannotbe subtracted from unearned premiums.The final regulations do not permitamounts includable in gross premiumswritten to be discounted, regardless ofwhen such amounts are paid to the insur-ance company.

The final regulations do not provideany inference as to whether some or all ofa retrospective arrangement can qualify asan insurance contract, or as to whether orthe extent to which amounts paid orpayable to an insurance company with re-

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spect to a retrospective arrangement arefor insurance coverage.

Premium stabilization reserves

Several comments asked for clarifica-tion of the treatment of premium stabi-lization reserves.4 As noted below, thefinal regulations provide that retro creditsare not unearned premiums for Federal in-come tax purposes. Thus, retro creditsadded to premium stabilization reservesare not unearned premiums for Federal in-come tax purposes. The final regulationsalso provide that amounts withdrawnfrom a premium stabilization reserve topay premiums are included in gross pre-miums written for the taxable year inwhich these amounts are withdrawn fromthe stabilization reserve for that purpose.

Unearned premiums

The proposed regulations define un-earned premiums as the portion of thegross premiums written that is attributableto future insurance coverage to be pro-vided under an insurance or reinsurancecontract. The final regulations generallyretain the rules relating to unearned pre-miums. Consistent with the existing reg-ulations under §1.801–4(a), the final reg-ulations provide that an insurancecompany must exclude from unearnedpremiums amounts attributable to the netvalue of risks reinsured with, or retro-ceded to, another insurance company.The final regulations also provide that un-earned premiums do not include a liabilityestablished by an insurance company onits annual statement to cover premium de-ficiencies.

The proposed regulations provide thatan insurance company may consider theincidence or pattern of the insured risks indetermining the portion of the gross pre-mium written that is attributable to the un-expired portion of the insurance coverage.The final regulations clarify that, if therisk of loss under an insurance contract

does not vary significantly over the effec-tive period of the contract, the unearnedpremium attributable to the unexpiredportion of the effective period of the con-tract is determined on a pro rata basis.However, if the risk of loss under an in-surance contract varies significantly overthe effective period of the contract, the in-surance company may consider the pat-tern and incidence of the risk in determin-ing the portion of gross premium whichare attributable to the unexpired portionof the effective period of the contract,provided that the company maintains suf-ficient information to demonstrate that itsmethod of computing unearned premiumsaccurately reflects the pattern and inci-dence of the risk for the insurance con-tract.

Effective date and transition rules

Under the proposed regulations, thenew rules apply to the determination ofpremiums earned for insurance contractsissued or renewed during taxable yearsbeginning after January 6, 2000. Severalcomments requested that the regulationspermit an insurance company to adopt thenew rules for determining premiumsearned as a change in method of account-ing deemed made with the Commission-ers’ consent, with audit protection forprior years. These comments also urgedthat the insurance company be given theoption of either implementing the changein method of accounting on a cut-off basisor spreading the section 481(a) adjust-ments resulting from the change over anumber of years consistent with the Com-missioner’s general administrative proce-dures when a taxpayer files a request tochange a method of accounting under sec-tion 446(e).

In response to these comments, the finalregulations permit taxpayers to changetheir method of accounting for determin-ing premiums earned to comply with thefinal regulations under the automaticchange in method of accounting provi-sions of Rev. Proc. 99–49, 1999–52 I.R.B.725, subject to certain limitations. A tax-payer makes the automatic change inmethod of accounting on its Federal in-come tax return for the first taxable yearbeginning after December 31, 1999. Thescope limitations in section 4.02 of Rev.Proc. 99–49 do not apply to a taxpayer’sautomatic change in method of accounting

pursuant to this regulation. The timely du-plicate filing requirement in section 6.02of Rev. Proc. 99–49 also does not apply tothis change. If the taxpayer’s method ofcomputing earned premiums was an issueunder consideration (within the meaningof section 3.09 of Rev. Proc. 99–49) onJanuary 5, 2000, however, then the auditprotection rule in section 7.01 of Rev.Proc. 99–49 does not apply to the tax-payer’s change in method of accounting.

Special Analyses

It has been determined that this TreasuryDecision is not a significant regulatory ac-tion as defined in Executive Order 12866.Therefore, a regulatory assessment is notrequired. It also has been determined thatsection 553(b) of the Administrative Pro-cedure Act (5 U.S.C. chapter 5) does notapply to these regulations, and, becausethese regulations do not impose on smallentities a collection of information require-ment, the Regulatory Flexibility Act (5U.S.C. chapter 6) does not apply. There-fore, a Regulatory Flexibility Analysis isnot required. Pursuant to section 7805(f)of the Internal Revenue Code, the notice ofproposed rulemaking preceding these reg-ulations was submitted to the Chief Coun-sel for Advocacy of the Small BusinessAdministration for comment on its impacton small business.

Drafting Information

The principal author of these regula-tions is Gary Geisler, Office of the Assis-tant Chief Counsel (Financial Institutionsand Products), IRS. However, other per-sonnel from the IRS and Treasury Depart-ment participated in their development.

Adoption of Amendments to theRegulations

Accordingly, 26 CFR part 1 is amendedas 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. Section 1.832–4 is amended as

follows:1. Paragraph (a)(3) is revised.2. Paragraphs (a)(4) and (a)(5) are re-

designated as paragraphs (a)(13) and(a)(14).

2000–4 I.R.B. 369 January 24, 2000

4In Rev. Rul. 97–5, 1997–1 C.B. 136, the Servicerevoked Rev. Rul. 70–480, 1970–2 C.B. 142, whichhad held that amounts held by a non-life insurancecompany in a premium stabilization reserve fundedby retro credits are not unearned premiums undersection 832(b)(4). Rev. Rul. 97–5 reasoned that theassumption in Rev. Rul. 70–480 that stabilizationreserves are part of the insurance company’s surpluswas erroneous.

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3. New paragraphs (a)(4) through(a)(12) are added.The additions and revisions read as fol-lows: §1.832–4 Gross income.

(a) * * * (3) Premiums earned. The determina-

tion of premiums earned on insurancecontracts during the taxable year beginswith the insurance company’s gross pre-miums written on insurance contracts dur-ing the taxable year, reduced by returnpremiums and premiums paid for reinsur-ance. Subject to the exceptions in sec-tions 832(b)(7), 832(b)(8), and 833(a)(3),this amount is increased by 80 percent ofthe unearned premiums on insurance con-tracts at the end of the preceding taxableyear, and is decreased by 80 percent of theunearned premiums on insurance con-tracts at the end of the current taxableyear.

(4) Gross premiums written—(i) Ingeneral. Gross premiums written areamounts payable for insurance coverage.The label placed on a payment in a con-tract does not determine whether anamount is a gross premium written.Gross premiums written do not includeother items of income described in sec-tion 832(b)(1)(C) (for example, chargesfor providing loss adjustment or claimsprocessing services under administrativeservices or cost-plus arrangements).Gross premiums written on an insurancecontract include all amounts payable forthe effective period of the insurance con-tract. To the extent that amounts paid orpayable with respect to an arrangementare not gross premiums written, the in-surance company may not treat amountspayable to customers under the applica-ble portion of such arrangements aslosses incurred described in section832(b)(5).

(ii) Items included. Gross premiumswritten include—

(A) Any additional premiums resultingfrom increases in risk exposure during theeffective` period of an insurance contract;

(B) Amounts subtracted from a pre-mium stabilization reserve to pay for in-surance coverage; and

(C) Consideration in respect of assum-ing insurance liabilities under insurancecontracts not issued by the taxpayer (suchas a payment or transfer of property in anassumption reinsurance transaction).

(5) Method of reporting gross premi-ums written—(i) In general. Except asotherwise provided under this paragraph(a)(5), an insurance company reportsgross premiums written for the earlier ofthe taxable year that includes the effectivedate of the insurance contract or the yearin which the company receives all or aportion of the gross premium for the in-surance contract. The effective date ofthe insurance contract is the date onwhich the insurance coverage provided bythe contract commences. The effectiveperiod of an insurance contract is the pe-riod over which one or more rates for in-surance coverage are guaranteed in thecontract. If a new rate for insurance cov-erage is guaranteed after the effective dateof an insurance contract, the making ofsuch a guarantee generally is treated asthe issuance of a new insurance contractwith an effective period equal to the dura-tion of the new guaranteed rate for insur-ance coverage.

(ii) Special rule for additional premi-ums resulting from an increase in riskexposure. An insurance company reportsadditional premiums that result from anincrease in risk exposure during the ef-fective period of an insurance contract ingross premiums written for the taxableyear in which the change in risk expo-sure occurs. Unless the increase in riskexposure is of temporary duration (forexample, an increase in risk exposureunder a workers’ compensation policydue to seasonal variations in the policy-holder’s payroll), the company reportsadditional premiums resulting from anincrease in risk exposure based on the re-mainder of the effective period of the in-surance contract.

(iii) Exception for certain advancepremiums. If an insurance company re-ceives a portion of the gross premium foran insurance contract prior to the first dayof the taxable year that includes the effec-tive date of the contract, the companymay report the advance premium (ratherthan the full amount of the gross premiumfor the contract) in gross premiums writ-ten for the taxable year in which the ad-vance premium is received. An insurancecompany may adopt this method of re-porting advance premiums only if thecompany’s deduction for premium acqui-sition expenses for the taxable year inwhich the company receives the advance

premium does not exceed the limitation ofparagraph (a)(5)(vii) of this section. Acompany that reports an advance pre-mium in gross premiums written underthis paragraph (a)(5)(iii) takes into ac-count the remainder of the gross premiumwritten and premium acquisition expensesfor the contract in the taxable year that in-cludes the effective date of the contract.A company that adopts this method of re-porting advance premiums must use themethod for all contracts with advance pre-miums.

(iv) Exception for certain cancellableaccident and health insurance contractswith installment premiums. If an insur-ance company issues or proportionallyreinsures a cancellable accident andhealth insurance contract (other than acontract with an effective period that ex-ceeds 12 months) for which the gross pre-mium is payable in installments over theeffective period of the contract, the com-pany may report the installment premi-ums (rather than the total gross premiumfor the contract) in gross premiums writ-ten for the earlier of the taxable year inwhich the installment premiums are dueunder the terms of the contract or the yearin which the installment premiums are re-ceived. An insurance company mayadopt this method of reporting installmentpremiums for a cancellable accident andhealth insurance contract only if the com-pany’s deduction for premium acquisitionexpenses for the first taxable year inwhich an installment premium is due orreceived under the contract does not ex-ceed the limitation of paragraph(a)(5)(vii) of this section. A company thatadopts this method of reporting install-ment premiums for a cancellable accidentand health contract must use the methodfor all of its cancellable accident andhealth insurance contracts with install-ment premiums.

(v) Exception for certain multi-year in-surance contracts. If an insurance com-pany issues or proportionally reinsures aninsurance contract, other than a contractdescribed in paragraph (a)(5)(vi) of thissection, with an effective period that ex-ceeds 12 months, for which the gross pre-mium is payable in installments over theeffective period of the contract, the com-pany may treat the insurance coverageprovided under the multi-year contract asa series of separate insurance contracts.

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The first contract in the series is treated ashaving been written for an effective pe-riod of twelve months. Each subsequentcontract in the series is treated as havingbeen written for an effective period equalto the lesser of 12 months or the remain-der of the period for which the rates forinsurance coverage are guaranteed in themulti-year insurance contract. An insur-ance company may adopt this method ofreporting premiums on a multi-year con-tract only if the company’s deduction forpremium acquisition expenses for eachyear of the multi-year contract does notexceed the limitation of paragraph(a)(5)(vii) of this section. A company thatadopts this method of reporting premiumsfor a multi-year contract must use themethod for all multi-year contracts withinstallment premiums.

(vi) Exception for insurance contractsdescribed in section 832(b)(7). If an in-surance company issues or reinsures therisks related to a contract described insection 832(b)(7), the company may re-port gross premiums written for the con-tract in the manner required by sections803 and 811(a) for life insurance compa-nies. An insurance company may adoptthis method of reporting premiums oncontracts described in section 832(b)(7)only if the company also determines thededuction for premium acquisition costsfor the contract in accordance with sec-tion 811(a), as adjusted by the amount re-quired to be taken into account under sec-tion 848 in connection with the netpremiums of the contract. A companythat adopts this method of reporting pre-miums for a contract described in section832(b)(7) must use the method for all ofits contracts described in that section.

(vii) Limitation on deduction of pre-mium acquisition expenses. An insurancecompany’s deduction for premium acqui-sition expenses (for example, commis-sions, state premium taxes, overhead re-imbursements to agents or brokers, andother similar amounts) related to an insur-ance contract is within the limitation ofthis paragraph (a)(5)(vii) if–

(A) The ratio obtained by dividing thesum of the company’s deduction for pre-mium acquisition expenses related to theinsurance contract for the taxable yearand previous taxable years by the totalpremium acquisition expenses attribut-able to the insurance contract; does not

exceed(B) The ratio obtained by dividing the

sum of the amounts included in gross pre-miums written with regard to the insur-ance contract for the taxable year and pre-vious taxable years by the total grosspremium written for the insurance con-tract.

(viii) Change in method of reportinggross premiums. An insurance companythat adopts a method of accounting forgross premiums written and premium ac-quisition expenses described in paragraph(a)(5)(iii), (iv), (v), or (vi) of this sectionmust continue to use the method to reportgross premiums written and premium ac-quisition expenses unless the companyobtains the consent of the Commissionerto change to a different method under sec-tion 446(e) and §1.446–1(e).

(6) Return premiums—(i) In general.An insurance company’s liability for re-turn premiums includes amounts previ-ously included in an insurance company’sgross premiums written, which are re-fundable to a policyholder or ceding com-pany, provided that the amounts are fixedby the insurance contract and do not de-pend on the experience of the insurancecompany or the discretion of its manage-ment.

(ii) Items included. Return premiumsinclude amounts–

(A) Which were previously paid andbecome refundable due to policy cancel-lations or decreases in risk exposure dur-ing the effective period of an insurancecontract;

(B) Which reflect the unearned portionof unpaid premiums for an insurance con-tract that is canceled or for which there isa decrease in risk exposure during its ef-fective period; or

(C) Which are either previously paidand refundable or which reflect the un-earned portion of unpaid premiums for aninsurance contract, arising from the rede-termination of a premium due to correc-tion of posting or other similar errors.

(7) Method of reporting return premi-ums. An insurance company reports theliability for a return premium resultingfrom the cancellation of an insurance con-tract for the taxable year in which the con-tract is canceled. An insurance companyreports the liability for a return premiumattributable to a reduction in risk exposureunder an insurance contract for the tax-

able year in which the reduction in riskexposure occurs.

(8) Unearned premiums—(i) In gen-eral. The unearned premium for a con-tract, other than a contract described insection 816(b)(1)(B), generally is the por-tion of the gross premium written that isattributable to future insurance coverageduring the effective period of the insur-ance contract. However, unearned premi-ums held by an insurance company withregard to the net value of risks reinsuredwith other solvent companies (whether ornot authorized to conduct business understate law) are subtracted from the com-pany’s unearned premiums. Unearnedpremiums also do not include any addi-tional liability established by the insur-ance company on its annual statement tocover premium deficiencies. Unearnedpremiums do not include an insurancecompany’s estimate of its liability foramounts to be paid or credited to a cus-tomer with regard to the expired portionof a retrospectively rated contract (retrocredits). An insurance company’s esti-mate of additional amounts payable by itscustomers with regard to the expired por-tion of a retrospectively rated contract(retro debits) cannot be subtracted fromunearned premiums.

(ii) Special rules for unearned premi-ums. For purposes of computing “premi-ums earned on insurance contracts duringthe taxable year” under section 832(b)(4),the amount of unearned premiums in-cludes—

(A) Life insurance reserves (as definedin section 816(b), but computed in accor-dance with section 807(d) and sections811(c) and (d));

(B) In the case of a mutual flood or fireinsurance company described in section832(b)(1)(D) (with respect to contractsdescribed in that section), the amount ofunabsorbed premium deposits that thecompany would be obligated to return toits policyholders at the close of the tax-able year if all its insurance contractswere terminated at that time;

(C) In the case of an interinsurer orreciprocal underwriter that reports un-earned premiums on its annual statementnet of premium acquisition expenses, theunearned premiums on the company’s an-nual statement increased by the portion ofpremium acquisition expenses allocableto those unearned premiums; and

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(D) In the case of a title insurancecompany, its discounted unearned premi-ums (computed in accordance with sec-tion 832(b)(8)).

(9) Method of determining unearnedpremiums. If the risk of loss under an in-surance contract does not vary signifi-cantly over the effective period of thecontract, the unearned premium attribut-able to the unexpired portion of the effec-tive period of the contract is determinedon a pro rata basis. If the risk of lossvaries significantly over the effective pe-riod of the contract, the insurance com-pany may consider the pattern and inci-dence of the risk in determining theportion of the gross premium that is at-tributable to the unexpired portion of theeffective period of the contract. An insur-ance company that uses a method of com-puting unearned premiums other than thepro rata method must maintain sufficientinformation to demonstrate that itsmethod of computing unearned premiumsaccurately reflects the pattern and inci-dence of the risk for the insurance con-tract.

(10) Examples. The provisions ofparagraphs (a)(4) through (a)(9) of thissection are illustrated by the following ex-amples:

Example 1. (i) IC is a non-life insurance com-pany which, pursuant to section 843, files its returnson a calendar year basis. IC writes a casualty insur-ance contract that provides insurance coverage for aone-year period beginning on July 1, 2000 and end-ing on June 30, 2001. IC charges a $500 premiumfor the insurance contract, which may be paid eitherin full by the effective date of the contract or inquarterly installments over the contract’s one yearterm. The policyholder selects the installment pay-ment option. As of December 31, 2000, IC collected$250 of installment premiums for the contract.

(ii) The effective period of the insurance contractbegins on July 1, 2000 and ends on June 30, 2001.For the taxable year ending December 31, 2000, ICincludes the $500 gross premium, based on the ef-fective period of the contract, in gross premiumswritten under section 832(b)(4)(A). IC’s unearnedpremium with respect to the contract was $250 as ofDecember 31, 2000. Pursuant to section832(b)(4)(B), to determine its premiums earned, ICdeducts $200 ($250 x .8) for the insurance contractat the end of the taxable year.

Example 2. (i) The facts are the same as Exam-ple 1, except that the insurance contract has a statedterm of 5 years. On each contract anniversary date,IC may adjust the rate charged for the insurance cov-erage for the succeeding 12 month period. Theamount of the adjustment in the charge for insurancecoverage is not substantially limited under the insur-ance contract.

(ii) Under paragraph (a)(5)(i) of this section, ICis required to report gross premiums written for the

insurance contract based on the effective period forthe contract. The effective period of the insurancecontract is the period for which a rate for insurancecoverage is guaranteed in the contract. Although theinsurance contract issued by IC has a stated term of5 years, a rate for insurance coverage is guaranteedonly for a period of 12 months beginning with thecontract’s effective date and each anniversary datethereafter. Thus, for the taxable year ending Decem-ber 31, 2000, IC includes the $500 gross premiumfor the 12 month period beginning with the con-tract’s effective date in gross premiums written.IC’s unearned premium with respect to the contractwas $250 as of December 31, 2000. Pursuant to sec-tion 832(b)(4)(B), to determine its premiums earned,IC deducts $200 ($250 x .8) for the insurance con-tract at the end of the taxable year.

Example 3. (i) The facts are the same as Exam-ple 1, except that coverage under the insurance con-tract begins on January 1, 2001 and ends on Decem-ber 31, 2001. On December 15, 2000, IC collectsthe first $125 premium installment on the insurancecontract. For the taxable year ended December 31,2000, IC deducts $20 of premium acquisition ex-penses related to the insurance contract. IC’s totalpremium acquisition expenses, based on the insur-ance contract’s $500 gross premium, are $80.

(ii) Under paragraph (a)(5)(iii) of this section, IC may elect to report only the $125 advance pre-

mium (rather than the contract’s $500 gross pre-mium) in gross premiums written for the taxableyear ended December 31, 2000, provided that IC’sdeduction for the premium acquisition expenses re-lated to the insurance contract does not exceed thelimitation in paragraph (a)(5)(vii). IC’s deductionfor premium acquisition expenses is within this limi-tation only if the ratio of the insurance contract’spremium acquisition expenses deducted for the tax-able year and any previous taxable year to the insur-ance contract’s total premium acquisition expensesdoes not exceed the ratio of the amounts included ingross premiums written for the taxable year and anyprevious taxable year for the contract to the totalgross premium written for the contract.

(iii) For the taxable year ended December 31,2000, IC deducts $20 of premium acquisition ex-penses related to the insurance contract. This deduc-tion represents 25% of the total premium acquisitionexpenses for the insurance contract ($20/$80 =25%). This ratio does not exceed the ratio of the$125 advance premium to the insurance contract’s$500 gross premium ($125/$500 = 25%). There-fore, under paragraph (a)(5)(iii) of this section, ICmay elect to report only the $125 advance premium(rather than the $500 gross premium) in gross pre-miums written for the taxable year ending December31, 2000. IC reports the balance of the gross pre-mium for the insurance contract ($375) and deductsthe remaining premium acquisition expenses ($60)for the insurance contract in the taxable year endingDecember 31, 2001.

Example 4. (i) The facts are the same as Exam-ple 3, except that for the taxable year ending Decem-ber 31, 2000, IC deducts $60 of premium acquisitionexpenses related to the insurance contract.

(ii) For the taxable year ended December 31,2000, IC deducted 75% of total premium acquisitionexpenses for the insurance contract ($60/$80 =75%). This ratio exceeds the ratio of the $125 ad-vance premium to the $500 gross premium

($125/$500 = 25%). Because IC’s deduction forpremium acquisition expenses allocable to the con-tract exceeds the limitation in paragraph (a)(5)(vii)of this section, paragraph (a)(5)(i) of this section re-quires IC to report the $500 gross premium in grosspremiums written for the taxable year ending De-cember 31, 2000. IC’s unearned premium with re-spect to the contract was $500 as of December 31,2000. Pursuant to section 832(b)(4)(B), to deter-mine its premiums earned, IC deducts $400 ($500 x.8) for the insurance contract at the end of the tax-able year.

Example 5. (i) IC is a non-life insurance com-pany which, pursuant to section 843, files its returnson a calendar year basis. On August 1, 2000, IC is-sues a one-year cancellable accident and health in-surance policy to X, a corporation with 80 coveredemployees. The gross premium written for the in-surance contract is $320,000. Premiums are payablein monthly installments. As of December 31, 2000,IC has collected $150,000 of installment premiumsfrom X. For the taxable year ended December 31,2000, IC has paid or incurred $21,000 of premiumacquisition expenses related to the insurance con-tract. IC’s total premium acquisition expenses forthe insurance contract, based on the $320,000 grosspremium, are $48,000.

(ii) Under paragraph (a)(5)(iv) of this section, IC may elect to report only the $150,000 of install-

ment premiums (rather than the $320,000 estimatedgross premium) in gross premiums written for thetaxable year ended December 31, 2000, providedthat its deduction for premium acquisition expensesallocable to the insurance contract does not exceedthe limitation in paragraph (a)(5)(vii). For the tax-able year ended December 31, 2000, IC deducts$21,000 of premium acquisition expenses related tothe insurance contract, or 43.75% of total premiumacquisition expenses for the insurance contract($21,000/$48,000 = 43.75%). This ratio does notexceed the ratio of installment premiums to thegross premium for the contract ($150,000/$320,000= 46.9%). Therefore, under paragraph (a)(5)(iv) ofthis section, IC may elect to report only $150,000 ofinstallment premiums for the insurance contract(rather than $320,000 of gross premium) in grosspremiums written for the taxable year ending De-cember 31, 2000.

Example 6. (i) IC is a non-life insurance com-pany which, pursuant to section 843, files its returnson a calendar year basis. On July 1, 2000, IC issuesa one-year workers’ compensation policy to X, anemployer. The gross premium for the policy is de-termined by applying a monthly rate of $25 to eachof X’s employees. This rate is guaranteed for a pe-riod of 12 months, beginning with the effective dateof the contract. On July 1, 2000, X has 1,050 em-ployees. Based on the assumption that X’s payrollwould remain constant during the effective period ofthe contract, IC determines an estimated gross pre-mium for the contract of $315,000 (1,050 x $25 x 12= $315,000). The estimated gross premium ispayable by X in equal monthly installments. At theend of each calendar quarter, the premiums payableunder the contract are adjusted based on an audit ofX’s actual payroll during the preceding three monthsof coverage.

(ii) Due to an expansion of X’s business in 2000,the actual number of employees covered under thecontract during each month of the period between

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July 1, 2000 and December 31, 2000 is 1,050 (July),1,050 (August), 1,050 (September), 1,200 (Octo-ber), 1,200 (November), and 1,200 (December).The increase in the number of employees during theyear is not attributable to a temporary or seasonalvariation in X’s business activities and is expected tocontinue for the remainder of the effective period ofthe contract.

(iii) Under paragraph(a)(5)(i) of this section,IC is required to report gross premiums written forthe insurance contract based the effective period ofthe contract. The effective period of X’s contractis based on the 12 month period for which IC hasguaranteed rates for insurance coverage. Underparagraph (a)(5)(ii), IC must also report the addi-tional premiums resulting from the change in riskexposure under the contract for the taxable year inwhich the change in such exposure occurs. Unlessthe change in risk exposure is of temporary dura-tion, the additional gross premiums are included ingross premiums written for the remainder of theeffective period of the contract. Thus, for the tax-able year ending December 31, 2000, IC reportsgross premiums written of $348,750 with respectto the workers’ compensation contract issued to X,consisting of the sum of the initial gross premiumfor the contract ($315,000) plus the additionalgross premium attributable to the 150 employeesadded to X’s payroll who will be covered duringthe last nine months of the contract’s effective pe-riod (150 x $25 (monthly premium) x 9 =$33,750). IC’s unearned premium with respect tothe contract was $180,000 as of December 31,2000, which consists of the sum of the remainingportion of the original gross premium ($315,000 x6/12 = $157,500), plus the additional premiums re-sulting from the change in risk exposure ($33,750x 6/9 = $22,500) that are allocable to the remain-ing six months of the contract’s effective period.Pursuant to section 832(b)(4)(B), to determine itspremiums earned, IC deducts $144,000 ($180,000x .8) for the insurance contract at the end of thetaxable year.

Example 7. (i) The facts are the same as Exam-ple 6, except that the increase in the number of X’semployees for the period ending December 31,2000 is attributable to a seasonal variation in X’sbusiness activity.

(ii) Under paragraph (a)(5)(ii) of this section,for the taxable year ending December 31, 2000, ICreports gross premiums written of $326,500, con-sisting of the sum of the initial gross premium forthe contract ($315,000) plus the additional pre-mium attributable to the temporary increase in riskexposure during the taxable year (150 x $25 x 3 =$11,250). The unearned premium that is allocableto the remaining six months of the effective periodof the contract is $157,500. Pursuant to section832(b)(4)(B), to determine its premiums earned,IC deducts $126,000 ($157,500 x .8) for the insur-ance contract at the end of the taxable year.

Example 8. (i) IC, a non-life insurance com-pany, issues a noncancellable accident and healthinsurance contract (other than a qualified long-term care insurance contract, as defined in section7702B(b)) to A, an individual, on July 1, 2000.The contract has an entry-age annual premium of$2,400, which is payable by A in equal monthly in-stallments of $200 on the first day of each monthof coverage. IC incurs agents’ commissions, pre-

mium taxes, and other premium acquisition ex-penses equal to 10% of the gross premiums re-ceived for the contract. As of December 31, 2000,IC has collected $1,200 of installment premiumsfor the contract.

(ii) A noncancellable accident and health insur-ance contract is a contract described in section832(b)(7). Thus, under paragraph (a)(5)(vi) of thissection, IC may report gross premiums written inthe manner required for life insurance companiesunder sections 803 and 811. Accordingly, for thetaxable year ending December 31, 2000, IC mayreport gross premiums written of $1,200, based onthe premiums actually received on the contract.Pursuant to section (a)(5)(vi) of this section, ICdeducts a total of $28 of premium acquisition costsfor the contract, based on the difference betweenthe acquisition costs actually paid or incurredunder section 811(a) ($1,200 x .10 = $120) and theamount required to taken into account under sec-tion 848 in connection with the net premiums forthe contract ($1,200 x .077 = $92).

(iii) Under paragraph (a)(8)(ii)(A) of this sec-tion, IC includes the amount of life insurance re-serves (as defined in section 816(b), but computedin accordance with section 807(d) and sections811(c) and (d)) in unearned premiums under sec-tion 832(b)(4)(B). Section 807(d)(3)(A)(iii) re-quires IC to use a two-year preliminary termmethod to compute the amount of life insurancereserves for a noncancellable accident and healthinsurance contract (other than a qualified long-term care contract). Under this tax reservemethod, no portion of the $1,200 gross premiumreceived by IC for A’s contract is allocable to fu-ture insurance coverage. Accordingly, for the tax-able year ending December 31, 2000, no life insur-ance reserves are included in IC’s unearnedpremiums under section 832(b)(4)(B) with respectto the contract.

Example 9. (i) IC, a non-life insurance com-pany, issues an insurance contract with a twelvemonth effective period for $1,200 on December 1,2000. Immediately thereafter, IC reinsures 90% ofits liability under the insurance contract for $900with IC-2, an unrelated and solvent insurancecompany. On December 31, 2000, IC-2 has an$825 unearned premium with respect to the rein-surance contract it issued to IC. In computing itsearned premiums, pursuant to section832(b)(4)(B), IC-2 deducts $660 of unearned pre-miums ($825 x .8) with respect to the reinsurancecontract.

(ii) Under paragraph (a)(8)(i) of this section,unearned premiums held by an insurance companywith regard to the net value of the risks reinsuredin other solvent companies are deducted from theceding company’s unearned premiums taken intoaccount for purposes of section 832(b)(4)(B). IfIC had not reinsured 90% of its risks, IC’s un-earned premium for the insurance contract wouldhave been $1,100 ($1,200 x 11/12) and IC wouldhave deducted $880 ($1,100 x .8) of unearned pre-miums with respect to such contract. However,because IC reinsured 90% of its risks under thecontract with IC-2, as of December 31, 2000, thenet value of the risks retained by IC for the re-maining 11 months of the effective period of thecontract is $110 ($1,100 - $990). For the taxableyear ending December 31, 2000, IC includes the

$1,200 gross premium in its gross premiums writ-ten and deducts the $900 reinsurance premiumpaid to IC-2 under section 832(b)(4)(A). Pursuantto section 832(b)(4)(B), to determine its premiumsearned, IC deducts $88 ($110 x .8) for the insur-ance contract at the end of the taxable year.

(11) Change in method ofaccounting—(i) In general. A changein the method of determining premiumsearned to comply with the provisions ofparagraphs (a)(3) through (a)(10) of thissection is a change in method of ac-counting for which the consent of theCommissioner is required under section446(e) and §1.446–1(e).

(ii) Application. For the first taxableyear beginning after December 31, 1999,a taxpayer is granted consent of the Com-missioner to change its method of deter-mining premiums earned to comply withthe provisions of paragraphs (a)(3)through (a)(10) of this section. A tax-payer changing its method of accountingin accordance with this section must fol-low the automatic change in accountingprovisions of Rev. Proc. 99–49, 1999–52I.R.B. 725 (see §601.601(d)(2) of thischapter), except that–

(A) The scope limitations in section4.02 of Rev.

Proc. 99–49 shall not apply;(B) The timely duplicate filing require-

ment in section 6.02(2) of Rev. Proc.99–49 shall not apply; and

(C) If the method of accounting for de-termining premiums earned is an issueunder consideration within the meaningof section 3.09 of Rev. Proc. 99–49 as ofJanuary 5, 2000, then section 7.01 of Rev.Proc. 99–49 shall not apply.

(12) Effective date. Paragraphs (a)(3)through (a)(11) of this section are applica-ble with respect to the determination ofpremiums earned for taxable years begin-ning after December 31, 1999. * * * * *

Robert E. Wenzel,Deputy Commissioner

of Internal Revenue.

Approved December 23, 1999.

Jonathan Talisman,Acting Assistant Secretary

of the Treasury.

(Filed by the Office of the Federal Register on Janu-ary 5, 2000, 8:45 a.m., and published in the issue ofthe Federal Register for January 6, 2000, 65 F.R.701)

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Section 1441.—Withholding ofTax on Nonresident Aliens26 CFR 1.1441–10: Recharacterizing financingarrangements involving fast-pay stock.

See T.D. 8853 on page 377

Section 4251.—Imposition ofTax26 CFR 49.4251–4: Prepaid telephone cards.

T.D. 8855

DEPARTMENT OF THE TREASURYInternal Revenue Service26 CFR Parts 49 and 602

Communications Excise Tax;Prepaid Telephone Cards

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document containsfinal regulations relating to the applica-tion of the communications excise tax toprepaid telephone cards (PTCs). The reg-ulations implement certain changes madeby the Taxpayer Relief Act of 1997. Theyaffect certain telecommunications carri-ers, resellers, and purchasers of PTCs.

DATES: Effective Dates: These regula-tions are effective January 7, 2000.

Applicability Dates: For the date of ap-plicability, see §49.4251–4(f).

FOR FURTHER INFORMATION CON-TACT: Bernard H. Weberman (202) 622-3130 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information con-tained in these final regulations has beenapproved by the Office of Managementand Budget in accordance with the Paper-work Reduction Act (44 U.S.C. 3507)under control number 1545-1628. Re-sponses to this collection of informationare required to obtain a tax benefit.

An agency may not conduct or sponsor,and a person is not required to respond to,a collection of information unless the col-

lection of information displays a validcontrol number.

The estimated average burden per re-spondent is 0.25 hour. The estimated av-erage annual burden per recordkeeper is1.2 hours.

Comments concerning the accuracy ofthis burden estimate and suggestions forreducing this burden should be sent to theInternal Revenue Service, Attn: IRSReports Clearance Officer, OP:FS:FP,Washington, DC 20224, and to the Officeof Management and Budget, Attn: DeskOfficer for the Department of the Trea-sury, Office of Information and Regula-tory Affairs, Washington, DC 20503.

Books or records relating to this collec-tion of information must be retained aslong as their contents may become mater-ial in the administration of any internalrevenue law. Generally, tax returns andtax return information are confidential, asrequired by 26 U.S.C. 6103.

Background

On December 17, 1998, a notice of pro-posed rulemaking (REG–118620–97,1999–9 I.R.B. 46) was published in the Fed-eral Register(63 FR 69585). Three writtencomments were received but no hearing washeld because no requests to speak were re-ceived. The proposed regulations areadopted as revised by this Treasury decision.

The principal concerns of the com-menters related to the rules for determiningthe face amount of an untariffed unit cardtransferred to a transferee reseller. The pro-posed regulations provide that the faceamount can be determined by reference toactual retail sales by the carrier, by referenceto the price at which the PTC is sold to thetransferee reseller, or by reference to theminutes of domestic communications ser-vice provided by the PTC. One commenterrequested additional explanation of the basisfor these rules. Another suggested that inmany situations, particularly in the case ofhigh-denomination (for example, multi-hour) PTCs, none of the proposed methodsfor determining the face amount will accu-rately reflect the true retail value of thePTC. This commenter also suggested that ifa carrier can substantiate the actual retailprice of a PTC it should have the option oftreating that price as the face amount.

The final regulations modify the rules re-lating to untariffed unit cards in three re-spects. First, they clarify that when the face

amount is determined by reference to actualretail sales by the carrier, the retail salestaken into account are sales of PTCs thatprovide the same type and amount of com-munications service. The final regulationsalso modify the markup percentage usedwhen the face amount is determined by ref-erence to the price at which the carrier sellsthe PTC to the transferee reseller. The pro-posed regulations apply a markup of 65percent. Under the final regulations, themarkup is reduced to 35 percent to corre-spond more closely to markups in the retailsector generally. Lastly, the final regula-tions modify the rule for determining theface amount by reference to the minutes ofdomestic communications service providedby the PTC. The proposed regulations pro-vide that the face amount may be deter-mined by multiplying the number of min-utes by a flat $0.30 per-minute rate. Asnoted in the comments, however, a high-de-nomination PTC generally provides lowercost service on a per-minute basis than anotherwise equivalent low- denominationPTC. Accordingly, the final regulationsprovide that the per-minute rate used to de-termine face amount is reduced from $0.30per minute to $0.20 per minute as theamount of domestic communications ser-vice provided by a PTC increases from 40to 240 minutes.

For sales to transferee resellers, the finalregulations do not permit carriers that cansubstantiate the actual retail price of a PTCto use that price as the face amount. TheIRS and Treasury Department believe thatthe modifications to the methods for deter-mining face amount address concerns thatthe prescribed methods may overstate theface amount. Moreover, a system based onthe actual retail sale price when the retailsale is made by a person other than the car-rier could prove very difficult for the IRS toadminister because of the difficulty of veri-fying the prices at which PTCs are sold bylarge numbers of small retailers that mayhave acquired the PTCs indirectly throughone or more transferee resellers.

Commenters also suggested that stateand local taxes should be excluded from theface amount even if they are not separatelystated. In general, the comments proposean exclusion based on the average amountof state and local taxes imposed on the car-rier’s PTCs. These suggestions were notadopted. Section 4254(c) excludes fromthe section 4251 tax base only those state

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and local taxes that are imposed on the saleor furnishing of communications servicesand that are separately stated in the bill. Atax that is not separately stated (because,for example, it is imposed after the taxablesale of the PTC and its amount is notknown at the time of the sale) does notqualify for this exclusion.

The regulations apply to PTCs trans-ferred by carriers in calendar quarters be-ginning after January 7, 2000. Carriersand transferees may, however, rely on theregulations in determining the tax treat-ment of PTCs transferred in quarters be-ginning on or before that date.

Special Analyses

It has been determined that this Treasurydecision is not a significant regulatory ac-tion as defined in Executive Order 12866.Therefore, a regulatory assessment is notrequired. It also has been determined thatsection 553(b) of the Administrative Proce-dure Act (5 U.S.C. chapter 5) does notapply to these regulations. It is hereby cer-tified that the collection of information inthese regulations will not have a significanteconomic impact on a substantial numberof small entities. This certification is basedon the fact that the time required to prepareor retain the notification is minimal andwill not have a significant impact on thosesmall entities that are required to providenotification. Furthermore, notification isprovided only once to each seller. Accord-ingly, a Regulatory Flexibility Analysisunder the Regulatory Flexibility Act (5U.S.C. chapter 6) is not required. Pursuantto section 7805(f) of the Internal RevenueCode, the notice of proposed rulemakingpreceding these regulations was submittedto the Chief Counsel for Advocacy of theSmall Business Administration for com-ment on its impact on small business.

Drafting Information

The principal author of these regulationsis Bernard H. Weberman, Office of Assis-tant Chief Counsel (Passthroughs and Spe-cial Industries). However, other personnelfrom the IRS and Treasury Department par-ticipated in their development.

* * * * *

Adoption of Amendments to theRegulations

Accordingly, 26 CFR parts 49 and 602are amended as follows:

PART 49—FACILITIES ANDSERVICES EXCISE TAXES

Paragraph 1. The authority citation forpart 49 is revised to read as follows:

Authority: 26 U.S.C. 7805.Section 49.4251–4 also issued under 26

U.S.C. 4251(d).Par. 2. Section 49.4251–4 is added to

read as follows:§49.4251–4 Prepaid telephone cards.

(a) In general. In the case of communi-cations services acquired by means of aprepaid telephone card (PTC), the faceamount of the PTC is treated as anamount paid for communications servicesand that amount is treated as paid whenthe PTC is transferred by any carrier toany person that is not a carrier. This sec-tion provides rules for the application ofthe section 4251 tax to PTCs.

(b) Definitions. The following defini-tions apply to this section:

Carrier means a telecommunicationscarrier as defined in 47 U.S.C. 153.

Comparable PTCmeans a currentlyavailable dollar card or tariffed unit card(other than a PTC transferred in bulk orunder special circumstances, such as forpromotional purposes) that provides thesame type and amount of communicationsservices as the PTC to which it is beingcompared.

Dollar card means a PTC the value ofwhich is designated by the carrier in dol-lars (even if also designated in units ofservice), provided that the designatedvalue is not less than the amount forwhich the PTC is expected to be sold to aholder.

Holder means a person that purchasesother than for resale.

Prepaid telephone card (PTC) means acard or similar arrangement that permitsits holder to obtain a fixed amount ofcommunications services by means of acode (such as a personal identificationnumber (PIN)) or other access device pro-vided by the carrier and to pay for thoseservices in advance.

Tariff means a schedule of rates andregulations filed by a carrier with the Fed-eral Communications Commission.

Tariffed unit card means a unit cardthat is transferred by a carrier—

(1) To a holder at a price that does notexceed the designated number of units onthe PTC multiplied by the carrier’s tar-iffed price per unit; or

(2) To a transferee reseller subject to acontractual or other arrangement underwhich the price at which the PTC is soldto a holder will not exceed the designatednumber of units on the PTC multiplied bythe carrier’s tariffed price per unit.

Transfereemeans the first person thatis not a carrier to whom a PTC is trans-ferred by a carrier.

Transferee resellermeans a transfereethat purchases a PTC for resale.

Unit card means a PTC other than adollar card.

Untariffed unit cardmeans a unit cardother than a tariffed unit card.

(c) Determination of face amount—(1)Dollar card. The face amount of a dollarcard is the designated dollar value.

(2) Tariffed unit card. The face amountof a tariffed unit card is the designatednumber of units on the PTC multiplied bythe tariffed price per unit.

(3) Untariffed unit card—(i) Transferto holder. The face amount of an untar-iffed unit card transferred by a carrier to aholder is the amount for which the carriersells the PTC to the holder.

(ii) Transfer to transferee reseller—(A)In general. The face amount of an untar-iffed unit card transferred by a carrier to atransferee reseller is at the option of thecarrier—

(1) The highest amount for which thecarrier sells a PTC that provides the sametype and amount of communications ser-vices to a holder that ordinarily would notbe expected to buy more than one suchPTC at a time (if the carrier makes suchsales on a regular and arm’s-length basis)or the face amount of a comparable PTC(if the carrier does not make such sales ona regular and arm’s-length basis);

(2) 135 percent of the amount forwhich the carrier sells the PTC to thetransferee reseller (including in thatamount, in addition to any sum certainfixed at the time of the sale, any contin-gent amount per unit multiplied by thedesignated number of units on the PTC);or

(3) If the PTC is of a type that ordinar-ily is used entirely for domestic commu-nications service, the maximum numberof minutes of domestic communicationsservice on the PTC multiplied by the ap-plicable rate.

(B) Applicable rate. The applicablerate under paragraph (c)(3)(ii)(A)(3) of

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this section with respect to a PTC is $0.30reduced (but not below $0.20) by $0.01for each full 20 minutes by which themaximum number of minutes of domesticcommunications service on the PTC ex-ceeds 40 minutes.

(C) Sales not at arm’s length. In thecase of a transfer of an untariffed unitcard by a carrier to a transferee resellerotherwise than through an arm’s-lengthtransaction, the fair market retail value ofthe PTC shall be substituted for theamount determined in paragraph(c)(3)(ii)(A)(2) of this section.

(4) Exclusion.The amount of any stateor local tax imposed on the furnishing orsale of communications services that isseparately stated in the bill or on the faceof the PTC and the amount of any section4251 tax separately stated in the bill or onthe face of the PTC are disregarded in de-termining, for purposes of this paragraph(c), the amount for which a PTC is sold.

(d) Liability for tax—(1) In general.Under section 4251(d), the section4251(a) tax is imposed on the transfer of aPTC by a carrier to a transferee. The per-son liable for the tax is the transferee. Ex-cept as provided in paragraph (d)(2) ofthis section, the person responsible forcollecting the tax is the carrier transfer-ring the PTC to the transferee. If a holderpurchases a PTC from a transferee re-seller, the amount the holder pays for thePTC is not treated as an amount paid forcommunications services and thus tax isnot imposed on that payment.

(2) Effect of statement that purchaser is acarrier—(i) On transferor. A carrier thattransfers a PTC to a purchaser is not re-sponsible for collecting the tax if, at thetime of transfer, the transferor carrier hasreceived written notification from the pur-chaser that the purchaser is a carrier, andthe transferor has no reason to believe oth-erwise. The notification to be provided bythe purchaser is a statement, signed underpenalties of perjury by a person with au-thority to bind the purchaser, that the pur-chaser is a carrier (as defined in paragraph(b) of this section). The statement is not re-quired to take any particular form.

(ii) On purchaser. If a purchaser that isnot a carrier provides the notification de-scribed in paragraph (d)(2)(i) of this sec-tion to the carrier that transfers a PTC, thepurchaser remains liable for the tax im-posed on the transfer of the PTC.

(3) Exemptions. Any exemptions avail-able under section 4253 apply to thetransfer of a PTC from a carrier to aholder. Section 4253 does not apply tothe transfer of a PTC from a carrier to atransferee reseller.

(e) Examples.The following examplesillustrate the provisions of this section:

Example 1. Unit card; sold to individual.(i) OnMay 1, 2000, A, a carrier, sells a card it calls a pre-paid telephone card at A’s retail store to P, an indi-vidual, for P’s use in making telephone calls. A pro-vides P with a PIN. The value of the card is notdenominated in dollars, but the face of the card ismarked 30 minutes. The sales price is $9. A tariffhas not been filed for the minutes on the card. Thetoll telephone service acquired by purchasing thecard will be obtained by entering the PIN and thetelephone number to be called.

(ii) Because P purchased from a carrier other thanfor resale, P is a holder. The card provides itsholder, P, with a fixed amount of communicationsservices (30 minutes of toll telephone service) to beobtained by means of a PIN, for which P pays in ad-vance of obtaining service; therefore, the card is aPTC. Because the value of the PTC is not desig-nated in dollars and a tariff has not been filed for theminutes on the PTC, the PTC is an untariffed unitcard. Because it is transferred by the carrier to theholder, the face amount is the sales price ($9).

(iii) The card is a PTC; thus, under section4251(d), the face amount is treated as an amountpaid for communications services and that amount istreated as paid when the PTC is transferred from Ato P. Accordingly, at the time of transfer, P is liablefor the 3 percent tax imposed by section 4251(a).The amount of the tax is $0.27 (3% x the $9 faceamount). Thus, the total paid by P is $9.27, the $9sales price plus $0.27 tax. A is responsible for col-lecting the tax from P.

Example 2. Unit card; given to individual. (i) Thefacts are the same as in Example 1, except that insteadof selling a card, A gives a 30 minute card to P.

(ii) Although the card provides P with a fixedamount of communications services (30 minutes oftoll telephone service) to be obtained by means of aPIN, P does not pay for the service. Therefore, thecard is not a PTC, even though it is called a prepaidtelephone card by A.

(iii) Because the card is not a PTC, section4251(d) does not apply. Furthermore, no tax is im-posed by section 4251(a) because no amount is paidfor the communications services.

Example 3. Unit card; adding value.(i) Afterusing the card described inExample 2, P arrangeswith A by telephone to have 30 minutes of toll tele-phone service added to the card. The sales price is$9. P is told to continue using the PIN providedwith the card.

(ii) Because P purchased from a carrier other thanfor resale, P is a holder. The arrangement providesits holder, P, with a fixed amount of communicationsservices (30 minutes of toll telephone service) to beobtained by means of a PIN, for which P pays in ad-vance of obtaining service; therefore, the arrange-ment is a PTC. Because the value of the PTC is notdesignated in dollars and a tariff has not been filedfor the minutes on the PTC, the PTC is an untariffed

unit card. Because it is transferred by the carrier tothe holder, the face amount is the sales price ($9).

(iii) The arrangement is a PTC; thus, under sec-tion 4251(d), the face amount is treated as anamount paid for communications services and thatamount is treated as paid when the PTC is trans-ferred from A to P. Accordingly, at the time of trans-fer, P is liable for the 3 percent tax imposed by sec-tion 4251(a). The amount of the tax is $0.27 (3% xthe $9 face amount). Thus, the total paid by P is$9.27, the $9 sales price plus $0.27 tax. A is respon-sible for collecting the tax from P.

Example 4. Dollar card; sold other than for re-sale. (i) On May 1, 2000, B, a carrier, sells 100,000cards it calls prepaid telephone cards to Q, an autodealer, for $50,000. Q will give away a card to eachperson that visits Q’s dealership. B provides Q witha PIN for each card. The face of each card is marked$3. The toll telephone service acquired by purchas-ing the card will be obtained by entering the PIN andthe telephone number to be called.

(ii) Because Q purchased from a carrier otherthan for resale, Q is a holder. Each card provides itsholder, Q, with a fixed amount of communicationsservices ($3 of toll telephone service) to be obtainedby means of a PIN, for which Q pays in advance ofobtaining service; therefore, each card is a PTC eventhough Q’s visitors do not pay for the cards. Thevalue of each PTC is designated in dollars; there-fore, each PTC is a dollar card. Because the PTC isa dollar card, the face amount is the designated dol-lar value ($3).

(iii) The cards are PTCs; thus, under section4251(d), the face amount is treated as an amount paidfor communications services and that amount istreated as paid when the PTCs are transferred from Bto Q. Accordingly, at the time of transfer, Q is liablefor the 3 percent tax imposed by section 4251(a).The amount of the tax is $9,000 (3% x the $3 faceamount x 100,000 PTCs). Thus, the total paid by Qis $59,000, the $50,000 sales price plus $9,000 tax.B is responsible for collecting the tax from Q.

Example 5. Tariffed unit card; sold to transfereereseller. (i) On May 1, 2000, C, a carrier, sells 1,000cards it calls prepaid telephone cards to R, a conve-nience store owner, for $7,000. C provides R with aPIN for each card. The value of the cards is not de-nominated in dollars, but the face of each card ismarked 30 minutes and a tariff of $0.33 per minutehas been filed for the minutes on each card. Ragrees that it will sell the cards to individuals fortheir own use and at a price that does not exceed$0.33 per minute. R actually sells the cards for $9each (that is, at a price equivalent to $0.30 perminute). The toll telephone service acquired by pur-chasing the card will be obtained by entering thePIN and the telephone number to be called.

(ii) Because R purchased from a carrier for re-sale, R is a transferee reseller. Because R’s cus-tomers will purchase other than for resale, they willbe holders. Each card sold by R provides its holder,R’s customer, with a fixed amount of communica-tions services (30 minutes of toll telephone service)to be obtained by means of a PIN provided by thecarrier, for which R’s customer pays in advance ofobtaining service; therefore, each card is a PTC. Be-cause the value of each PTC is not designated in dol-lars and C sells the PTCs to R subject to an arrange-ment under which the price at which the PTCs aresold to holders will not exceed the designated num-

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ber of minutes on the PTC multiplied by C’s tariffedprice per minute, each PTC is a tariffed unit card.Because the PTCs are tariffed unit cards, the faceamount of each PTC is $9.90, the designated num-ber of minutes on the PTC multiplied by the tariffedprice per minute (30 x $0.33), even though the retailsale price of each card is $9.

(iii) The cards are PTCs; thus, under section4251(d), the face amount is treated as an amountpaid for communications services and that amount istreated as paid when the PTC is transferred from Cto R. Accordingly, at the time of transfer, R is liablefor the 3 percent tax imposed by section 4251(a).The amount of the tax is $297 (3% x the $9.90 faceamount x 1,000 PTCs). Thus, the total paid by R is$7,297, the $7,000 sales price plus $297 tax. C is re-sponsible for collecting the tax from R.

Example 6. Unit card; sold to transferee reseller.(i) On May 1, 2000, D, a carrier, sells 10,000 cards itcalls prepaid telephone cards to S, a conveniencestore owner, for $60,000. D provides S with a PINfor each card. The value of the cards is not denomi-nated in dollars, but the face of each card is marked30 minutes. A tariff has not been filed for the min-utes on each card. S will sell the cards to individualsfor their own use for $9 each. D also sells a card thatprovides 30 minutes of the same type of communi-cations service at its retail store for $9. The toll tele-phone service acquired by purchasing the card willbe obtained by entering the PIN and the telephonenumber to be called.

(ii) Because S purchased from a carrier for resale,S is a transferee reseller. Because S’s customers willpurchase other than for resale, they will be holders.Each card sold by S provides its holder, S’s cus-tomer, with a fixed amount of communications ser-vices (30 minutes of toll telephone service) to be ob-tained by means of a PIN provided by the carrier, forwhich S’s customer pays in advance of obtainingservice; therefore, each card is a PTC. Because thevalue of each PTC is not designated in dollars and atariff has not been filed for the minutes on the PTC,each PTC is an untariffed unit card.

(iii) The PTCs are untariffed unit cards trans-ferred by the carrier to a transferee reseller. Thus,

the face amount is determined under paragraph(c)(3)(ii) of this section, which permits D to choosefrom three alternative methods. Under paragraph(c)(3)(ii)(A)(1) of this section, the face amount ofeach PTC would be $9, the highest amount forwhich D sells to holders purchasing a single PTC.Alternatively, under paragraph (c)(3)(ii)(A)(2) ofthis section, the face amount of each PTC would be$8.10, computed as follows: 135% x the $60,000sales price â 10,000 PTCs. Finally, under paragraph(c)(3)(ii)(A)(3) of this section (assuming the PTCsare of a type that ordinarily is used entirely for do-mestic communications services), the face amountof each PTC would be $9 ($0.30 x 30 minutes).

(iv) The cards are PTCs; thus, under section4251(d), the face amount is treated as an amountpaid for communications services and that amount istreated as paid when the PTCs are transferred fromD to S. Accordingly, at the time of transfer, S is li-able for the 3 percent tax imposed by section4251(a). Assuming that D chooses to determine theface amount as provided in paragraph(c)(3)(ii)(A)(2) of this section, the amount of the taxis $2,430 (3% x the $8.10 face amount x 10,000PTCs). Thus, the total paid by S is $62,430, the$60,000 sales price plus $2,430 tax. D is responsi-ble for collecting the tax from S.

Example 7. Transfer of card that is not a PTC.(i) On May 1, 2000, E, a carrier, provides a tele-phone card to T, an individual, for T’s use in makingtelephone calls. E provides T with a PIN. The cardprovides access to an unlimited amount of commu-nications services. E charges T $0.25 per minute ofservice, and bills T monthly for services used. Thecommunications services acquired by using the cardwill be obtained by entering the PIN and the tele-phone number to be called.

(ii) Although the communications services willbe obtained by means of a PIN, T does not receive afixed amount of communications services. Also, Tcannot pay in advance since the amount of T’s pay-ment obligation depends upon the number of min-utes used. Therefore, the card is not a PTC.

(iii) Because the card is not a PTC, section4251(d) does not apply. However, the 3 percent tax

imposed by section 4251(a) applies to the amountspaid by T to E for the communications services. Ac-cordingly, at the time an amount is paid for commu-nications services, T is liable for tax. E is responsi-ble for collecting the tax from T.

(f) Effective date. This section is ap-plicable with respect to PTCs transferredby a carrier on or after the first day of thefirst calendar quarter beginning after Jan-uary 7, 2000.

PART 602—OMB CONTROLNUMBERS UNDER THEPAPERWORK REDUCTION ACT

Par. 3. The authority citation for part602 continues to read as follows:

Authority: 26 U.S.C. 7805.Par. 4. In §602.101, paragraph (b) is

amended by adding an entry in numericalorder to the table to read as follows:§602.101 OMB Control numbers.* * * * *

(b) * * *

John M. Dalrymple,Acting Deputy Commissioner

of Internal Revenue.

Approved December 13, 1999.

Jonathan Talisman,Acting Assistant Secretary

of the Treasury.

(Filed by the Office of the Federal Register on Janu-

ary 6, 2000, 8:45 a.m., and published in the issue of

the Federal Register for January 7, 2000, 65 F.R.

1056)

2000–4 I.R.B. 377 January 24, 2000

CFR part or section where Current OMBidentified and described control No.

* * * * *

49.4251–4(d)(2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-1628

* * * * *

Section 7701.—Definitions

26 CFR 1.7701(l)–3: Recharacterizing financingarrangements involving fast-pay stock.

T.D. 8853

DEPARTMENT OF THE TREASURYInternal Revenue Service26 CFR Parts 1 and 602

Recharacterizing FinancingArrangements Involving Fast-pay Stock

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document containsfinal regulations that recharacterize, fortax purposes, financing arrangements in-

volving fast-pay stock. The regulationsare necessary to prevent taxpayers fromusing fast-pay stock to achieve inappro-priate tax avoidance. The regulations af-fect corporations that issue fast-pay stock,holders of fast-pay stock, and other share-holders that may claim tax benefits pur-ported to result from arrangements in-volving fast-pay stock.DATES: Effective Date: February 27,1997.

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Applicability Dates: For dates of ap-plicability, see sections 1.1441–10(e) and1.7701(l)–3(g) of these regulations.

FOR FURTHER INFORMATION CON-TACT: Jonathan Zelnik, (202) 622-3920(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information con-tained in these final regulations has beenreviewed and approved by the Office ofManagement and Budget in accordancewith the Paperwork Reduction Act of1995 (44 U.S.C. 3507(d)) under controlnumber 1545-1642. Responses to thiscollection of information are mandatory.

An agency may not conduct or sponsor,and a person is not required to respond to,a collection of information unless the col-lection of information displays a validcontrol number.

The estimated average annual burdenhours per respondent/recordkeeper: 1hour.

Comments concerning the accuracy ofthis burden estimate and suggestions forreducing this burden should be sent to theInternal Revenue Service, Attn: IRS Re-ports Clearance Officer, OP:FS:FP, Wash-ington, DC 20224, and to the Office ofManagement and Budget, Attn: DeskOfficer for the Department of the Trea-sury, Office of Information and Regula-tory Affairs, Washington, DC 20503.

Books or records relating to a collec-tion of information must be retained aslong as their contents may become mater-ial in the administration of any internalrevenue law. Generally, tax returns andtax information are confidential, as re-quired by 26 U.S.C. 6103.

Background

On February 27, 1997, the IRS issuedNotice 97–21, 1997–1 C.B. 407, whichrelates to financing arrangements involv-ing fast-pay stock. Among other things,the notice informed the public that theIRS and Treasury Department expected toissue regulations recharacterizing thesearrangements to prevent tax avoidance.No comments were received in responseto Notice 97–21.

On January 6, 1999, the IRS publishedin the Federal Registera notice of pro-posed rulemaking (REG–104072–97,

1999–11 I.R.B. 12 [64 F.R. 805]) provid-ing rules for the recharacterization of cer-tain fast-pay arrangements under section7701(l) of the Internal Revenue Code.Because no one requested to speak at thepublic hearing, the hearing was canceled.Four written comments responding to thenotice of proposed rulemaking were re-ceived. The comments addressed neither(1) the accuracy of the estimate of the col-lection of information burden nor (2) theaccuracy of the IRS’s understanding thatthe total number of entities engaging intransactions affected by these regulationsis not substantial and most are not smallentities within the meaning of the Regula-tory Flexibility Act (5 U.S.C. chapter 6).After considering the comments, the pro-posed regulations are adopted as final reg-ulations with some changes.

The preamble to the proposed regula-tions (64 FR 805) provides a detailed dis-cussion of fast-pay arrangements and theproposed regulations.

SUMMARY OF COMMENTS ANDCHANGES

In General

Two commentators were generally fa-vorable to the proposed regulations. Oneconsidered them a reasonable attempt toaddress abusive transactions. The otherviewed them as consistent with section7701(l), but preferred, as a matter of taxpolicy, a legislative solution. One of thesecommentators also recommended narrow-ing the scope of the proposed regulations,asserting they might penalize shareholderswho do not benefit from the fast-payarrangement. Significantly, neither of thesecommentators recommended that the finalregulations adopt a different approach, suchas the one taken in Notice 97–21.

A third commentator criticized the pro-posed regulations as inconsistent withsection 7701(l). This commentatorviewed them as addressing not a conduitfinancing issue, but a tax accountingissue, namely, that the amount of dividendincome under tax principles can exceedthe economic income from the stock. Ad-ditionally, this commentator believed thatregulations under section 7701(l) cannotoperate if there is no back-to-back struc-ture or if the corporation subject torecharacterization holds bona fide assetssuch as third-party debt. Finally, the com-

mentator questioned whether the grant ofregulatory authority under section 7701(l)permits recharacterizing transactions sub-ject to other, comprehensive statutoryrules such as the rules governing thetransactions of RICs and REITs.

The IRS and Treasury Department haveconcluded that section 7701(l) authorizesrecharacterization of any multiple-partyfinancing transaction, including a fast-payarrangement. The IRS and Treasury De-partment have also concluded (as did theother two commentators) that recharacter-izing a fast-pay arrangement as anarrangement directly between the fast-payshareholders and the benefited sharehold-ers is consistent with the legislative man-date of section 7701(l). Thus, the finalregulations retain the approach of the pro-posed regulations while making somechanges to address other comments.

Definition of Fast-pay Stock

Under the proposed regulations, stock isfast-pay stock if it is structured so that div-idends (as defined in section 316) paid bythe corporation with respect to the stockare economically (in whole or in part) a re-turn of the holder’s investment (as opposedto only a return on the holder’s invest-ment). To determine if it is fast-pay stock,stock is examined when issued, and, forstock that is not fast-pay stock when is-sued, when there is a significant modifica-tion in the terms of the stock or the relatedagreements or a significant change in therelevant facts and circumstances.

Two commentators expressed concernabout the interaction of section 302 withthe definition of fast-pay stock and theduty to retest stock. In particular, thecommentators asked whether stock that isnot fast-pay stock when issued can be-come fast-pay stock solely because a re-demption of the stock is treated as a divi-dend under section 302. This conversionis possible because section 302 treats cer-tain redemptions as distributions of prop-erty to which section 301 applies ratherthan as distributions in exchange forstock.

The commentators gave different rea-sons why stock should not become fast-pay stock solely because a redemption istreated as a dividend. One reason wasthat section 302 and the provisions refer-ring to it (for example, section 1059(e))already recharacterize certain redemp-

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tions of stock, which indicates Congresshas determined the appropriate tax treat-ment of these transactions. Another rea-son was that applying the fast-pay regula-tions to arrangements involvingredemptions may have a chilling effect oncommon, non-abusive transactions. Fi-nally, it was suggested that any changesaffecting the application of section 302should be accomplished by issuing newregulations under that statute.

The IRS and Treasury Departmentagree it is inappropriate to treat as a fast-pay arrangement every arrangement inwhich a redemption of stock producesdividend income under section 302. TheIRS and Treasury Department, however,conclude that eliminating all sucharrangements from the scope of the regu-lations would render the regulationsmeaningless. Little difference exists be-tween a fast-pay arrangement resultingfrom redemptions structured to be divi-dends and a fast-pay arrangement result-ing from dividends structured to be a re-turn of the holder’s investment.

To balance the concerns of the com-mentators and the concerns of the IRS andTreasury Department, the final regula-tions add a new rule clarifying the effectof section 302 on the determination ofwhether stock is fast-pay stock. Underthis rule, stock is not fast-pay stock solelybecause a redemption is treated as a divi-dend by section 302 unless there is a prin-cipal purpose of achieving the same eco-nomic and tax effect as a fast-payarrangement. In this way, only thosearrangements in which redemptions aredesigned to return a shareholder’s eco-nomic investment as dividends are rechar-acterized. Because the problem of stockredemptions may be common to manydifferent fast-pay arrangements, regard-less of how they are structured, the ruleaddressing such problem is placed withinthe regulations under section 7701(l)rather than under a different section.

Characterization of the FinancingInstruments

Under the proposed regulations, thefast-pay shareholders are treated as hold-ing financing instruments issued by thebenefited shareholders rather than asholding the fast-pay stock. The characterof financing instruments (for example,stock or debt) is determined under general

tax principles and depends on all the factsand circumstances.

All three commentators were con-cerned by the failure of the proposed reg-ulations to classify the financing instru-ments as debt. If the financinginstruments are classified as stock, thebenefited shareholders are subject to sub-stantially greater tax liabilities: they mustinclude in income all dividends paid bythe corporation that issues the fast-paystock, but cannot deduct amounts deemedpaid with respect to the financing instru-ments. According to the commentators,this result distorts the benefited share-holders’ economic income. Therefore,the regulations should classify the financ-ing instruments as debt in all cases.

After careful consideration of the com-ments, the IRS and Treasury Departmenthave decided against characterizing the fi-nancing instruments in the final regula-tions. Although debt characterizationmay be appropriate in some cases, inother cases it will be more appropriate tocharacterize the financing instruments asequity or something else. Thus, the rulein the proposed regulations is retained.(As explained below, however, the finalregulations permit taxpayers, for a limitedperiod, to determine their taxable incomeattributable to a recharacterized fast-payarrangement by treating the financing in-struments as debt.)

Election to Limit Taxable IncomeAttributable to a Recharacterized Fast-pay Arrangement for Periods BeforeApril 1, 2000

Because the regulations are effectiveFebruary 27, 1997 (the date Notice97–21 was issued to the public), the pro-posed regulations permit a shareholderof a recharacterized fast-pay arrange-ment to limit, for certain taxable years,its income from the arrangement.Specifically, a shareholder may limit itstaxable income attributable to a rechar-acterized fast-pay arrangement to thetaxable income that results if the fast-payarrangement is recharacterized underNotice 97–21. This limit is availableunder the proposed regulations for tax-able years ending after the effective dateof the regulations and before the regula-tions are finalized. Any amount ex-cluded under this limit must be includedas an adjustment to taxable income in the

shareholder’s first taxable year that in-cludes the date the regulations are final-ized. Thus, the sole benefit of limitingtaxable income under the proposed regu-lations is a timing benefit. The preambleto the proposed regulations found thisappropriate on the assumption that overthe life of a fast-pay arrangement ashareholder has the same amount of tax-able income whether the fast-payarrangement is recharacterized underNotice 97–21 or under the regulations.

One commentator criticized this as-sumption, and, therefore, the limit andlater adjustment. In particular, the com-mentator pointed out that if the financinginstruments are treated as equity underthe regulations, a benefited shareholderwould have had less taxable income overthe life of the fast-pay arrangementunder the recharacterization of Notice97–21 (that is, a shareholder would havea permanent reduction to taxable in-come). Thus, the limit is without anysubstantive effect because any non-tim-ing reduction in taxable income due tothe limit is included in the year the regu-lations are finalized. To rectify thisproblem, the commentator asked that, ifthe final regulations do not classify thefinancing instruments as debt in allcases, they should at least classify the fi-nancing instruments as debt for the pe-riod starting after the effective date ofthe final regulations and ending beforethe final regulations are published.

To address these concerns, the finalregulations adopt a different rule from theone in the proposed regulations. As withthe proposed regulations, a shareholdermay limit its taxable income to either theamount determined under Notice 97–21or the amount determined under the regu-lations. For purposes of this limit, ashareholder may assume the financing in-struments are debt under the final regula-tions. A shareholder may also make thisassumption to determine the amount ofany later adjustment to income because ofthe limit. Thus, the later adjustment willnot include any permanent reduction totaxable income a shareholder realizes bylimiting its taxable income to the amountdetermined under Notice 97–21.

The final regulations also adopt alonger period during which shareholdersmay limit their taxable income. Underthe proposed regulation, a shareholder

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may limit its taxable income for taxableyears ending after February 26, 1997, andbefore the date these regulations are pub-lished as final regulations in the FederalRegister. The final regulations permit ashareholder to limit its taxable income forall periods before April 1, 2000. Thus, forall taxable years ending after February 26,1997 and before April 1, 2000, and forthat part of a shareholder’s taxable yearbefore April 1, 2000, a shareholder maylimit its taxable income attributable to thefast-pay arrangement.

In permitting shareholders to determinetheir taxable income under the regulationsby assuming that the financing instru-ments are debt for periods before April 1,2000, the IRS and Treasury Departmentintend no implication regarding theproper characterization of the financinginstruments under general tax principles.Rather, the rule regarding the financinginstruments is intended solely for the pur-pose of giving shareholders the benefit ofthe recharacterization described in Notice97–21 for periods before April 1, 2000.

Use of Derivatives to Avoid theRegulations

One commentator recommendedadding an explicit rule to prevent partiesfrom using derivative contracts to create afast-pay arrangement that escapes eitherthe regulations or the effect of the rechar-acterization rules. To illustrate this point,the commentator posited a simplifiedtransaction in which a corporation issuesfast-pay stock to one tax-exempt entityand benefited stock to another tax-exemptentity. The tax-exempt entity holding thebenefited stock enters into a prepaid for-ward contract with a taxable person.Under the prepaid forward contract, thetaxable person must buy the benefitedstock in the future for an amount substan-tially below its expected value. Accord-ing to the commentator, unless the taxableperson is treated as owning the benefitedstock, the parties have created a fast-payarrangement in which the recharacteriza-tion of the regulations fails to prevent taxavoidance. Without making a recommen-dation, the commentator offered a numberof rules to correct this situation. (Thecommentator did not discuss whether thebenefited holder would be subject to the“debt-financing” rules in section 514).

The IRS and Treasury Department have

concluded that there is no present need tomodify the regulations to address thisproblem. First, the tax treatment of deriv-atives in general is outside of the scope ofthese regulations. Therefore, a rule spe-cific to these regulations would only in-crease the complexity regarding the taxtreatment of derivatives. Second, andmore importantly, the IRS and TreasuryDepartment have concluded that underexisting law the party entitled to purchasethe benefited stock under a prepaid for-ward contract such as the one describedabove is the owner of the benefited stockfor federal income tax purposes. SeeRev.Rul. 82–150, 1982–2 C.B. 110 (conclud-ing that the holder of a deep-in-the-money option is the owner of the refer-ence property). Finally, the regulationsstate they are to be interpreted in a man-ner consistent with preventing the avoid-ance of tax. Mechanically applying theregulations in a manner that does not pre-vent tax avoidance is clearly inconsistentwith the purpose of the regulations andthe Congressional mandate of section7701(l).

Fast-pay Arrangement Defined

The proposed regulations define a fast-pay arrangement as any arrangement inwhich a corporation has outstanding forany part of its taxable year two or moreclasses of stock, at least one of which isfast-pay stock. Some taxpayers assertthat the regulations can be avoided by cre-ating a fast-pay arrangement in which acorporation issues what is nominally asingle class of shares, notwithstandingthat some of the shares are subject to a re-lated agreement. These taxpayers appar-ently rely on the formal meaning of“class” under state corporate law and ig-nore the direction in the proposed regula-tions to determine whether stock is fast-pay stock based on all the facts andcircumstances.

To remove any doubt that the regula-tions cover fast-pay arrangements no mat-ter how contrived, the IRS and TreasuryDepartment have simplified the definitionof “fast-pay arrangement” in the final reg-ulations. Under this definition, a fast-payarrangement is any arrangement in whicha corporation has fast-pay stock outstand-ing for any part of its taxable year. Theregulations illustrate this point with an ex-ample.

Effective Date

These regulations apply to taxableyears ending after February 26, 1997.

Special Analyses

It has been determined that this Trea-sury decision is not a significant regula-tory action as defined in Executive Order12866. Therefore, a regulatory assess-ment is not required. It is hereby certifiedthat these regulations will not have a sig-nificant economic impact on a substantialnumber of small entities. This certifica-tion is based on the understanding of theIRS and Treasury Department that thetotal number of fast-pay arrangements isfewer than 100, that the number of enti-ties engaging in transactions affected bythese regulations is not substantial and, ofthose entities, few or none are small enti-ties within the meaning of the RegulatoryFlexibility Act (5 U.S.C. chapter 6).Therefore, a Regulatory FlexibilityAnalysis is not required. Pursuant to sec-tion 7805(f) of the Internal RevenueCode, the notice of proposed rulemakingpreceding these regulations was submit-ted to the Chief Counsel for Advocacy ofthe Small Business Administration forcomments on its impact on small busi-nesses.

Drafting Information

The principal authors of these regula-tions are Jonathan Zelnik and MarshallFeiring of the Office of the AssistantChief Counsel (Financial Institutions &Products). However, other personnelfrom the IRS and Treasury Departmentparticipated in their development.

* * * * *

Adoption of Amendments to theRegulations

Accordingly, 26 CFR parts 1 and 602are amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation forpart 1 is amended by adding an entry innumerical order to read in part as follows:

Authority: 26 U.S.C. 7805 * * *Section 1.7701(l)–3 also issued under

26 U.S.C. 7701(l). * * *Par. 2. Section 1.1441–10, is added to

read as follows:

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§1.1441–10 Withholding agents with re-spect to fast-pay arrangements.

(a) In general. A corporation that is-sues fast-pay stock in a fast-pay arrange-ment described in §1.7701(l)–3(b)(1) is awithholding agent with respect to pay-ments made on the fast-pay stock andpayments deemed made under the rechar-acterization rules of §1.7701(l)–3. Exceptas provided in this paragraph (a) or inparagraph (b) of this section, the with-holding tax rules under section 1441 andsection 1442 apply with respect to a fast-pay arrangement described in§1.7701(l)–3(c)(1)(i) in accordance withthe recharacterization rules provided in§1.7701(l)–3(c). In all cases, notwith-standing paragraph (b) of this section, ifat any time the withholding agent knowsor has reason to know that the Commis-sioner has exercised the discretion undereither §1.7701(l)–3(c)(1)(ii) to apply therecharacterization rules of§1.7701(l)–3(c), or §1.7701(l)–3(d) to de-part from the recharacterization rules of§1.7701(l)–3(c) for a taxpayer, the with-holding agent must withhold on paymentsmade (or deemed made) to that taxpayerin accordance with the characterization ofthe fast-pay arrangement imposed by theCommissioner under §1.7701(l)–3.

(b) Exception. If at any time the with-holding agent knows or has reason toknow that any taxpayer entered into afast-pay arrangement with a principal pur-pose of applying the recharacterizationrules of §1.7701(l)–3(c) to avoid taxunder section 871(a) or section 881, thenfor each payment made or deemed madeto such taxpayer under the arrangement,the withholding agent must withhold,under section 1441 or section 1442, thehigher of—

(1) The amount of withholding thatwould apply to such payment determinedunder the form of the arrangement; or

(2) The amount of withholding thatwould apply to deemed payments deter-mined under the recharacterization rulesof §1.7701(l)–3(c).

(c) Liability. Any person required todeduct and withhold tax under this sectionis made liable for that tax by section1461, and is also liable for applicablepenalties and interest for failing to com-ply with section 1461.

(d) Examples. The following examplesillustrate the rules of this section:

Example 1. REIT W issues shares of fast-paystock to foreign individual A, a resident of CountryC. United States source dividends paid to residentsof C are subject to a 30 percent withholding tax. Wissues all shares of benefited stock to foreign indi-viduals who are residents of Country D. D’s incometax convention with the United States reduces theUnited States withholding tax on dividends to 15percent. Under §1.7701(l)–3(c), the dividends paidby W to A are deemed to be paid by W to the bene-fited shareholders. W has reason to know that A en-tered into the fast-pay arrangement with a principalpurpose of using the recharacterization rules of§1.7701(l)–3(c) to reduce United States withholdingtax. W must withhold at the 30 percent rate becausethe amount of withholding that applies to the pay-ments determined under the form of the arrangementis higher than the amount of withholding that appliesto the payments determined under §1.7701(l)–3(c).

Example 2. The facts are the same as in Example1 of this paragraph (d) except that W does not know,or have reason to know, that A entered into thearrangement with a principal purpose of using therecharacterization rules of §1.7701(l)–3(c) to reduceUnited States withholding tax. Further, the Com-missioner has not exercised the discretion under§1.7701(l)–3(d) to depart from the recharacteriza-tion rules of §1.7701(l)–3(c). Accordingly, W mustwithhold tax at a 15 percent rate on the dividendsdeemed paid to the benefited shareholders.

(e) Effective date. This section appliesto payments made (or deemed made) onor after January 6, 1999.

Par. 3. Section 1.7701(l)–0 is added toread as follows:§1.7701(l)–0 Table of contents.

This section lists captions that appearin §§1.7701(l)–1 and 1.7701(l)–3:§1.7701(l)–1 Conduit financing arrange-ments.§1.7701(l)–3 Recharacterizing financingarrangements involving fast-pay stock.(a) Purpose and scope.(b) Definitions.(1) Fast-pay arrangement.(2) Fast-pay stock.(i) Defined.(ii) Determination.(3) Benefited stock.(c) Recharacterization of certain fast-payarrangements.(1) Scope.(2) Recharacterization.(i) Relationship between benefited share-holders and fast-pay shareholders.(ii) Relationship between benefited share-holders and corporation.(iii) Relationship between fast-pay share-holders and corporation.(3) Other rules.(i) Character of the financing instruments.(ii) Multiple types of benefited stock.(iii) Transactions affecting benefited

stock.(A) Sale of benefited stock.(B) Transactions other than sales.(iv) Adjustment to basis for amounts ac-crued or paid in taxable years ending be-fore February 27, 1997.(d) Prohibition against affirmative use ofrecharacterization by taxpayers.(e) Examples.(f) Reporting requirement.(1) Filing requirements.(i) In general.(ii) Controlled foreign corporation.(iii) Foreign personal holding company.(iv) Passive foreign investment company.(2) Statement.(g) Effective date.(1) In general.(2) Election to limit taxable income attrib-utable to a recharacterized fast-payarrangement for periods before April 1,2000.(i) Limit.(ii) Adjustment and statement.(iii) Examples.(3) Rule to comply with this section.(4) Reporting requirements.

Par. 4. Section 1.7701(l)–3 is added toread as follows:§1.7701(l)–3 Recharacterizing financingarrangements involving fast-pay stock.

(a) Purpose and scope. This section isintended to prevent the avoidance of taxby persons participating in fast-payarrangements (as defined in paragraph(b)(1) of this section) and should be inter-preted in a manner consistent with thispurpose. This section applies to all fast-pay arrangements. Paragraph (c) of thissection recharacterizes certain fast-payarrangements to ensure the participantsare taxed in a manner reflecting the eco-nomic substance of the arrangements.Paragraph (f) of this section imposes re-porting requirements on certain partici-pants.

(b) Definitions—(1) Fast-pay arrange-ment. A fast-pay arrangement is anyarrangement in which a corporation hasfast-pay stock outstanding for any part ofits taxable year.

(2) Fast-pay stock—(i) Defined. Stockis fast-pay stock if it is structured so thatdividends (as defined in section 316) paidby the corporation with respect to thestock are economically (in whole or inpart) a return of the holder’s investment(as opposed to only a return on the

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holder’s investment). Unless clearlydemonstrated otherwise, stock is pre-sumed to be fast-pay stock if—

(A) It is structured to have a dividendrate that is reasonably expected to decline(as opposed to a dividend rate that is rea-sonably expected to fluctuate or remainconstant); or

(B) It is issued for an amount that ex-ceeds (by more than a de minimisamount, as determined under the princi-ples of §1.1273–1(d)) the amount atwhich the holder can be compelled to dis-pose of the stock.

(ii) Determination. The determinationof whether stock is fast-pay stock is basedon all the facts and circumstances, includ-ing any related agreements such as op-tions or forward contracts. A relatedagreement includes any direct or indirectagreement or understanding, oral or writ-ten, between the holder of the stock andthe issuing corporation, or between theholder of the stock and one or more othershareholders in the corporation. To deter-mine if it is fast-pay stock, stock is exam-ined when issued, and, for stock that isnot fast-pay stock when issued, whenthere is a significant modification in theterms of the stock or the related agree-ments or a significant change in the rele-vant facts and circumstances. Stock is notfast-pay stock solely because a redemp-tion is treated as a dividend as a result ofsection 302(d) unless there is a principalpurpose of achieving the same economicand tax effect as a fast-pay arrangement.

(3) Benefited stock. With respect toany fast-pay stock, all other stock in thecorporation (including other fast-paystock having any significantly differentcharacteristics) is benefited stock.

(c) Recharacterization of certain fast-pay arrangements— (1) Scope. Thisparagraph (c) applies to any fast-payarrangement—

(i) In which the corporation that hasoutstanding fast-pay stock is a regulatedinvestment company (RIC) (as defined insection 851) or a real estate investmenttrust (REIT) (as defined in section 856);or

(ii) If the Commissioner determinesthat a principal purpose for the structureof the fast-pay arrangement is the avoid-ance of any tax imposed by the InternalRevenue Code. Application of this para-graph (c)(1)(ii) is at the Commissioner’s

discretion, and a determination under thisparagraph (c)(1)(ii) applies to all partiesto the fast-pay arrangement, includingtransferees.

(2) Recharacterization. A fast-payarrangement described in paragraph (c)(1)of this section is recharacterized as anarrangement directly between the bene-fited shareholders and the fast-pay share-holders. The inception and resulting rela-tionships of the recharacterizedarrangement are deemed to be as follows:

(i) Relationship between benefitedshareholders and fast-pay shareholders.The benefited shareholders issue financialinstruments (the financing instruments)directly to the fast-pay shareholders in ex-change for cash equal to the fair marketvalue of the fast-pay stock at the time ofissuance (taking into account any relatedagreements). The financing instrumentshave the same terms (other than issuer) asthe fast-pay stock. Thus, for example, thetiming and amount of the payments madewith respect to the financing instrumentsalways match the timing and amount ofthe distributions made with respect to thefast-pay stock.

(ii) Relationship between benefitedshareholders and corporation. The bene-fited shareholders contribute to the corpo-ration the cash they receive for issuing thefinancing instruments. Distributionsmade with respect to the fast-pay stockare distributions made by the corporationwith respect to the benefited sharehold-ers’ benefited stock.

(iii) Relationship between fast-payshareholders and corporation. For pur-poses of determining the relationship be-tween the fast-pay shareholders and thecorporation, the fast-pay stock is ignored.The corporation is the paying agent of thebenefited shareholders with respect to thefinancing instruments.

(3) Other rules—(i) Character of the fi-nancing instruments. The character of afinancing instrument (for example, stockor debt) is determined under general taxprinciples and depends on all the facts andcircumstances.

(ii) Multiple types of benefited stock. Ifany benefited stock has any significantlydifferent characteristics from any otherbenefited stock, the recharacterizationrules of this paragraph (c) apply amongthe different types of benefited stock asappropriate to match the economic sub-

stance of the fast-pay arrangement.(iii) Transactions affecting benefited

stock—(A) Sale of benefited stock. If oneperson sells benefited stock to another—

(1) In addition to any consideration ac-tually paid and received for the benefitedstock, the buyer is deemed to pay and theseller is deemed to receive the amountnecessary to terminate the seller’s posi-tion in the financing instruments at fairmarket value; and

(2) The buyer is deemed to issue fi-nancing instruments to the fast-pay share-holders in exchange for the amount neces-sary to terminate the seller’s position inthe financing instruments.

(B) Transactions other than sales. Ex-cept for transactions subject to paragraph(c)(3)(iii)(A) of this section, in the case ofany transaction affecting benefited stock,the parties to the transaction must makeappropriate adjustments to properly takeinto account the fast-pay arrangement ascharacterized under paragraph (c)(2) ofthis section.

(iv) Adjustment to basis for amountsaccrued or paid in taxable years endingbefore February 27, 1997. In the case ofa fast-pay arrangement involving amountsaccrued or paid in taxable years endingbefore February 27, 1997, and recharac-terized under this paragraph (c), a bene-fited shareholder must decrease its basisin any benefited stock (as determinedunder paragraph (c)(2)(ii) of this section)by the amount (if any) that—

(A) Its income attributable to the bene-fited stock (reduced by deductions attrib-utable to the financing instruments) fortaxable years ending before February 27,1997, computed by recharacterizing thefast-pay arrangement under this para-graph (c) and by treating the financing in-struments as debt; exceeds

(B) Its income attributable to suchstock for taxable years ending before Feb-ruary 27, 1997, computed without apply-ing the rules of this paragraph (c).

(d) Prohibition against affirmative useof recharacterization by taxpayers. A tax-payer may not use the rules of paragraph(c) of this section if a principal purposefor using such rules is the avoidance ofany tax imposed by the Internal RevenueCode. Thus, with respect to such tax-payer, the Commissioner may depart fromthe rules of this section and recharacterize(for all purposes of the Internal Revenue

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Code) the fast-pay arrangement in accor-dance with its form or its economic sub-stance. For example, if a foreign personacquires fast-pay stock in a REIT and aprincipal purpose for acquiring such stockis to reduce United States withholdingtaxes by applying the rules of paragraph(c) of this section, the Commissioner may,for purposes of determining the foreignperson’s United States tax consequences(including withholding tax), depart fromthe rules of paragraph (c) of this sectionand treat the foreign person as holdingfast-pay stock in the REIT.

(e) Examples. The following examplesillustrate the rules of paragraph (c) of thissection:

Example 1. Decline in dividend rate—(i) Facts.Corporation X issues 100 shares of A Stock and 100shares of B Stock for $1,000 per share. By its terms,a share of B Stock is reasonably expected to pay a$110 dividend in years 1 through 10 and a $30 divi-dend each year thereafter. If X liquidates, the holderof a share of B Stock is entitled to a preference equalto the share’s issue price. Otherwise, the B Stockcannot be redeemed at either X’s or the share-holder’s option.

(ii) Analysis. When issued, the B Stock has adividend rate that is reasonably expected to declinefrom an annual rate of 11 percent of its issue price toan annual rate of 3 percent of its issue price. Sincethe B Stock is structured to have a declining divi-dend rate, the B Stock is fast-pay stock, and the AStock is benefited stock.

Example 2. Issued at a premium—(i) Facts. Thefacts are the same as in Example 1of this paragraph(e) except that a share of B Stock is reasonably ex-pected to pay an annual $110 dividend as long as itis outstanding, and Corporation X has the right to re-deem the B Stock for $400 a share at the end of year10.

(ii) Analysis. The B Stock is structured so thatthe issue price of the B Stock ($1,000) exceeds (bymore than a de minimis amount) the price at whichthe holder can be compelled to dispose of the stock($400). Thus, the B Stock is fast-pay stock, and theA Stock is benefited stock.

Example 3. Planned section 302(d)redemptions—(i) Facts. Corporation L, a subchap-ter C corporation, issues 220 shares of commonstock for $1,000 per share. No other stock is autho-rized, but L can issue warrants entitling the holder toacquire L common stock for $3,000 per share untilsuch time as L adopts a plan of liquidation. L canadopt a plan of liquidation if approved by 90 percentof its shareholders. Half of L’s stock is purchased byCorporation M, and half by Organization N, whichis tax exempt. At the time of purchase, M and Nagree that for a period of ten years L will annuallyredeem (and N will tender) ten shares of stock in ex-change for $12,100 and ten warrants. It is antici-pated that, under sections 302 and 301, the annualpayment to N will be a distribution of property thatis a dividend.

(ii) Analysis. Considering all the facts and cir-cumstances, including the agreement between Mand N, L’s redemption of N’s stock is undertaken

with a principal purpose of achieving the same eco-nomic and tax effect as a fast-pay arrangement.Thus, N’s stock is fast-pay stock, M’s stock is bene-fited stock, and the parties have entered into a fast-pay arrangement. Because L is neither a RIC nor aREIT, whether this fast-pay arrangement is rechar-acterized under paragraph (c) of this section dependson whether the Commissioner determines, underparagraph (c)(1)(ii) of this section, that a principalpurpose for the structure of the fast-pay arrangementis the avoidance of any tax imposed by the InternalRevenue Code.

Example 4. Recharacterization illustrated—(i)Facts. On formation, REIT Y issues 100 shares of CStock and 100 shares of D Stock for $1,000 pershare. By its terms, a share of D Stock is reasonablyexpected to pay a $110 dividend in years 1 through10 and a $30 dividend each year thereafter. In years1 through 10, persons holding a majority of the DStock must consent before Y may take any actionthat would result in Y liquidating or dissolving,merging or consolidating, losing its REIT status, orselling substantially all of its assets. Thereafter, Ymay take these actions without consent so long asthe D Stock shareholders receive $400 in exchangefor their D Stock.

(ii) Analysis. When issued, the D Stock has adividend rate that is reasonably expected to declinefrom an annual rate of 11 percent of its issue price toan annual rate of 3 percent of its issue price. In addi-tion, the $1,000 issue price of a share of D Stock ex-ceeds the price at which the shareholder can be com-pelled to dispose of the stock ($400). Thus, the DStock is fast-pay stock, and the C Stock is benefitedstock. Because Y is a REIT, the fast-pay arrange-ment is recharacterized under paragraph (c) of thissection.

(iii) Recharacterization. The fast-pay arrange-ment is recharacterized as follows:

(A) Under paragraph (c)(2)(i) of this section, theC Stock shareholders are treated as issuing financinginstruments to the D Stock shareholders in exchangefor $100,000 ($1,000, the fair market value of eachshare of D Stock, multiplied by 100, the number ofshares).

(B) Under paragraph (c)(2)(ii) of this section, theC Stock shareholders are treated as contributing$200,000 to Y (the $100,000 received for the financ-ing instruments, plus the $100,000 actually paid forthe C Stock) in exchange for the C Stock.

(C) Under paragraph (c)(2)(ii) of this section,each distribution with respect to the D Stock istreated as a distribution with respect to the C Stock.

(D) Under paragraph (c)(2)(iii) of this section,the C Stock shareholders are treated as making pay-ments with respect to the financing instruments, andY is treated as the paying agent of the financing in-struments for the C Stock shareholders.

Example 5. Transfer of benefited stock illus-trated— (i) Facts. The facts are the same as in Ex-ample 4of this paragraph (e). Near the end of year5, a person holding one share of C Stock sells it for$1,300. The buyer is unrelated to REIT Y or to anyof the D Stock shareholders. At the time of the sale,the amount needed to terminate the seller’s positionin the financing instruments at fair market value is$747.

(ii) Benefited shareholder’s treatment on sale.Under paragraph (c)(3)(iii)(A) of this section, theseller’s amount realized is $2,047 ($1,300, the

amount actually received, plus $747, the amountnecessary to terminate the seller’s position in the fi-nancing instruments at fair market value). Theseller’s gain on the sale of the common stock is $47($2,047, the amount realized, minus $2,000, theseller’s basis in the common stock). The seller hasno income or deduction with respect to terminatingits position in the financing instruments.

(iii) Buyer’s treatment on purchase. Under para-graph (c)(3)(iii)(A) of this section, the buyer’s basisin the share of D Stock is $2,047 ($1,300, theamount actually paid, plus $747, the amount neededto terminate the seller’s position in the financing in-struments at fair market value). Under paragraph(c)(3)(iii)(B) of this section, simultaneous with thesale, the buyer is treated as issuing financing instru-ments to the fast-pay shareholders in exchange for$747, the amount necessary to terminate the seller’sposition in the financing instruments at fair marketvalue.

Example 6. Fast-pay arrangement involvingamounts accrued or paid in a taxable year endingbefore February 27, 1997— (i) Facts. Y is a calen-dar year taxpayer. In June 1996, Y acquires sharesof REIT T benefited stock for $15,000. In Decem-ber 1996, Y receives dividends of $100. Under therecharacterization rules of paragraph (c)(2) of thissection, Y’s 1996 income attributable to the bene-fited stock is $1,200, Y’s 1996 deduction attribut-able to the financing instruments is $500, and Y’sbasis in the benefited stock is $25,000.

(ii) Analysis. Under paragraph (c)(3)(iv) of thissection, Y’s basis in the benefited stock is reducedby $600. This is the amount by which Y’s 1996 in-come from the fast-pay arrangement as recharacter-ized under this section ($1,200 of income attribut-able to the benefited stock less $500 of deductionsattributable to the financing instruments), exceedsY’s 1996 income from the fast-pay arrangement asnot recharacterized under this section ($100 of in-come attributable to the benefited stock). Thus, in1997 when the fast-pay arrangement is recharacter-ized, Y’s basis in the benefited stock is $24,400.

(f) Reporting requirement—(1) Filingrequirements—(i) In general. A corpora-tion that has fast-pay stock outstanding atany time during the taxable year must at-tach the statement described in paragraph(f)(2) of this section to its federal incometax return for such taxable year. Thisparagraph (f)(1)(i) does not apply to acorporation described in paragraphs(f)(1)(ii), (iii), or (iv) of this section.

(ii) Controlled foreign corporation. Inthe case of a controlled foreign corpora-tion (CFC), as defined in section 957, thathas fast-pay stock outstanding at any timeduring its taxable year (during which timeit was a CFC), each controlling UnitedStates shareholder (within the meaning of§1.964-1(c)(5)) must attach the statementdescribed in paragraph (f)(2) of this sec-tion to the shareholder’s Form 5471 forthe CFC’s taxable year. The provisions ofsection 6038 and the regulations under

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section 6038 apply to any statement re-quired by this paragraph (f)(1)(ii).

(iii) Foreign personal holding com-pany. In the case of a foreign personalholding company (FPHC), as defined insection 552, that has fast-pay stock out-standing at any time during its taxableyear (during which time it was a FPHC),each United States citizen or resident whois an officer, director, or 10-percent share-holder (within the meaning of section6035(e)(1)) of such FPHC must attach thestatement described in paragraph (f)(2) ofthis section to his or her Form 5471 forthe FPHC’s taxable year. The provisionsof sections 6035 and 6679 and the regula-tions under sections 6035 and 6679 applyto any statement required by this para-graph (f)(1)(iii).

(iv) Passive foreign investment com-pany. In the case of a passive foreign in-vestment company (PFIC), as defined insection 1297, that has fast-pay stock out-standing at any time during its taxableyear (during which time it was a PFIC),each shareholder that has elected (undersection 1295) to treat the PFIC as a quali-fied electing fund and knows or has rea-son to know that the PFIC has outstandingfast-pay stock must attach the statementdescribed in paragraph (f)(2) of this sec-tion to the shareholder’s Form 8621 forthe PFIC’s taxable year. Each share-holder owning 10 percent or more of theshares of the PFIC (by vote or value) ispresumed to know that the PFIC has is-sued fast-pay stock. The provisions ofsections 1295(a)(2) and 1298(f) and theregulations under those sections (includ-ing §1.1295–1T(f)(2)) apply to any state-ment required by this paragraph (f)(1)(iv).

(2) Statement. The statement requiredunder this paragraph (f) must say, “Thisfast-pay stock disclosure statement is re-quired by §1.7701(l)–3(f) of the incometax regulations.” The statement must alsoidentify the corporation that has outstand-ing fast-pay stock and must contain thedate on which the fast-pay stock was is-sued, the terms of the fast-pay stock, and(to the extent the filing person knows orhas reason to know such information) thenames and taxpayer identification num-bers of the shareholders of any stock thatis not traded on an established securitiesmarket (as described in §1.7704–1(b)).

(g) Effective date—(1) In general. Ex-cept as provided in paragraph (g)(4) of

this section (relating to reporting require-ments), this section applies to taxableyears ending after February 26, 1997.Thus, all amounts accrued or paid duringthe first taxable year ending after Febru-ary 26, 1997, are subject to this section.

(2) Election to limit taxable income at-tributable to a recharacterized fast-payarrangement for periods before April 1,2000—(i) Limit. For periods before April1, 2000, provided the shareholder rechar-acterizes the fast-pay arrangement consis-tently for all such periods, a shareholdermay limit its taxable income attributableto a fast-pay arrangement recharacterizedunder paragraph (c) of this section to thetaxable income that results if the fast-payarrangement is recharacterized under ei-ther—

(A) Notice 97–21, 1997–1 C.B. 407,see §601.601(d)(2) of this chapter; or

(B) Paragraph (c) of this section, com-puted by assuming the financing instru-ments are debt.

(ii) Adjustment and statement. Ashareholder that limits its taxable incometo the amount determined under para-graph (g)(2)(i)(A) of this section must in-clude as an adjustment to taxable incomethe excess, if any, of the amount deter-mined under paragraph (g)(2)(i)(B) of thissection, over the amount determinedunder paragraph (g)(2)(i)(A) of this sec-tion. This adjustment to taxable incomemust be made in the shareholder’s firsttaxable year that includes April 1, 2000.A shareholder to which this paragraph(g)(2)(ii) applies must include a statementin its books and records identifying eachfast-pay arrangement for which an adjust-ment must be made and providing theamount of the adjustment for each suchfast-pay arrangement.

(iii) Examples. The following exam-ples illustrate the rules of this paragraph(g)(2). For purposes of these examples,assume that a shareholder may limit itstaxable income under this paragraph(g)(2) for periods before January 1,2000.

Example 1. Fast-pay arrangement recharacter-ized under Notice 97–21; REIT holds third-partydebt—(i) Facts. (A) REIT Y is formed on January1, 1997, at which time it issues 1,000 shares of fast-pay stock and 1,000 shares of benefited stock for$100 per share. Y and all of its shareholders areU.S. persons and have calendar taxable years. Allshareholders of Y have elected to accrue market dis-count based on a constant interest rate, to include themarket discount in income as it accrues, and to

amortize bond premium.(B) For years 1 through 5, the fast-pay stock has

an annual dividend rate of $17 per share ($17,000for all fast-pay stock); in later years, the fast-paystock has an annual dividend rate of $1 per share($1,000 for all fast-pay stock). At the end of year 5,and thereafter, a share of fast-pay stock can be ac-quired by Y in exchange for $50 ($50,000 for allfast-pay stock).

(C) On the day Y is formed, it acquires a five-year mortgage note (the note) issued by an unrelatedthird party for $200,000. The note provides for an-nual interest payments on December 31 of $18,000(a coupon interest rate of 9.00 percent, compoundedannually), and one payment of principal at the end of5 years. The note can be prepaid, in whole or inpart, at any time.

(ii) Recharacterization under Notice 97–21—(A)In general. One way to recharacterize the fast-payarrangement under Notice 97–21 is to treat the fast-pay shareholders and the benefited shareholders as ifthey jointly purchased the note from the issuer withthe understanding that over the five-year term of thenote the benefited shareholders would use theirshare of the interest to buy (on a dollar-for-dollarbasis) the fast-pay shareholders’ portion of the note.The benefited shareholders’ and the fast-pay share-holders’ yearly taxable income under Notice 97–21can then be calculated after determining their initialportions of the note and whether those initial por-tions are purchased at a discount or premium.

(B) Determining initial portions of the debt in-strument. The fast-pay shareholders’ and the bene-fited shareholders’ initial portions of the note can bedetermined by comparing the present values of theirexpected cash flows. As a group, the fast-pay share-holders expect to receive cash flows of $135,000(five annual payments of $17,000, plus a final pay-ment of $50,000). As a group, the benefited share-holders expect to receive cash flows of $155,000(five annual payments of $1,000, plus a final pay-ment of $150,000). Using a discount rate equal tothe yield to maturity (as determined under§1.1272–1(b)(1)(i)) of the mortgage note (9.00 per-cent, compounded annually), the present value ofthe fast-pay shareholders’ cash flows is $98,620, andthe present value of the benefited shareholders’ cashflows is $101,380. Thus, the fast-pay shareholdersinitially acquire 49 percent of the note at a $1,380premium (that is, they paid $100,000 for $98,620 ofprincipal in the note). The benefited shareholdersinitially acquire 51 percent of the note at a $1,380discount (that is, they paid $100,000 for $101,380 ofprincipal in the note). Under section 171, the fast-pay shareholders’ premium is amortizable based ontheir yield in their initial portion of the note (8.574percent, compounded annually). The benefitedshareholders’ discount accrues based on the yield intheir initial portion of the note (9.353 percent, com-pounded annually).

(C) Taxable income under Notice 97–21—(1)Fast-pay shareholders. Under Notice 97–21, thefast-pay shareholders compute their taxable incomeattributable to the fast-pay arrangement for periodsbefore January 1, 2000, by subtracting the amortiz-able premium from the accrued interest on the fast-pay shareholders’ portion of the note. For purposesof paragraph (g)(2)(i)(A) of this section, the fast-payshareholders’ taxable income as a group is as fol-lows:

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(2) Benefited shareholders. Under Notice97–21, the benefited shareholders compute theirtaxable income attr ibutable to the fast-pay

arrangement for periods before January 1, 2000,by adding the accrued discount to the accrued in-terest on the benefited shareholders’ portion of the

note. For purposes of paragraph (g)(2)(i)(A) ofthis section, the benefited shareholders’ taxable in-come as a group is as follows:

2000–4 I.R.B. 385 January 24, 2000

Interest Amortizable Taxable

Taxable Period Income Premium Income

1/1/97 - 12/31/97 $ 8,876 ($302) $ 8,574

1/1/98 - 12/31/98 $ 8,145 ($293) $ 7,852

1/1/99 - 12/31/99 $ 7,348 ($281) $ 7,067

$24,369 ($876) $23,493

Interest Accrued TaxableTaxable Period Income Discount Income

1/1/97 - 12/31/97 $ 9,124 $229 $ 9,353

1/1/98 - 12/31/98 $ 9,855 $251 $10,106

1/1/99 - 12/31/99 $10,652 $274 $10,926

$29,631 $754 $30,385

(iii) Taxable income under the recharacteriza-tion of this section—(A) Fast-pay shareholders.Under paragraphs (c) and (g)(2)(i)(B) of this sec-tion, the fast-pay shareholders’ taxable incomeattributable to the fast-pay arrangement for peri-ods before January 1, 2000, is the interestdeemed paid on the financing instruments. Forpurposes of paragraph (g)(2)(i)(B) of this section,the fast-pay shareholders’ taxable income as agroup is as follows:

Taxable

Taxable Period Income

1/1/97 - 12/31/97 $ 8,574

1/1/98 - 12/31/98 $ 7,852

1/1/99 - 12/31/99 $ 7,067

$23,493

(B) Benefited shareholders. Under paragraphs (c)and (g)(2)(i)(B) of this section, the benefited share-holders compute their taxable income attributable tothe fast-pay arrangement for periods before January1, 2000, by subtracting the interest deemed paid onthe financing instruments from the dividends actu-ally and deemed paid on the benefited stock. Forpurposes of paragraph (g)(2)(i)(B) of this section,the benefited shareholders’ taxable income as agroup is as follows:

Dividends Interest PaidPaid On On Financing Taxable

Taxable Period Benefited Stock Instruments Income

1/1/97 - 12/31/97 $18,000 ($ 8,574) $ 9,426

1/1/98 - 12/31/98 $18,000 ($ 7,852) $10,148

1/1/99 - 12/31/99 $18,000 ($ 7,067) $10,933

$54,000 ($23,493) $30,507

(iv) Limit on taxable income under paragraph(g)(2)(i) of this section—(A) Fast-pay sharehold-ers. For periods before January 1, 2000, the fast-pay shareholders have the same taxable incomeunder the recharacterization of Notice 97–21 andparagraph (g)(2)(i)(A) of this section ($23,493) asthey have under the recharacterization of para-graphs (c) and (g)(2)(i)(B) of this section($23,493). Thus, under paragraph (g)(2)(i) of thissection, the fast-pay shareholders may limit theirtaxable income attributable to the fast-pay arrange-ment for periods before January 1, 2000, to$23,493 (as a group).

(B) Benefited shareholders. For periods beforeJanuary 1, 2000, the benefited shareholders havetaxable income attributable to the fast-pay arrange-ment of $30,385 under the recharacterization ofNotice 97–21 and paragraph (g)(2)(i)(A) of thissection, and taxable income of $30,507 under therecharacterization of paragraphs (c) and(g)(2)(i)(B) of this section. Thus, under paragraph(g)(2)(i) of this section, the benefited shareholdersmay limit their taxable income attributable to thefast-pay arrangement for periods before January 1,2000, to either $30,385 (as a group) or $30,507 (asa group).

(v) Adjustment to taxable income under para-

graph (g)(2)(ii) of this section. Under paragraph(g)(2)(ii) of this section, any benefited shareholderthat limited its taxable income to the amount deter-mined under paragraph (g)(2)(i)(A) of this sectionmust include as an adjustment to taxable incomethe excess, if any, of the amount determined underparagraph (g)(2)(i)(B) of this section, over theamount determined under paragraph (g)(2)(i)(A) ofthis section. If all benefited shareholders limitedtheir taxable income to the amount determinedunder paragraph (g)(2)(i)(A) of this section, then asa group their adjustment to income is $122($30,507, minus $30,385). Each shareholder mustinclude its adjustment in income for the taxableyear that includes January 1, 2000.

Example 2. REIT holds debt issued by a bene-fited shareholder—(i) Facts. The facts are thesame as in Example 1of this paragraph (g)(2) ex-cept that corporation Z holds 800 shares (80 per-cent) of the benefited stock, and Z, instead of athird party, issues the mortgage note acquired by Y.

(ii) Recharacterization under Notice 97–21.Because Y holds a debt instrument issued by Z, thefast-pay arrangement is recharacterized under No-tice 97–21 as an arrangement in which Z issuedone or more instruments directly to the fast-payshareholders and the other benefited shareholders.

(A) Fast-pay shareholders. Consistent with thisrecharacterization, Z is treated as issuing a debt in-strument to the fast-pay shareholders for $100,000.The debt instrument provides for five annual pay-ments of $17,000 and an additional payment of$50,000 in year five. Thus, the debt instrument’syield to maturity is 8.574 percent per annum, com-pounded annually.

(B) Benefited shareholders. Zis also treated as issuing a debt instrument to theother benefited shareholders for $20,000 (200shares multiplied by $100, or 20 percent of the$100,000 paid to Y by the benefited shareholdersas a group). This debt instrument provides for fiveannual payments of $200 and an additional pay-ment of $30,000 in year five. The debt instru-ment’s yield to maturity is 9.304 percent perannum, compounded annually.

(C) Issuer ’s interest expense under Notice97–21. Under Notice 97-21, Z’s interest expenseattributable to the fast-pay arrangement for periodsbefore January 1, 2000, equals the interest accruedon the debt instrument held by the fast-pay share-holders, plus the interest accrued on the debt in-strument held by the benefited shareholders otherthan Z. For purposes of paragraph (g)(2)(i)(A) ofthis section, Z’s interest expense is as follows:

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Accrued AccruedInterest Interest TotalFast-pay Other Benefited Interest

Taxable Period Shareholders Shareholders Expense1/1/97 - 12/31/97 ($ 8,574) ($1,861) ($10,435)1/1/98 - 12/31/98 ($ 7,852) ($2,015) ($ 9,867)1/1/99 - 12/31/99 ($ 7,067) ($2,184) ($ 9,251)

($23,493) ($6,060) ($29,553)

January 24, 2000 386 2000–4 I.R.B.

(iii) Recharacterization under this section.Under paragraphs (c) and (g)(2)(i)(B) of this section,Z’s taxable income attributable to the fast-payarrangement for periods before January 1, 2000,

equals Z’s share of the dividends actually anddeemed paid on the benefited stock (80 percent ofthe outstanding benefited stock), reduced by the sumof the interest accrued on the note held by Y and the

interest accrued on the financing instrumentsdeemed to have been issued by Z. For purposes ofparagraph (g)(2)(i)(B) of this section, Z’s taxable in-come is as follows:

Accrued AccruedDividends Interest InterestBenefited On Debt Financing Taxable

Taxable Period Stock Held By Y Instruments Expense1/1/97 - 12/31/97 $14,400 ($18,000) ($ 6,859) ($10,459)1/1/98 - 12/31/98 $14,400 ($18,000) ($ 6,281) ($ 9,881)1/1/99 - 12/31/99 $14,400 ($18,000) ($ 5,654) ($ 9,254)

$43,200 ($54,000) ($18,794) ($29,594)

(iv) Limit on taxable income under this paragraph(g)(2). For periods before January 1, 2000, Z has ataxable loss attributable to the fast-pay arrangement of$29,553 under the recharacterization of Notice 97-21and paragraph (g)(2)(i)(A) of this section, and a tax-able loss of $29,594 under the recharacterization ofparagraphs (c) and (g)(2)(i)(B) of this section. Thus,under paragraph (g)(2)(i) of this section, Z may reporta taxable loss attributable to the fast-pay arrangementfor periods before January 1, 2000, of either $29,553or $29,594. Under paragraph (g)(2)(ii), Z has no ad-justment to its taxable income for its taxable year thatincludes January 1, 2000.

(3) Rule to comply with this section. Tocomply with this section for each taxableyear in which it failed to do so, a taxpayershould file an amended return. For tax-able years ending before January 10,2000, a taxpayer that has complied withNotice 97–21, 1997–1 C.B. 407 (see§601.601(d)(2) of this chapter), for all

such taxable years is considered to havecomplied with this section and limited itstaxable income under paragraph(g)(2)(i)(A) of this section.

(4) Reporting requirements. The re-porting requirements of paragraph (f) ofthis section apply to taxable years (of theperson required to file the statement) end-ing after January 10, 2000.

PART 602—OMB CONTROLNUMBERS UNDER THEPAPERWORK REDUCTION ACT

Par. 5. The authority citation for part602 continues to read as follows:

Authority: 26 U.S.C. 7805.Par. 6. Section 602.101(b) is amended

by adding an entry in numerical order tothe table to read as follows:

§602.101 OMB Control numbers.* * * * *

(b) * * *

Robert E. Wenzel,Deputy Commissioner

of Internal Revenue.

Approved January 7, 2000.

Jonathan Talisman,Acting Assistant Secretary

of the Treasury.

(Filed by the Office of the Federal Register on Janu-ary 7, 2000, 8:45 a.m., and published in the issue ofthe Federal Register for January 10, 2000, 65 F.R.1310)

CFR part or section where Current OMBidentified and described control No.

* * * * *

49.4251–4(d)(2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-1628

* * * * *

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Application Procedures forQualified Intermediary StatusUnder Section 1441; FinalQualified IntermediaryWithholding Agreement

Rev. Proc. 2000–12

SECTION 1. PURPOSE AND SCOPE

.01 Purpose. This revenue procedureprovides guidance for entering into aqualified intermediary (QI) withholdingagreement with the Internal RevenueService (IRS) under §1.1441–1(e)(5) ofthe income tax regulations.1 Section 3of this revenue procedure provides theapplication procedures for becoming aQI and Section 4 provides the final qual-ified intermediary withholding agree-ment (“QI withholding agreement”).The objective of the QI withholdingagreement is to simplify withholdingand reporting obligations for paymentsof income (including interest, dividends,royalties, and gross proceeds) made toan account holder through one or moreforeign intermediaries.

.02 Scope. This revenue procedure ap-plies to persons described in §1.1441–1(e)(5)(ii)(A) and (B)–foreign financialinstitutions, foreign clearing organiza-tions, and foreign branches of U.S. finan-cial institutions and U.S. clearing organi-zations. The principles of this agreementmay, however, be used to conclude QIwithholding agreements with foreign cor-porations described in§1.1441–1(e)(5)(ii)(C) seeking to becomea QI to present claims of benefits under anincome tax treaty on behalf of sharehold-ers and to other persons that the IRS mayaccept to be qualified intermediaries asauthorized under §1.1441–1(e)(5)(ii)(D).This revenue procedure does not apply toa foreign partnership seeking to qualify asa withholding foreign partnership. See§1.1441–5(c)(2)(ii). The IRS and Trea-sury will, however, consider applying theprinciples of the QI withholding agree-

ment provided in this revenue procedureto a foreign partnership acting on behalfof its partners in appropriate circum-stances. A person that is not within thescope of this revenue procedure may seekQI status by contacting the Office of theAssistant Commissioner (International) atthe address or telephone number in Sec-tion 3.01 of this revenue procedure.

SECTION 2. BACKGROUND

.01 Withholding and reporting on pay-ments to foreign persons.Under sections1441 and 1442 of the Internal RevenueCode (Code), a person that makes a pay-ment of U.S. source interest, dividends,royalties, and certain other types of in-come to a foreign person must generallydeduct and withhold 30 percent from thepayment. A lower rate of withholdingmay apply under the Code (e.g., section1443), the regulations, or an income taxtreaty. Generally, a payor of these typesof income must also report the paymentson Forms 1042–S. See §1.1461–1(c).

Under sections 6041, 6042, 6045, 6049,and 6050N of the Code (the Form 1099 re-porting provisions), payors of interest, div-idends, royalties, gross proceeds from thesales of securities, and other fixed or deter-minable income must report payments onForm 1099 unless an exception applies. Ifa payment is reportable on Form 1099, apayor must generally obtain a Form W-9from the payee. If the payor does not re-ceive the Form W-9, it must generallybackup withhold at a 31 percent rate undersection 3406 of the Code and report thepayment on Form 1099. An exception tothe Form 1099 reporting provisions appliesif the payee is a foreign person. A payorcan treat a person as foreign if the payorcan reliably associate the payment withdocumentation that establishes that the per-son is the beneficial owner of the incomeor a foreign payee. See §§1.6041–4(a),1.6042–3(b)(1)(iii); 1.6045–1(g)(1)(i);1.6049–5(b)(12); and 1.6050N–1(c)(1)(i).Moreover, a payor does not have to backupwithhold on payments to foreign beneficialowners or foreign payees because backupwithholding applies only to amounts thatthe payor must report on Form 1099.

.02 Responsibilities of intermediariesthat enter into the QI withholding agree-ment. When the IRS enters into a QI

withholding agreement with a foreignperson, that foreign person becomes a QI.A QI is a withholding agent under chapter3 of the Code and a payor under chapter61 and section 3406 of the Code foramounts that it pays to its account hold-ers. Except as otherwise provided in theAgreement, a QI’s obligations with re-spect to amounts it pays to account hold-ers are governed by chapter 3, chapter 61,and section 3406 of the Code and the reg-ulations thereunder. A QI shall act in itscapacity as a QI pursuant to the Agree-ment only for those accounts the QI haswith a withholding agent that the QI hasdesignated as accounts for which it acts asa QI. A QI is not required to act as a QIfor all accounts that it has with a with-holding agent. However, if QI designatesan account as one for which it will act as aQI, it must act as a QI for all paymentsmade to that account.

SECTION 3. APPLICATION FOR QISTATUS

.01 Where to Apply. To apply for QIstatus, an eligible person must submit theinformation required by this Section 3 to:

Assistant Commissioner (International)Foreign Payments DivisionOP:IN:I:FP950 L’Enfant Plaza South, SWWashington, DC 20024Telephone: (202) 874-1800Fax: (202) 874-1797.02 Contents of the Application. A

prospective QI must submit an applica-tion to become a QI. The applicationmust establish to the satisfaction of theIRS that the applicant has adequate re-sources and procedures to comply withthe terms of the QI withholding agree-ment. An application must include the in-formation specified in this section 3.02,and any additional information and docu-mentation requested by the IRS:

(1) A statement that the applicant is aneligible person and that it requests to enterinto a QI withholding agreement with theIRS.

(2) The applicant’s name, address, andemployer identification number (EIN), ifany.

(3) The country in which the applicantwas created or organized and a descrip-tion of the applicant’s business.

Part III. Administrative, Procedural, and Miscellaneous

1 All citations to income tax regulations in this rev-enue procedure are to the regulations as amended byT.D. 8734 (62 FR 53387), T.D. 8804 (63 FR 72183),and T.D. 8856 (64 FR 73408).

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(4) A list of the position titles of thosepersons who will be the responsible par-ties for performance under the Agreementand the names, addresses, and telephonenumbers of those persons as of the datethe application is submitted.

(5) An explanation and sample of theaccount opening agreements and otherdocuments used to open and maintain theaccounts at each location covered by theAgreement.

(6) A list describing the type of accountholders (e.g., U.S., foreign, treaty benefitclaimant, or intermediary), the approxi-mate number of account holders withineach type, and the estimated value of U.S.investments that the QI agreement willcover.

(7) A general description of U.S. assetsby type (e.g., U.S. securities, U.S. real es-tate), including assets held by U.S. custo-dians, and their approximate aggregatevalue by type. The applicant should pro-vide separate information for assets bene-ficially owned by the applicant and for as-sets it holds for others.

(8) A completed Form SS-4 (Applica-tion for Employer Identification Number)to apply for a QI Employer IdentificationNumber (QI-EIN) to be used solely for QIreporting and filing purposes. An appli-cant must apply for a QI-EIN even if it al-ready has another EIN. Each legal entitygoverned by the QI withholding agree-ment must complete a Form SS-4.

(9) Completed appendices and attach-ments that appear at the end of the QIagreement set forth in section 4.

The IRS will not enter into a QI with-holding agreement that provides for theuse of documentary evidence obtainedunder a country’s know-your-customerrules if it has not received the “know-your-customer” practices and proceduresfor opening accounts and responses to the18 specific items presented below. If theinformation has already been provided tothe IRS, it is not necessary for a particularprospective QI to submit the information.The IRS may publish lists of countries forwhich it has received know-your-cus-tomer information and for which theknow-your-customer rules are acceptable.A prospective QI applicant may also con-tact the IRS at the address or telephonenumber provided in section 3.01 to obtaininformation. The 18 items are as follows:1. An English translation of the laws

and regulations (“know-your-cus-tomer” rules) governing the require-ments of a QI to obtain documenta-tion confirming the identity of QI’saccount holders. The translationmust include the name of the law, andthe appropriate citations to the lawand regulations.

2. The name of the organization(whether a governmental entity orprivate association) responsible forenforcing the know-your-customerrules. Specify how those rules areenforced (e.g., through audit) and thefrequency of compliance checks.

3. The penalties that apply for failure toobtain, or evaluate, documentationunder the know-your-customer rules.

4. The definition of customer or accountholder that is used under the know-your- customer rules. Specifywhether the definition encompassesdirect and indirect beneficiaries of anaccount if the activity in the accountinvolves the receipt or disbursal offunds. Specify whether the definitionof customer or account holderincludes a trust beneficiary, a compa-ny whose assets are managed by anasset manager, a controlling share-holder of a closely held corporationor the grantor of a trust.

5. A statement regarding whether thedocumentation required under theknow-your- customer rules requires afinancial institution to determine if itsaccount holder is acting as an inter-mediary for another person.

6. A statement regarding whether thedocumentation required under theknow-your- customer rules requires afinancial institution to identify theaccount holder as a beneficial ownerof income credited to an account.

7. A list of the specific documentationrequired to be used under the know-your- customer rules, or if those rulesdo not require use of specific docu-mentation, the documentation that isgenerally accepted by the authoritiesresponsible for enforcing those rules.

8. A statement regarding whether theknow-your-customer rules requirethat an account holder provide a per-manent residence address.

9. A summary of the rules that apply ifan account is not opened in person(e.g., correspondence, telephone,

Internet).10. Whether an account holder’s identity

may be established, in whole or inpart, by introductions or referrals.

11. The circumstances under which newdocumentation must be obtained, orexisting documentation verified,under the know-your-customer rules.

12. A list of all the exceptions, if any, tothe documentation requirementsunder the know-your-customer rules.

13. A statement regarding whether theknow-your-customer rules do notrequire documentation from anaccount holder if a payment to orfrom that account holder is cleared byanother financial institution.2

14. A statement regarding how long thedocumentation remains valid underthe know- your-customer rules.

15. A statement regarding how long thedocumentation obtained under theknow-your- customer rules must beretained and the manner for maintain-ing that documentation.

16. Specify whether the rules require themaintenance of wire transfer records,the form of the wire transfer recordsand how long those records must bemaintained. State whether the wiretransfer records require information asto both the original source of the fundsand the final destination of the funds.

17. A list of any payments or types ofaccounts that are not subject to theknow-your- customer rules.

18. Specify whether there are specialrules that apply for purposes of pri-vate banking activities.

SECTION 4. QUALIFIEDINTERMEDIARY WITHHOLDINGAGREEMENT

The text of the QI agreement is setforth below. Upon receipt and review ofan application to become a qualified inter-mediary, the IRS will complete the QIagreement (e.g., insertion of the QI’sname, etc.). A prospective QI should en-sure that it has provided to the IRS all ofthe information that is required to com-plete the agreement. It may be necessaryfor the IRS to contact the potential quali-fied intermediary, or its authorized repre-

2 Generally, the IRS will not permit a QI toestablish the identity of an account holder with-out obtaining documentation directly from theaccount holder.

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sentative, to obtain additional informa-tion. Once the IRS has obtained all theinformation required to complete theagreement, the IRS will send two un-signed copies of the QI withholdingagreement to the prospective QI for signa-ture. Both copies of the agreement shouldbe signed by a person with the authorityto sign the agreement and returned to theIRS at the address specified in section3.01. The IRS will sign the QI agreementand return one of the originals to the qual-ified intermediary.The IRS will consider changes to the textof the QI agreement as set forth belowonly in rare and unusual circumstances.The IRS will not accept, however, anychanges that it determines would providea potential QI with a competitive advan-tage over other similarly situated QIs.

COUNTRY-BY-COUNTRYREPORTING

The IRS and Treasury have decided thata QI that has executed a QI withholdingagreement prior to January 1, 2001, willnot be required to provide a country-by-country break down of reporting pools onForm 1042-S. See section 8.03 of the QIwithholding agreement for a definition ofreporting pool. It was decided that requir-ing such information at this time wouldimpede implementation of the QI systemsince it is recognized that financial institu-tions will be required to commit substan-tial information technology resources toaddress technology issues that have beendelayed by the year 2000 problem. TheIRS and Treasury, however, are continuingto study whether to require country codeinformation for reporting pools in the fu-ture. Therefore, the IRS and Treasury mayrequire a potential QI that enters into anagreement after December 31, 2000, or aQI that enters into an agreement after theexpiration of an agreement’s initial term, toprovide a country-by-country break downof reporting pools.

SECTION 1. PURPOSE AND SCOPE

Sec. 1.01. General ObligationsSec. 1.02. Parties to the Agreement

SECTION 2. DEFINITIONS

Sec. 2.01. Account HolderSec. 2.02. AgreementSec. 2.03. Amounts Subject to NRA

WithholdingSec. 2.04. Assumption ofWithholding ResponsibilitySec. 2.05. Backup WithholdingSec. 2.06. Beneficial OwnerSec. 2.07. Broker ProceedsSec. 2.08. Chapter 3 of the CodeSec. 2.09. Chapter 61 of the CodeSec. 2.10. Deposit InterestSec. 2.11. Designated BrokerProceedsSec. 2.12. Documentary EvidenceSec. 2.13. DocumentationSec. 2.14. Documented AccountHolderSec. 2.15. Exempt RecipientSec. 2.16. External AuditorSec. 2.17. Flow -Through EntitySec. 2.18. Foreign PersonSec. 2.19. Form W-8Sec. 2.20. Form W-9Sec. 2.21. Form 945Sec. 2.22. Form 1042Sec. 2.23. Form 1042-SSec. 2.24. Form 1096Sec. 2.25. Form 1099Sec. 2.26. Form 1099 ReportingSec. 2.27. IntermediarySec. 2.28. Know-Your-CustomerRulesSec. 2.29. Marketable SecuritiesSec. 2.30. Non-Exempt RecipientSec. 2.31. Nonqualified IntermediarySec. 2.32. NRA WithholdingSec. 2.33. OverwithholdingSec. 2.34. Paid Outside the UnitedStatesSec. 2.35. PaymentSec. 2.36. PayorSec. 2.37. Presume/PresumptionSec. 2.38. Private ArrangementIntermediarySec. 2.39. Qualified IntermediarySec. 2.40. Qualified Intermediary (orQI) EINSec. 2.41. Reduced Rate ofWithholdingSec. 2.42. Reliably Associating aPayment With DocumentationSec. 2.43. Reportable AmountSec. 2.44. Reportable PaymentSec. 2.45. Reporting PoolSec. 2.46. Short-Term ObligationSec. 2.47. TINSec. 2.48. UnderwithholdingSec. 2.49. Undocumented AccountHolderSec. 2.50. U.S. Payor/Non-U.S.

PayorSec. 2.51. U.S. PersonSec. 2.52. Withholding AgentSec. 2.53. Withholding Rate PoolSec. 2.54. Withholding StatementSec. 2.55. Other Terms

SECTION 3. WITHHOLDINGRESPONSIBILITY

Sec. 3.01. NRA WithholdingResponsibilitySec. 3.02. Primary NRA WithholdingResponsibility Not AssumedSec. 3.03. Assumption of PrimaryNRA Withholding ResponsibilitySec. 3.04. Backup WithholdingResponsibilitySec. 3.05. Primary Form 1099Reporting and Backup WithholdingResponsibility For ReportablePayments Other Than ReportableAmountsSec. 3.06. Primary Form 1099Reporting and Backup WithholdingResponsibility For ReportableAmounts Not AssumedSec. 3.07. Assumption of PrimaryForm 1099 Reporting and BackupWithholding ResponsibilitySec. 3.08. Deposit Requirements

SECTION 4. PRIVATEARRANGEMENTINTERMEDIARIES

Sec. 4.01. In GeneralSec. 4.02. Modification ofObligations for PAI AgreementsSec. 4.03. Termination ofArrangement

SECTION 5. DOCUMENTATIONREQUIREMENTS

Sec. 5.01. DocumentationRequirementsSec. 5.02. Documentation ForForeign Account HoldersSec. 5.03. In General.Sec. 5.04. Documentation forInternational OrganizationsSec. 5.05. Documentation for ForeignGovernments and Foreign CentralBanks of IssueSec. 5.06. Documentation for ForeignTax-Exempt OrganizationsSec. 5.07. Documentation FromIntermediaries or Flow-ThroughEntities

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Sec. 5.08. Documentation For U.S.Exempt RecipientsSec. 5.09. Documentation for U.S.Non-Exempt RecipientsSec. 5.10. Documentation ValiditySec. 5.11. Documentation ValidityPeriodSec. 5.12. Maintenance and Retentionof DocumentationSec. 5.13. Application ofPresumption Rules

SECTION 6. QUALIFIEDINTERMEDIARY WITHHOLDINGCERTIFICATE AND DISCLOSUREOF ACCOUNT HOLDERS TOWITHHOLDING AGENT

Sec. 6.01. Qualified IntermediaryWithholding CertificateSec. 6.02. Withholding StatementSec. 6.03. Withholding Rate PoolsSec. 6.04. Legal Prohibitions AgainstDisclosure of U.S. Non-ExemptRecipients

SECTION 7. TAX RETURNOBLIGATIONS

Sec. 7.01. Form 1042 FilingRequirementSec. 7.02. Form 945 FilingRequirementSec. 7.03. Retention of Returns

SECTION 8. INFORMATIONREPORTING OBLIGATIONS

Sec. 8.01. Form 1042-S ReportingSec. 8.02. Recipient SpecificReportingSec. 8.03. Reporting Pools for Form1042-S ReportingSec. 8.04. Form 1099 ReportingResponsibility

SECTION 9. ADJUSTMENTS FOROVER- AND UNDER-WITHHOLDING; REFUNDS

Sec. 9.01. Adjustments for NRAOverwithholding by WithholdingAgentSec. 9.02. Adjustments for NRAOverwithholding by QISec. 9.03. Repayment of BackupWithholdingSec. 9.04. Collective Credit orRefund Procedures for NRAOverwithholdingSec. 9.05. Adjustments for NRA

UnderwithholdingSec. 9.06. NRA UnderwithholdingAfter Form 1042 FiledSec. 9.07. Special Rule RegardingFailure to Deposit Penalties

SECTION 10. EXTERNAL AUDITPROCEDURES

Sec. 10.01. In GeneralSec. 10.02. Designation of ExternalAuditorSec. 10.03. Timing and Scope ofExternal AuditsSec. 10.04. Use of StatisticalSamplingSec. 10.05. External Auditor’s ReportSec. 10.06. Expanding Scope andTiming of External Audit

SECTION 11. EXPIRATION,TERMINATION AND DEFAULT

Sec. 11.01. Term of AgreementSec. 11.02. Termination ofAgreementSec. 11.03. Significant Change inCircumstancesSec. 11.04. Events of DefaultSec. 11.05. Notice and CureSec. 11.06. Renewal

SECTION 12. MISCELLANEOUSPROVISIONS

THIS AGREEMENT is made in dupli-cate under and in pursuance of section1441 of the Internal Revenue Code of1986, as amended, (the “Code”) and Trea-sury Regulation §1.1441–1(e)(5) by andbetween ______________, any affiliatedentities of ____________ designated inAppendix A of this Agreement that aresignatories to this Agreement (individu-ally and collectively referred to as “QI”),and the INTERNAL REVENUE SER-VICE (the “IRS”):

WHEREAS, QI has submitted an ap-plication in accordance with RevenueProcedure 2000–12 to be a qualified inter-mediary for purposes of Treas. Reg.§1.1441–1(e)(5);

WHEREAS, QI and the IRS desire toenter into an agreement to establish QI’srights and obligations regarding docu-mentation, withholding, information re-porting, tax return filing, deposits, and re-fund procedures under sections 1441,1442, 1443, 1461, 3406, 6041, 6042,6045, 6049, 6050N, 6302, 6402, and 6414

of the Code with respect to certain typesof payments;

NOW, THEREFORE , in considera-tion of the following terms, representa-tions, and conditions, the parties agree asfollows:

SECTION 1. PURPOSE AND SCOPE

Sec. 1.01. General Obligations.QI is awithholding agent under chapter 3 of theCode and a payor under chapter 61 and sec-tion 3406 of the Code for amounts that itpays to its account holders. Except as oth-erwise provided in this Agreement, QI’sobligations with respect to amounts it paysto account holders are governed by chapter3, chapter 61, and section 3406 of the Codeand the regulations thereunder. QI shall actin its capacity as a qualified intermediarypursuant to this Agreement only for thoseaccounts QI has with a withholding agentthat QI has designated as accounts forwhich it acts as a qualified intermediary.QI is not required to act as a qualified inter-mediary for all accounts that it has with awithholding agent. However, if QI desig-nates an account as one for which it will actas a qualified intermediary, it must act as aqualified intermediary for all paymentsmade to that account.Sec. 1.02. Parties to the Agreement.This Agreement applies to:(A) All offices of QI located in the coun-tries described in Appendix A of thisAgreement; and(B) The Internal Revenue Service. Notwithstanding section 1.02(A) of thisAgreement, an office of QI shall be sub-ject to the provisions of this Agreementonly to the extent it receives a paymentfrom a withholding agent with respect toan account that QI has designated as anaccount for which it is acting as a quali-fied intermediary. See section 6.02 of thisAgreement for the procedure to designatean account. QI may add any countries notinitially included in Appendix A withoutprior IRS approval if the country is onefor which the IRS will enter a model qual-ified intermediary agreement and QI pro-vides the IRS an amended Appendix A atthe address described in section 12.06 ofthis Agreement. Offices in the additionalcountries may begin to operate under thisAgreement immediately after QI satisfiesthe notification requirement of this sec-tion 1.02. Appendix A, as amended, shallbecome part of this Agreement.

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SECTION 2. DEFINITIONS

For purposes of this Agreement, the termslisted below are defined as follows:Sec. 2.01. Account Holder.An “accountholder” means any person that is a directaccount holder or an indirect accountholder and for which QI acts as a quali-fied intermediary. A direct account holderis any person who has an account directlywith QI (including an intermediary orflow-through entity). An indirect accountholder is any person who receivesamounts from a QI but who does not havea direct account relationship with QI. Forexample, a person that has an accountwith a foreign intermediary or an interestin a flow-through entity which, in turn, isa direct account holder of QI is an indirectaccount holder. In addition, the personthat is the sole owner of an entity that isdisregarded under Treas. Reg.§301.7701–2(c)(2) as an entity separatefrom its owner is an indirect accountholder. A person is an indirect accountholder even if there are multiple tiers ofintermediaries or flow-through entitiesbetween the person and the QI. Sec. 2.02. Agreement.“Agreement”means this Agreement, all appendices andattachments to this Agreement, and QI’sapplication to become a qualified inter-mediary. All such appendices, attach-ments, and QI’s application are incorpo-rated into this Agreement by reference.Sec. 2.03. Amounts Subject to NRAWithholding. An “amount subject toNRA withholding” is an amount de-scribed in Treas. Reg. §1.1441–2(a). Anamount subject to NRA withholding shallnot include interest paid as part of the pur-chase price of an obligation sold betweeninterest payment dates or original issuediscount paid as part of the purchase priceof an obligation sold in a transaction otherthan the redemption of such obligation,unless the sale is part of a plan the princi-pal purpose of which is to avoid tax andQI has actual knowledge or reason toknow of such plan.Sec. 2.04. Assumption of WithholdingResponsibility. A QI that assumes pri-mary NRA withholding responsibility, orassumes primary Form 1099 reportingand backup withholding responsibility,assumes the primary responsibility for de-ducting, withholding, and depositing theappropriate amount from a payment.Generally, a qualified intermediary’s as-

sumption of primary NRA withholdingresponsibility or the assumption of pri-mary backup withholding responsibilityrelieves the person who makes a paymentto the qualified intermediary from the re-sponsibility to withhold. Under section3.05 of this Agreement, QI generally hasprimary Form 1099 reporting and backupwithholding responsibility with respect tocertain payments even though it does notassume such responsibility for paymentsnot described in that section.Sec. 2.05. Backup Withholding.“Backup withholding” means the with-holding required under section 3406 ofthe Code.Sec. 2.06. Beneficial Owner.A “benefi-cial owner” has the meaning given to thatterm in Treas. Reg. §1.1441–1(c)(6).Sec. 2.07. Broker Proceeds.“Broker pro-ceeds” means the gross proceeds from asale of an asset to the extent that the grossproceeds would be subject to Form 1099reporting if paid to a U.S. non-exempt re-cipient. For purposes of this Agreement,broker proceeds also include any proceedspaid by QI from the sale of assets pursuantto the provisions of section 6.04 of thisAgreement that are owned by a U.S. non-exempt recipient and that produce, or couldproduce, reportable payments regardless ofwhether the sale is effected at an office in-side or outside the United States and re-gardless of whether or not the sale is ef-fected by QI or another person oninstructions from QI. Thus, the exceptionin Treas. Reg. §1.6045–1(a), which ex-cludes from Form 1099 reporting certainsales effected at an office outside theUnited States, shall not apply in the case ofU.S. non-exempt recipients whose identityis prohibited by law from disclosure. In ad-dition, the exception from backup with-holding on certain payments contained inTreas. Reg. §31.3406(g)–1(e) shall notapply to such broker proceeds.Sec. 2.08. Chapter 3 of the Code.Anyreference to “chapter 3 of the Code”means sections 1441, 1442, 1443, 1461,1463, and 1464 of the Code.Sec. 2.09. Chapter 61 of the Code.Anyreference to “chapter 61 of the Code”means sections 6041, 6042, 6045, 6049,and 6050N of the Code.Sec. 2.10. Deposit Interest.“Deposit in-terest” means interest described in section871(i)(2)(A) of the Code. Sec. 2.11. Designated Broker Proceeds.

“Designated broker proceeds” means–(A) Any broker proceeds from the sale ofassets that produce, or could produce, re-portable amounts if the sale is effected atan office inside the United States, as de-fined in Treas. Reg. §1.6045–1(g)(3), (un-less an exception to reporting appliesunder chapter 61 of the Code); and(B) Any broker proceeds from the sale ofan asset that produces, or could produce,reportable amounts that are beneficiallyowned by a U.S. non-exempt recipientwhose identity and account information isprohibited from disclosure as described insection 6.04 of this Agreement. For thispurpose, it is irrelevant whether the sale iseffected by QI or another person upon in-structions from QI. It is also irrelevantwhether the sale is effected at an office in-side or outside the United States. Thus,the exception in Treas. Reg. §1.6045–1(a)(which excepts sales effected at an officeoutside the United States by a non-U.S.payor) and the exception in Treas. Reg.31.3406(g)–1(e) (which excepts certainpayments made outside the United Statesfrom backup withholding) do not apply inthe case of an account holder whose iden-tity is prohibited by law from disclosure.Sec. 2.12. Documentary Evidence.“Documentary evidence” means any doc-umentation obtained under the appropri-ate know-your-customer rules (as de-scribed in the Attachments to thisAgreement), any documentary evidencedescribed in Treas. Reg. §1.1441–6 suffi-cient to establish entitlement to a reducedrate of withholding under an income taxtreaty, or any documentary evidence de-scribed in Treas. Reg. §1.6049–5(c) suffi-cient to establish an account holder’s sta-tus as a foreign person for purposes ofchapter 61 of the Code. Documentary ev-idence does not include a Form W-8 orForm W-9 (or an acceptable substituteForm W-8 or Form W-9). Sec. 2.13. Documentation.“Documen-tation” means any valid Form W-8, FormW-9 (or acceptable substitute Form W-8or Form W-9) or documentary evidenceas defined in section 2.12 of this Agree-ment, including all statements or other in-formation required to be associated withthe form or documentary evidence.Sec. 2.14. Documented AccountHolder. A “documented account holder”is an account holder for whom QI holdsvalid documentation.

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Sec. 2.15. Exempt Recipient.For pur-poses of Form 1099 reporting and backupwithholding, an “exempt recipient”means a person described in Treas. Reg.§1.6049– 4(c)(1)(ii) (for interest, divi-dends, and royalties), a person describedin Treas. Reg. §5f.6045–1(c)(3)(i)(B) and§1.6045–2(b)(2)(i) (for broker proceeds),and a person described in Treas. Reg.§1.6041–3(q) (for rents, amounts paid onnotional principal contracts, and otherfixed or determinable income). Exemptrecipients are not exempt from NRA with-holding. Sec. 2.16. External Auditor.An “exter-nal auditor” is any approved auditor listedin Appendix B of this Agreement that QI(or any private arrangement intermediaryof QI) engages to perform the audits re-quired by section 10 of this Agreement.Sec. 2.17. Flow -Through Entity. Aflow-through entity is a foreign partner-ship described in Treas. Reg.§301.7701–2 or 3 (other than a withhold-ing foreign partnership), a foreign trustthat is described in section 651(a) of theCode, or a foreign trust all or a portion ofwhich is treated as owned by the grantoror other person under sections 671through 679 of the Code. For an item ofincome for which a treaty benefit isclaimed, an entity is also a flow-throughentity to the extent it is treated as fiscallytransparent under section 894 and the reg-ulations thereunder.Sec. 2.18. Foreign Person.A “foreignperson” is any person that is not a “UnitedStates person” and includes a “nonresi-dent alien individual,” a “foreign corpora-tion,” a “foreign partnership,” a “foreigntrust,” and a “foreign estate,” as thoseterms are defined in section 7701 of theCode. For purposes of chapter 3 of theCode, the term foreign person also means,with respect to a payment by a withhold-ing agent (including a qualified interme-diary), a foreign branch of a U.S. personthat provides a valid Form W-8IMY onwhich it represents that it is a qualified in-termediary. A foreign branch of a U.S.person that is a qualified intermediary is,however, a U.S. payor for purposes ofchapter 61 and section 3406 of the Code.Sec. 2.19. Form W-8. “Form W-8”means IRS Form W-8BEN, Certificate ofForeign Status of Beneficial Owner forUnited States Tax Withholding; IRS FormW-8ECI, Certificate of Foreign Person’s

Claim for Exemption From Withholdingon Income Effectively Connected Withthe Conduct of a Trade or Business in theUnited States; IRS Form W-8EXP, Cer-tificate of Foreign Governments andOther Foreign Organizations for UnitedStates Tax Withholding; and IRS FormW-8IMY, Certificate of Foreign Interme-diary, Foreign Partnership, and CertainU.S. Branches for United States TaxWithholding, as appropriate. It also in-cludes any acceptable substitute form. Sec. 2.20. Form W-9. “Form W-9”means IRS Form W-9, Request for Tax-payer Identification Number and Certifi-cation, or any acceptable substitute.Sec. 2.21. Form 945.“Form 945” meansIRS Form 945, Annual Return of With-held Federal Income Tax.Sec. 2.22. Form 1042.“Form 1042”means an IRS Form 1042, Annual With-holding Tax Return for U.S. Source In-come of Foreign Persons.Sec. 2.23. Form 1042-S.“Form 1042-S”means an IRS Form 1042-S, Foreign Per-son’s U.S. Source Income Subject toWithholding.Sec. 2.24. Form 1096.“Form 1096”means IRS Form 1096, Annual Summaryand Transmittal of U.S. Information Re-turns.Sec. 2.25. Form 1099.“Form 1099”means IRS Form 1099-B, Proceeds FromBroker and Barter Exchange Transac-tions; IRS Form 1099-DIV, Dividendsand Distributions; IRS Form 1099-INT,Interest Income; IRS Form 1099-MISC,Miscellaneous Income; IRS Form 1099-OID, Original Issue Discount, and anyother form in the IRS Form 1099 seriesappropriate to the type of payment re-quired to be reported.Sec. 2.26. Form 1099 Reporting.“Form 1099 reporting” means the report-ing required on Form 1099.Sec. 2.27. Intermediary.An “intermedi-ary” means any person that acts on behalfof another person such as a custodian,broker, nominee, or other agent.Sec. 2.28. Know-Your-Customer Rules.The phrase “know-your customer rules”refers to the applicable laws, regulations,rules, and administrative practices andprocedures, identified in the Attachmentsto this Agreement, governing the require-ments of QI to obtain documentation con-firming the identity of QI’s account hold-ers.

Sec. 2.29. Marketable Securities. Forpurposes of this Agreement, the term“marketable securities” means those secu-rities described in Treas. Reg. §1.1441–6for which a TIN is not required to obtaintreaty benefits. Sec. 2.30. Non-Exempt Recipient.A“non-exempt recipient” means a personthat is not an exempt recipient under thedefinition in section 2.15 of this Agree-ment.Sec. 2.31. Nonqualified Intermediary.A “nonqualified intermediary” is any in-termediary that is not a qualified interme-diary. A nonqualified intermediary in-cludes any custodian, nominee, or otheragent as well as any financial institutionintermediary unless such person enters anagreement to be a qualified intermediaryand acts in such capacity.Sec. 2.32. NRA Withholding.“Nonresi-dent alien (NRA) withholding” is anywithholding required under chapter 3 ofthe Code, whether the payment subject towithholding is made to an individual or toan entity.Sec. 2.33. Overwithholding.The term“overwithholding” means the excess ofthe amount actually withheld under chap-ter 3 or section 3406 of the Code over theamount required to be withheld.Sec. 2.34. Paid Outside the UnitedStates. An amount is “paid outside theUnited States” if it is paid outside theUnited States within the meaning ofTreas. Reg. §1.6049–5(e). Sec. 2.35. Payment.A “payment” isconsidered made to a person if that personrealizes income whether or not such in-come results from an actual transfer ofcash or other property. See Treas. Reg.§1.1441–2(e). For example, a paymentincludes crediting an amount to an ac-count.Sec. 2.36. Payor.A “payor” is defined inTreas. Reg. §31.3406(a)–2 and§1.6049–4(a)(2) and generally means anyperson required to make an information re-turn under chapter 61 of the Code. Theterm includes any person that makes a pay-ment, directly or indirectly, to QI and towhom QI provides information, pursuantto this Agreement, so that such person canreport a payment on Form 1099 and, if ap-propriate, backup withhold. See sections3.05 and 6 of this Agreement. Also seesection 2.50 of this Agreement for the defi-nition of U.S. payor and non-U.S. payor.

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Sec. 2.37. Presume/Presumption.Theterms “presume” or “presumption” referto the presumption rules set forth in sec-tion 5.13(C) of this Agreement.Sec. 2.38. Private Arrangement Inter-mediary. A “private arrangement inter-mediary” or “PAI” is an intermediary de-scribed in section 4 of this Agreement.Sec. 2.39. Qualified Intermediary. A“qualified intermediary” is a person, de-scribed in Treas. Reg.§1.1441–1(e)(5)(ii), that enters into awithholding agreement with the IRS to betreated as a qualified intermediary andacts in its capacity as a qualified interme-diary.Sec. 2.40. Qualified Intermediary (orQI) EIN. A “qualified intermediary EIN”or “QI-EIN” means the employer identifi-cation number assigned by the IRS to aqualified intermediary. QI’s QI-EIN isonly to be used when QI is acting as aqualified intermediary. For example, QImust give a withholding agent its non-QIEIN, if any, rather than its QI-EIN if it isreceiving income as a beneficial ownerand a taxpayer identification number isrequired. QI must also use its non-QIEIN, if any, when acting as a nonqualifiedintermediary. Each signatory to thisagreement must have its own QI-EIN.Sec. 2.41. Reduced Rate of Withhold-ing. A “reduced rate of withholding”means a rate of withholding under chapter3 of the Code that is less than 30 percent,including an exemption from withhold-ing, or not withholding 31 percent undersection 3406 of the Code.Sec. 2.42. Reliably Associating a Pay-ment With Documentation. See section5.13(B) of this Agreement to determinewhether QI can reliably associate a pay-ment with documentation.Sec. 2.43. Reportable Amount.A “re-portable amount” means an amount sub-ject to NRA withholding (as defined insection 2.03 of this Agreement); U.S.source deposit interest (as defined in sec-tion 2.10 of this Agreement); and U.S.source interest or original issue discountpaid on the redemption of short-termobligations (as defined in section 2.46 ofthis Agreement). The term does not in-clude payments on deposits with banksand other financial institutions that re-main on deposit for two weeks or less. Italso does not include amounts of originalissue discount arising from a sale and re-

purchase transaction completed within aperiod of two weeks or less, or amountsdescribed in Treas. Reg. §1.6049–5(b)(7),(10), or (11) (relating to certain foreigntargeted registered obligations and certainobligations issued in bearer form).Sec. 2.44. Reportable Payment.Forpurposes of this Agreement, a reportablepayment means amounts described in sec-tion 2.44(A) of this Agreement, in thecase of a U.S. payor, and amounts de-scribed in section 2.44(B) of this Agree-ment, in the case of a non-U.S. payor.(A) U.S. Payor. If QI is a U.S. payor, areportable payment means any reportablepayment as defined in section 3406(b) ofthe Code, including any broker proceedsfrom the sale of assets beneficially ownedby a U.S. non-exempt recipient accountholder that produce, or could produce, re-portable payments if the identity and ac-count information of that account holderis prohibited by law, including by con-tract, from disclosure as described in sec-tion 6.04 of this Agreement. For this pur-pose, it is irrelevant whether the sale iseffected by QI or QI instructs another per-son to effect the sale. It is also irrelevantwhether the sale is effected at an office in-side or outside the United States. Thus,the exception in Treas. Reg. §1.6045–1(a)(which excepts sales effected at an officeoutside the United States by a non-U.S.payor) and the exception in Treas. Reg.31.3406(g)–1(e) (which excepts certainpayments made outside the United Statesfrom backup withholding) do not apply inthe case of an account holder whose iden-tity is prohibited by law from disclosure.(B) Non-U.S. Payor. If QI is a non-U.S.payor a reportable payment means–(1) Any reportable amount (unless an ex-ception to reporting applies under chapter61 of the Code);(2) Any broker proceeds from the sale ofassets that produce, or could produce, re-portable amounts if the sale is effected atan office inside the United States, as de-fined in Treas. Reg. §1.6045–1(g)(3), (un-less an exception to reporting appliesunder chapter 61 of the Code);(3) Any broker proceeds from the sale ofan asset that produces, or could produce,reportable amounts that are beneficiallyowned by a U.S. non-exempt recipientwhose identity and account information isprohibited by law, including by contract,from disclosure as described in section

6.04 of this Agreement. For this purpose,it is irrelevant whether the sale is effectedby QI or another person upon instructionsfrom QI. It is also irrelevant whether thesale is effected at an office inside or out-side the United States. Thus, the excep-tion in Treas. Reg. §1.6045–1(a) (whichexcepts sales effected at an office outsidethe United States by a non-U.S. payor)and the exception in Treas. Reg.31.3406(g)–1(e) (which excepts certainpayments made outside the United Statesfrom backup withholding) do not apply inthe case of an account holder whose iden-tity is prohibited by law from disclosure;and(4)Any foreign source interest, dividends,rents, royalties, or other fixed and deter-minable income if such income is paid inthe United States or to an account main-tained in the United States or any otheramount presumed paid to a U.S. non-ex-empt recipient under section 5.13(C)(4)of this Agreement (unless an exception toreporting applies under chapter 61 of theCode).Sec. 2.45. Reporting Pool.A reportingpool is defined in section 8.03 of thisAgreement.Sec. 2.46. Short-Term Obligation. A“short-term obligation” is any obligationdescribed in section 871(g)(1)(B)(i) of theCode.Sec. 2.47. TIN. A “TIN” is a U.S. tax-payer identification number.Sec. 2.48. Underwithholding. “Under-withholding” means the excess of theamount required to be withheld underchapter 3 or section 3406 of the Codeover the amount actually withheld.Sec. 2.49. Undocumented AccountHolder. An “undocumented accountholder” is an account holder for whom QIdoes not hold valid documentation.Sec. 2.50. U.S. Payor/Non-U.S. Payor.The terms “U.S. payor” and “non-U.S.payor” have the same meaning as inTreas. Reg. §1.6049–5(c). Sec. 2.51. U.S. Person.A “United States(or U.S.) person” is a person described insection 7701(a)(30) of the Code, the U.S.government (including an agency or in-strumentality thereof), a State of theUnited States (including an agency or in-strumentality thereof), or the District ofColumbia (including an agency or instru-mentality thereof). Sec. 2.52. Withholding Agent.A “with-

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holding agent” has the same meaning asset forth in Treas. Reg. §1.1441–7(a) andincludes a payor (as defined in section2.36 of this Agreement). As used in thisAgreement, the term generally refers tothe person making a payment to a quali-fied intermediary. Sec. 2.53. Withholding Rate Pool.Theterm “withholding rate pool” is defined insection 6.03 of this Agreement.Sec. 2.54. Withholding Statement.Theterm “withholding statement” is definedin section 6.02 of this Agreement.Sec. 2.55. Other Terms.Any term notdefined in this section has the same mean-ing that it has under the Code, the incometax regulations under the Code, or any ap-plicable income tax treaty.

SECTION 3. WITHHOLDINGRESPONSIBILITY

Sec. 3.01. NRA Withholding Responsi-bility. QI is subject to the withholdingand reporting provisions applicable towithholding agents under chapter 3 of theCode. Under chapter 3, a withholdingagent must withhold 30 percent of anypayment of an amount subject to NRAwithholding made to an account holderthat is a foreign person unless the with-holding agent can reliably associate thepayment with documentation upon whichit can rely to treat the payment as made toa payee that is a U.S. person or as made toa beneficial owner that is a foreign personentitled to a reduced rate of withholding.See section 5 of this Agreement regardingdocumentation requirements.Sec. 3.02. Primary NRA WithholdingResponsibility Not Assumed. Notwith-standing sections 1.01 and 3.01 of thisAgreement, QI shall not be required towithhold under chapter 3 of the Code if itdoes not accept primary NRA withhold-ing responsibility under section 3.03 ofthis Agreement and it has provided a validwithholding certificate and correct with-holding statements to a withholding agentfrom which it receives an amount subjectto NRA withholding in accordance withsection 6 of this Agreement. Notwith-standing its election not to assume pri-mary NRA withholding responsibility, QIshall, however, withhold the differencebetween the amount of NRA withholdingrequired under chapter 3 of the Code andthe amount actually withheld by anotherwithholding agent if QI–

(A) Actually knows that the appropriateamount has not been withheld by anotherwithholding agent; or(B) Made an error which results in thewithholding agent’s failure to withholdthe correct amount due (e.g., QI fails toprovide an accurate withholding state-ment with respect to the payment) and QIhas not corrected the underwithholdingunder the reimbursement and setoff pro-cedures of section 9.05 of this Agreement.QI is not required to withhold under chap-ter 3 of the Code on an amount subject toNRA withholding that it pays to anotherqualified intermediary that has assumedprimary NRA withholding responsibilitywith respect to the payment or to a with-holding foreign partnership. See section8 of this Agreement regarding QI’s re-sponsibility to report amounts subject towithholding on Form 1042–S.Sec. 3.03. Assumption of Primary NRAWithholding Responsibility. QI, uponnotification to a withholding agent, mayassume primary NRA withholding respon-sibility for an amount subject to NRAwithholding by providing a valid withhold-ing certificate described in section 6 of thisAgreement to a withholding agent thatmakes a payment of an amount subject toNRA withholding and by designating onthe withholding statement associated withsuch certificate the account for which QIassumes primary NRA withholding re-sponsibility. QI may assume primaryNRA withholding responsibility withoutinforming the IRS. QI is not required toassume primary NRA withholding respon-sibility for all accounts it has with the with-holding agent. However, if QI assumesprimary NRA withholding responsibilityfor any account, it must assume that re-sponsibility for all payments of amountssubject to NRA withholding made by thewithholding agent to that account. To theextent that QI assumes primary NRA with-holding responsibility, QI shall withholdfrom amounts subject to NRA withholdingthe amount required to be withheld underchapter 3 of the Code. QI is not required,however, to withhold on amounts it pays toanother qualified intermediary that has cer-tified to QI on Form W-8IMY that it hasassumed primary withholding responsibil-ity with respect to the payment or to awithholding foreign partnership. See sec-tion 8 of this Agreement regarding QI’s re-sponsibility to report amounts subject to

withholding on Form 1042-S.Sec. 3.04. Backup Withholding Re-sponsibility. QI is a payor under section3406 of the Code with respect to re-portable payments. Under section 3406, apayor is required to deduct and withhold31 percent from the payment of a re-portable payment to a U.S. non-exemptrecipient if the U.S. non-exempt recipienthas not provided its TIN in the manner re-quired under that section; the IRS notifiesthe payor that the TIN furnished by thepayee is incorrect; there has been a noti-fied payee under-reporting described insection 3406(c); or there has been a payeecertification failure described in section3406(d). QI represents that there are nolegal restrictions that prohibit it fromcomplying with the Form 1099 reportingrequirements of this Agreement or impos-ing backup withholding and depositingthe amounts withheld in accordance withsection 3.08 of this Agreement.Sec. 3.05. Primary Form 1099 Report-ing and Backup Withholding Responsi-bility For Reportable Payments OtherThan Reportable Amounts. Under sec-tion 6.01 of this Agreement, QI is only re-quired to provide a withholding agentwith information regarding reportableamounts. Therefore, QI is primarily re-sponsible for reporting on Form 1099and, if required, backup withholding onthe payments described in section 3.05(A)and (B) of this Agreement whether or notQI assumes primary Form 1099 reportingand backup withholding responsibilitywith respect to reportable amounts undersection 3.07 of this Agreement. No provi-sion of this Agreement which requires QIto provide another withholding agent withinformation regarding reportable amountsshall be construed as relieving QI of itsForm 1099 reporting and backup with-holding obligations with respect to re-portable payments that are not reportableamounts.(A) U.S. Payor. Except as provided insection 3.05(C) of this Agreement, if QI isa U.S. payor, QI has primary Form 1099reporting and backup withholding respon-sibility for reportable payments as definedin section 3406(b) of the Code other thanreportable amounts. For example, if QI isa U.S. payor, it has primary Form 1099reporting and backup withholding respon-sibility for payments of foreign source in-come as well as all broker proceeds paid

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to account holders that are, or are pre-sumed to be, U.S. non-exempt recipients,unless an exception to reporting orbackup withholding applies. QI also hasprimary Form 1099 reporting and backupwithholding responsibility for broker pro-ceeds from the sale of assets beneficiallyowned by a U.S. non-exempt recipient ac-count holder that produce or could pro-duce, reportable payments if the identityand account information of that accountholder is prohibited by law from disclo-sure as described in section 6.04 of thisAgreement. See section 2.44(A) of thisAgreement for the instances in which cer-tain reporting and withholding exceptionsdo not apply. (B) Non-U.S. Payor. Except as providedin section 3.05(C) of this Agreement, ifQI is a non-U.S. payor, QI has primaryForm 1099 reporting and backup with-holding responsibility for broker proceedsdescribed in section 2.44(B)(2) and (3) ofthis Agreement and foreign source in-come paid in the United States or to an ac-count maintained in the United States asdescribed in section 2.44(B)(4) of thisAgreement, if such payments are made, orpresumed made under section 5.13(C)(4)of this Agreement, to U.S. non-exempt re-cipients.(C) Designated Broker Proceeds Proce-dure. Whether QI is a U.S. payor or non-U.S. payor, QI may request another payorto report on Form 1099 and, if required,backup withhold on designated brokerproceeds (as defined in section 2.11 ofthis Agreement), provided the other payoractually receives the broker proceeds. QIwill not be primarily responsible for Form1099 reporting and for backup withhold-ing if the other payor agrees to do the re-porting and backup withholding and QIprovides all of the information necessaryfor the other payor to properly report, andbackup withhold on the designated brokerproceeds. QI, however, remains primarilyresponsible for Form 1099 reporting andbackup withholding if the other payordoes not agree to report and backup with-hold, or QI knows that the other payorfailed to do so.Sec. 3.06. Primary Form 1099 Report-ing and Backup Withholding Responsi-bility For Reportable Amounts Not As-sumed. Notwithstanding sections 1.01and 3.04 of this Agreement, QI shall notbe required to backup withhold on a re-

portable amount if QI does not assumeprimary Form 1099 reporting and backupwithholding responsibility and it providesa payor from which it receives a re-portable amount the Forms W-9 of itsU.S. non- exempt recipient account hold-ers (or, if a U.S. non-exempt recipientfails to provide a Form W-9, informationregarding the account holder’s name, ad-dress, and TIN, if a TIN is available) to-gether with the withholding rate pools (asdefined in section 6.03 of this Agreement)attributable to U.S. non-exempt recipientaccount holders. Notwithstanding itselection not to assume primary Form1099 reporting and backup withholdingresponsibility, QI shall backup withholdand report a reportable amount if–(A) QI actually knows a reportableamount is subject to backup withholdingand another payor failed to apply backupor NRA withholding;(B) Another payor has not applied backupor NRA withholding to a reportableamount because of an error made by QI(e.g., QI failed to provide the other payorwith information regarding the name, ad-dress, TIN, if available, and withholdingrate pool for a U.S. non-exempt recipientaccount holder subject to backup with-holding); (C) QI pays a reportable amount to a U.S.non-exempt recipient whose identity andother account information are prohibitedby law from disclosure (see section 6.04of this Agreement) and another payor ofthe reportable amount has not backupwithheld.QI is not required to backup withhold,however, on a reportable amount it makesto a withholding foreign partnership or toanother qualified intermediary if the otherqualified intermediary has assumed pri-mary Form 1099 reporting and backupwithholding responsibility with respect tothe payment. See section 3.05 of thisAgreement for backup withholding re-sponsibility for reportable payments otherthan reportable amounts. See section 8.04of this Agreement regarding QI’s respon-sibility to report reportable payments onForm 1099.[NOTE: A qualified intermediary that isnot a U.S. payor must obtain IRS approvalto assume primary Form 1099 reportingand backup withholding responsibility withrespect to reportable amounts. The IRSwill evidence its approval of a non-U.S.

payor’s assumption of primary Form 1099reporting and backup withholding respon-sibility by the signature of the Commis-sioner, or his delegate, in the margin ofsection 3.07 of this Agreement. ] Sec. 3.07. Assumption of PrimaryForm 1099 Reporting and BackupWithholding Responsibility. QI may as-sume primary Form 1099 reporting re-sponsibility under chapter 61 of the Codeand primary backup withholding respon-sibility under section 3406 of the Codewith respect to reportable amounts. Seesections 3.05 and 8.04 of this Agreementfor QI’s obligations regarding reportablepayments other than reportable amounts.A qualified intermediary that assumessuch responsibility is subject to all of theobligations imposed by chapter 61 andsection 3406 of the Code and shall be sub-ject to any applicable penalties for failureto meet those obligations. The exceptionfrom backup withholding under Treas.Reg. §31.3406(g)–1(e) shall not apply,however, to payments of deposit interest,or interest or original issue discount on re-demptions of short-term obligations, tothe extent QI must presume that an ac-count holder is a U.S. non-exempt recipi-ent under section 5.13(C)(2) of thisAgreement. QI shall inform a withhold-ing agent from which it receives a re-portable amount that it has assumed pri-mary Form 1099 reporting and backupwithholding responsibility by providingthe withholding agent with a valid with-holding certificate described in section 6of this Agreement and by designating onthe withholding statement associated withsuch certificate the account for which QIassumes primary Form 1099 reportingand backup withholding responsibility.QI may assume primary Form 1099 re-porting and backup withholding responsi-bility without informing the IRS, unlessQI is a non-U.S. payor. QI is not requiredto assume primary Form 1099 reportingand backup withholding responsibility forall accounts it has with a withholdingagent. However, if QI assumes primaryForm 1099 reporting and backup with-holding responsibility for any account, itmust assume that responsibility for all re-portable amounts made by a payor to thataccount. QI shall not be required tobackup withhold on a reportable amountit makes to another qualified intermediarythat has assumed primary Form 1099 re-

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porting and backup withholding responsi-bility with respect to the reportableamount. See section 8 of this Agreementregarding QI’s responsibility to report re-portable payments on Form 1099.Sec. 3.08. Deposit Requirements.If QIis a U.S. payor or a non-U.S. payor thatassumes primary NRA withholding re-sponsibility or primary Form 1099 andbackup withholding responsibility, it mustdeposit amounts withheld under chapter 3or section 3406 of the Code with a Fed-eral Reserve bank or authorized financialinstitution at the time and in the mannerprovided under section 6302 of the Code(see Treas. Reg. §1.6302–2(a) or§31.6302–1(h)). If QI is a non-U.S. payorthat does not assume primary NRA with-holding responsibility or primary Form1099 and backup withholding responsibil-ity, QI must deposit amounts withheld bythe 15th day following the month inwhich the NRA or backup withholdingoccurred.

SECTION 4. PRIVATEARRANGEMENTINTERMEDIARIES

Sec. 4.01. In General.QI may enter intoa private arrangement with another inter-mediary under which the other intermedi-ary agrees to perform all of the obliga-tions of QI under this Agreement, exceptas provided in section 4.02 of this Agree-ment. Such agreement shall be betweenthe QI and all the offices of the other in-termediary located in a specified country.The specified country must be one forwhich this Agreement is available. Suchan intermediary is referred to in thisAgreement as a private arrangement inter-mediary (“PAI”). By entering into a PAIagreement, QI is not assigning its liabilityfor the performance of any of its obliga-tions under this Agreement. Therefore,QI shall remain liable for any tax, penal-ties, interest, and any other sanction thatmay result from the failure of the PAI tomeet any of the obligations imposed by itsagreement with QI. QI agrees not to as-sert any defenses against the IRS for thefailures of the PAI or any defenses thatthe PAI may assert against QI. For pur-poses of this Agreement, the PAI’s actualknowledge or reason to know of facts rel-evant to withholding or reporting shall beimputed to QI. QI’s liability for the fail-ures of the PAI shall apply even though

the PAI is itself a withholding agent underchapter 3 of the Code and a payor underchapter 61 and section 3406 and is itselfseparately liable for its failure to meet itsobligations under the Internal RevenueCode. Notwithstanding the foregoing, QIshall not be liable for tax, interest, orpenalties for failure to withhold and re-port under chapters 3, 61, and section3406 of the Code unless the underwith-holding or the failure to report amountscorrectly on Forms 945, 1042, 1042-S or1099 are due to QI’s or its PAI’s failure toproperly perform its obligations underthis Agreement. The PAI is not requiredto enter into an agreement with the IRS.The IRS may, however, in its sole discre-tion, refuse to permit an intermediary tooperate as a PAI by providing notice to QIat the address provided in section 12.06 ofthis Agreement. QI may, however, appealthe IRS’s determination by following thenotice and cure provisions in section11.05 of this Agreement. For purposes ofthis Agreement, an intermediary shall beconsidered a PAI only if the followingconditions are met:(A) The PAI is, pursuant to a writtenagreement between QI and the PAI, sub-ject to all the obligations of QI under thisAgreement, except to the extent modifiedby section 4.02 of this Agreement;(B) QI files a notice with the Commis-sioner, or his delegate, at the address setforth in section 12.06 of this Agreement,before the first payment for which the in-termediary acts as a PAI giving the name,address, taxpayer identification numberof the intermediary, if any, and the nameof the country or countries in which theoffices of the intermediary that are subjectto the PAI agreement are located;(C) The PAI is subject to the identical ex-ternal audit procedures that apply to QIunder this Agreement and the PAI uses anexternal auditor designated in Appendix Bof this Agreement, or another auditor ap-proved by the IRS for that PAI; and (D) The PAI furnishes QI with a Form W-8IMY described in section 6 of thisAgreement as modified by this section4.01(D). The PAI is required to provideQI with the Forms W-9 (or, in absence ofthe form, the name, address and TIN, ifavailable) of the PAI’s U.S. non-exemptrecipient account holders and the with-holding rate pool information for thoseaccount holders as required by section

6.03 of this Agreement. In addition, thePAI is required to disclose to QI the ac-count holders of a nonqualified intermedi-ary, or interest holders in a flow-throughentity, which has an account with the PAIand all of the information relating to thoseaccount holders that is required for theQI, or another withholding agent, to re-port the payments made to those accountholders as required by sections 8.02(B)and 8.04 of this Agreement. The PAI isnot required to disclose to QI, or anotherwithholding agent, its direct accountholders that are foreign persons. Sec. 4.02. Modification of Obligationsfor PAI Agreements. The agreement be-tween QI and a PAI must provide that QIshall include all reportable paymentsmade by the PAI in QI’s Forms 945 and1099 and all payments of amounts subjectto NRA withholding made by the PAI inQI’s Forms 1042 and 1042-S as if QI hadmade the payments directly to the PAI’saccount holders. Therefore, QI shall re-port payments made to a PAI’s direct for-eign account holders (other than interme-diaries, custodians, nominees, agents orflow-through entities) using the reportingpools as described in section 8.03 of thisAgreement and shall report paymentsmade to indirect foreign account holdersof the PAI by reporting the payments asmade to specific recipients under the rulesof section 8.02 of this Agreement. QIshall also file Forms 1099 and, if re-quired, backup withhold on reportablepayments made to U.S. non-exempt recip-ient direct or indirect account holders of aPAI in accordance with the terms of thisAgreement. QI shall require a PAI to pro-vide QI with all the information necessaryfor QI to meet its obligations under thisAgreement. No provisions shall be con-tained in the agreement between QI and aPAI that preclude, and no provisions ofthis Agreement shall be construed to pre-clude, the PAI’s joint and several liabilityfor tax, penalties, and interest under chap-ters 3, 61, and section 3406 of the Code tothe extent that underwithholding, penal-ties, and interest have not been collectedfrom QI and the underwithholding or fail-ure to report amounts correctly on Forms945, 1042, 1042-S or 1099 are due to aPAI’s failure to properly perform itsobligations under its agreement with QI.QI’s agreement with a PAI must requirethe PAI to disclose information regarding

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U.S. non-exempt recipients to the sameextent that QI is required to disclose suchinformation to the IRS or another payorunder this Agreement. Nothing in theagreement between QI and a PAI shallpermit the PAI to assume primary NRAwithholding responsibility or primaryForm 1099 reporting and backup with-holding responsibility.Sec. 4.03. Termination of Arrange-ment. QI shall cease to treat an interme-diary as a PAI within 90 days from theday QI knows that the PAI is in default ofits agreement with QI unless the PAI hascured the event of default prior to the ex-piration of such 90 day period. QI mustprovide the IRS with notice of any PAIagreement that has been terminatedwithin 30 days of the termination.

SECTION 5. DOCUMENTATIONREQUIREMENTS

Sec. 5.01. Documentation Require-ments. QI shall apply the presumptionrules to any account holder that receives areportable amount or reportable paymentunless QI can reliably associate the pay-ment with valid documentation from theaccount holder. QI agrees to use its bestefforts to obtain documentation from ac-count holders. If QI is obtaining docu-mentary evidence, QI also agrees to ad-here to the know-your-customer rules thatapply to QI with respect to the accountholder from whom the documentary evi-dence is obtained. As set forth in section11.04(F) of this Agreement, failure to ob-tain documentation from a significantnumber of direct account holders consti-tutes an event of default. QI agrees to re-view and maintain documentation in ac-cordance with this section 5 and, in thecase of documentary evidence obtainedfrom direct account holders, in accordancewith the know-your-customer rules setforth in the Attachments to this Agree-ment. QI also agrees to make documenta-tion (together with any associated with-holding statements and other documentsor information) available upon request forinspection by QI’s external auditor. QIrepresents that none of the laws to which itis subject prohibits disclosure of the iden-tity of any account holder (including ac-count holders subject to the provisions ofsection 6.04 of this Agreement) or accountinformation to QI’s external auditor. QImay rely on the documentation it obtains

under this section 5 as the basis for the in-formation it provides another withholdingagent under section 6 of this Agreement,as well as to determine its own withhold-ing and reporting obligations.Sec. 5.02. Documentation For ForeignAccount Holders. Except as otherwiseprovided in section 5 of this Agreement, QImay treat an account holder (including anaccount holder that is a collective invest-ment vehicle) as a foreign beneficial ownerof an amount if the account holder providesa valid Form W-8 (other than Form W-8IMY) or valid documentary evidence, asdescribed in section 2.12 of this Agreement,that supports the account holder’s status as aforeign person. QI may treat a documentedforeign beneficial owner account holder asentitled to a reduced rate of NRA withhold-ing if all the requirements to a reduced rateare met and the documentation provided bythe account holder supports entitlement to areduced rate. QI may not, however, reducethe rate of NRA withholding or backupwithholding required under the presumptionrules of section 5.13(C) of this Agreement ifQI knows that the account holder (includinga collective investment vehicle) is not thebeneficial owner of a reportable amount orreportable payment. In addition, QI maynot treat an account holder that providesdocumentation indicating that it is a bank,broker, intermediary, or agent (such as an at-torney) as a beneficial owner unless QI re-ceives a statement, in writing and signed bya person with authority to sign such a state-ment, stating that such account holder is thebeneficial owner of the income. Further, QImay not reduce the rate of withholding thatapplies under the presumption rules of sec-tion 5.13(C) of this Agreement on the basisof a collective or global certification that ismade by any person (such as an intermedi-ary or flow-through entity) on behalf of oth-ers unless the certification is a valid FormW-8IMY, and then, only to the extent thatQI can reliably associate the payment withvalid documentation that establishes the ac-count holder’s entitlement to a reduced rateof withholding. See section 5.13(B) of thisAgreement for rules regarding reliable asso-ciation with documentation.Sec. 5.03. In General.QI may not reducethe rate of withholding based on a benefi-cial owner’s claim of treaty benefits unlessQI obtains the documentation required bysection 5.03(A) of this Agreement. In addi-tion, QI agrees to establish procedures to

inform account holders of the terms of lim-itation on benefits provisions of a treaty(whether or not those provisions are con-tained in a separate article entitled Limita-tion on Benefits) under which the accountholder is claiming benefits.(A) Treaty Documentation. The docu-mentation required by this section5.03(A) is as follows:(1) The account holder has provided aproperly completed Form W-8BEN withpart II of the form completed, includingthe appropriate limitation on benefits andsection 894 certifications. A TIN shallnot be required, however, if the beneficialowner is a direct account holder. An indi-rect account holder is required to have aTIN to claim treaty benefits unless it isclaiming treaty benefits on income from amarketable security;(2) The account holder has provided doc-umentary evidence that has been obtainedpursuant to the know-your-customer rulesthat apply to the account holder and theaccount holder has made the treaty state-ment required by section 5.03(B) of thisAgreement, if applicable; or(3) The account holder provides the type ofdocumentary evidence required underTreas. Reg. §1.1441-6 to establish entitle-ment to a reduced rate of withholding undera treaty and the account holder has madethe treaty statement required by section5.03(B) of this Agreement, if applicable.(B) Treaty Statement. The treaty state-ment required by this section 5.03(B) is asfollows:

[Name of account holder] meets allprovisions of the treaty that are neces-sary to claim a reduced rate of with-holding, including any limitation onbenefits provisions, and derives the in-come within the meaning of section894 of the Code, and the regulationsthereunder, as the beneficial owner.

QI shall not be required to obtain a treatystatement required by this section 5.03(B)from an individual who is a resident of anapplicable treaty country or from the gov-ernment, or its political subdivisions, of atreaty country.(C) Transition Rule for Treaty Certifi-cation. QI may reduce the rate of with-holding on a payment made to a benefi-cial owner account holder that isotherwise entitled to a reduced rate ofwithholding under an income tax treatywithout obtaining the treaty statement re-

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quired in sections 5.03(B) of this Agree-ment provided that the account to whichthe payment is made was established be-fore January 1, 2001, and the payment towhich a reduced rate of withholdingunder the income tax treaty is applied isreceived on or before December 31, 2002. Sec. 5.04. Documentation for Interna-tional Organizations. QI may not treatan account holder as an international or-ganization entitled to an exemption fromwithholding under section 892 of theCode unless the name provided on thedocumentation (including a Form W-8EXP) is the name of an entity designatedas an international organization by execu-tive order pursuant to 22 United StatesCode 288 through 288(f) and the docu-mentation is valid under section 5.10 ofthis Agreement. If an international orga-nization is not claiming benefits undersection 892 of the Code but under anotherCode exception, the provisions of sec-tions 5.02 of this Agreement apply ratherthan the provisions of this section 5.04. Sec. 5.05. Documentation for ForeignGovernments and Foreign CentralBanks of Issue.(A) Documentation From a ForeignGovernment or Foreign Central Bankof Issue Claiming an Exemption FromWithholding Under Section 892 or Sec-tion 895. QI may not treat an accountholder as a foreign government or foreigncentral bank of issue exempt from with-holding under section 892 or 895 of theCode unless–(1) QI receives from the account holder aForm W-8EXP or documentary evidenceestablishing that the account holder is aforeign government or foreign centralbank of issue;(2) The income paid to the account holderis the type of income that qualifies for anexemption from withholding under sec-tion 892 or 895; and(3) QI does not know, or have reason toknow, that the account holder is a con-trolled commercial entity, that the incomeowned by the foreign government or for-eign central bank of issue is being re-ceived from a controlled commercial en-tity, or that the income is from thedisposition of an interest in a controlledcommercial entity.(B) Treaty Exemption. QI may treat anaccount holder as a foreign government orforeign central bank of issue entitled to a

reduced rate of withholding under an in-come tax treaty if it has valid documenta-tion that, under section 5.03 of this Agree-ment, is sufficient to obtain a reduced rateof withholding under a treaty.(C) Other Code Exception. If a foreigngovernment or foreign central bank ofissue is not claiming benefits under sec-tion 892 of the Code but under anotherCode exception (e.g., the portfolio inter-est exception under sections 871(h) or881(c) of the Code), the provisions of sec-tions 5.02 of this Agreement apply ratherthan the provisions of this section 5.05. Sec. 5.06. Documentation for ForeignTax-Exempt Organizations.(A) Reduced Rate of WithholdingUnder Section 501. QI may not treat anaccount holder as a foreign organizationdescribed under section 501(c) of theCode, and therefore exempt from with-holding (or, if the account holder is a for-eign private foundation, subject to with-holding at a 4-percent rate under section1443(b) of the Code) unless QI obtains avalid Form W-8EXP on which Part III ofthe form is completed.(B) Reduced Rate of WithholdingUnder Treaty. QI may not treat an ac-count holder as a foreign organization thatis tax-exempt on an item of income pur-suant to a treaty unless QI obtains validdocumentation as described under section5.03 of this Agreement that is sufficientfor obtaining a reduced rate of withhold-ing under a treaty and the documentationestablishes that the account holder is anorganization exempt from tax under thetreaty on that item of income.(C) Other Exceptions. If a tax-exemptentity is not claiming a reduced rate ofwithholding because it is an organizationdescribed under section 501(c) of theCode or under a treaty article that appliesto exempt certain organizations from tax,but is claiming a reduced rate of with-holding under another Code or treaty ex-ception, the provisions of section 5.02 ofthis Agreement shall apply rather than theprovisions of this section 5.06.Sec. 5.07. Documentation From Inter-mediaries or Flow-Through Entities.QI shall apply the presumption rules ofsection 5.13 of this Agreement to a re-portable amount or reportable paymentmade to a nonqualified intermediary orflow-through entity except to the extentQI follows the documentation procedures

set forth below.(A) Nonqualified Intermediaries andFlow-Through Entities. QI shall notapply the presumption rules on a paymentmade to a nonqualified intermediary orflow-through entity to the extent–(1) QI receives a valid Form W-8IMYprovided by the nonqualified intermedi-ary or the flow- through entity; and (2) QI can reliably associate the payment,within the meaning of section 5.13(B) ofthis Agreement, with valid documentationdescribed in this section 5 provided by ac-count holders that are not themselves non-qualified intermediaries or flow throughentities.(B) Qualified Intermediaries and With-holding Foreign Partnerships. QI shallnot apply the presumption rules to a pay-ment made to a qualified intermediary orwithholding foreign partnership to the ex-tent QI can reliably associate the paymentwith a valid Form W-8IMY provided bythe qualified intermediary or withholdingforeign partnership and, for those pay-ments for which a qualified intermediaryhas not assumed primary NRA withhold-ing responsibility or primary Form 1099reporting and backup withholding respon-sibility, QI can reliably associate the pay-ment with a withholding rate pool, as de-scribed in section 6.03 of this Agreement.(C) Private Arrangement Intermedi-aries. QI shall not apply the presumptionrules of section 5.13 of this Agreement ifQI has an agreement with a PAI, QI ob-tains from the PAI a Form W-8IMY com-pleted as if the PAI were a qualified inter-mediary (with the exception that the PAImust not provide a QI-EIN on the FormW-8IMY) and QI can reliably associatethe payment with reporting pools as de-scribed under section 8 of this Agreement,or with withholding rate pool informationrelating to U.S. non-exempt recipientsand indirect foreign account holders. Sec. 5.08. Documentation For U.S. Ex-empt Recipients. QI shall not treat anaccount holder as a U.S. exempt recipientunless QI obtains from the accountholder–(A) A valid Form W-9 on which the ac-count holder writes “Exempt” in Part II ofthe Form;(B) Documentary evidence that is sufficientto establish both the account holder’s U.S.and exempt recipient status; or(C) Documentary evidence that is suffi-

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cient to establish the account holder’s sta-tus as a U.S. person and QI can treat theperson as an exempt recipient under therules of Treas. Reg. §§1.6041–3(q),5f.6045–1(c)(3)(i)(B), 1.6045–2(b)(2)(i),or 1.6049–4(c)(1)(ii), as appropriate,without obtaining documentation. Sec. 5.09. Documentation for U.S. Non-Exempt Recipients. QI shall not treat anaccount holder as a U.S. non-exempt re-cipient unless QI obtains a valid Form W-9 from the account holder, QI knows anaccount holder is a U.S. non-exempt re-cipient, or QI must presume a person is aU.S. non-exempt recipient under sections5.13(C)(2) or (4) of this Agreement. Seesection 6.04 of this Agreement for rulesthat apply if the identity of a U.S. non-ex-empt recipient is prohibited by law frombeing disclosed.Sec. 5.10. Documentation Validity. (A) In General. QI may not rely on doc-umentation if QI has actual knowledge, orreason to know as described in section5.10(B) and (C) of this Agreement, thatthe information or statements contained inthe documentation are unreliable or incor-rect. Once QI knows, or has reason toknow, that documentation provided by anaccount holder is unreliable or incorrect,it can no longer reliably associate a pay-ment with valid documentation and,therefore, shall treat the account holder asan undocumented account holder andshall apply the presumption rules of sec-tion 5.13 of this Agreement until it ob-tains valid documentation. In addition, ifQI discovers that information containedin documentation is unreliable or incor-rect, QI agrees that it will promptly pro-vide a withholding agent with correctedinformation (e.g., corrected withholdingrate pools, corrected Forms W-9, or cor-rect TINs), if necessary for the withhold-ing agent to perform its obligations,within 30 days after QI discovers that thedocumentation upon which it has relied isunreliable or incorrect. If QI receives no-tification from the IRS that documenta-tion provided by an account holder is un-reliable or incorrect (e.g., that the TINprovided by an account holder is incor-rect) QI shall follow the procedures setforth in Treas. Reg. §31.3406(d)–5.(B) Reason to Know–Direct AccountHolders. QI shall be considered to havereason to know that documentation pro-vided by a direct account holder is unreli-

able or incorrect only if one or more ofthe circumstances described in this sec-tion 5.10(B) apply. If an account holderhas provided documentation that is not re-liable under the rules of this section5.10(B), QI may require new documenta-tion. Alternatively, QI may rely on thedocumentation originally provided if therules of this section 5.10(B) permit suchreliance based on additional statementsand documentation. (1) General Rules.(i) To the extent QI has primary Form1099 and backup withholding responsibil-ity, QI shall not rely on a Form W-9 if it isnot permitted to do so under the rules ofTreas. Reg. §31.3406(h)–3(e).(ii) QI shall not treat documentary evi-dence provided by an account holder asvalid if the documentary evidence doesnot reasonably establish the identity of theperson presenting the documentary evi-dence. For example, documentary evi-dence is not valid if it is provided in per-son by an account holder that is a naturalperson and the photograph on the docu-mentary evidence, if any, does not matchthe appearance of the person presentingthe document.(iii) QI may not rely on documentation toreduce the withholding rate that wouldotherwise apply under the presumptionrules if the account holder’s documenta-tion is incomplete, contains informationthat is inconsistent with the accountholder’s claim, QI has other account in-formation that is inconsistent with the ac-count holder’s claim, or the documenta-tion lacks information necessary toestablish entitlement to a reduced rate ofwithholding. For example, if an accountholder provides documentary evidence toclaim treaty benefits and the documentaryevidence establishes the account holder’sstatus as a foreign person and a resident ofa treaty country, but fails to provide thetreaty statement in section 5.03 of thisAgreement, if required, the documentaryevidence does not establish the accountholder’s entitlement to a reduced rate ofwithholding. However, for purposes ofestablishing an account holder’s status asa foreign person or residency under an in-come tax treaty, documentation shall beconsidered inconsistent only if it is not re-liable under the rules of section5.10(B)(2) and (3) of this Agreement.(2) Rules Regarding Establishment of

Foreign Status.(i) QI shall not treat documentary evi-dence provided by an account holder afterDecember 31, 2000, as valid for purposesof establishing the account holder’s for-eign status if the only mailing or resi-dence address that is available to QI is anaddress at a financial institution (unlessthe financial institution is a beneficialowner), an in-care-of address, or a P.O.Box. In this case, QI must obtain addi-tional documentation that is sufficient toestablish the account holder’s identity as aforeign person. QI shall not treat docu-mentary evidence provided by an accountholder before January 1, 2001, as valid forpurposes of establishing an accountholder’s status as a foreign person if it hasactual knowledge that a person is a U.S.person or if it has a mailing or residenceaddress for the account holder in theUnited States. If QI has an address for theaccount holder in the United States, QImay treat the account holder as a foreignperson if it can so treat the account holderunder the rules of section 5.10(B)(2)(ii) ofthis Agreement.(ii) QI shall not treat documentation asvalid for purposes of establishing an ac-count holder’s status as a foreign person ifQI has a mailing or residence address(whether or not on the documentation) forthe account holder in the United States orif the account holder notifies QI of a newaddress in the United States.If the account holder is a natural person,QI may nevertheless treat the accountholder as a foreign person if QI–(a) Has in its possession or obtains addi-tional documentary evidence (which doesnot contain a U.S. address) supporting theclaim of foreign status and a reasonableexplanation in writing supporting the ac-count holder’s foreign status;(b) Has in its possession or obtains a validForm W-8, if the initial documentationprovided was not a Form W-8, and theForm W-8 contains a permanent residenceaddress outside the United States and amailing address outside the United States(or if a mailing address is inside theUnited States the account holder providesa reasonable explanation in writing sup-porting the account holder’s foreign sta-tus); or(c) Is required to report annually a pay-ment to the account holder on a tax infor-mation statement in the country in which

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QI, or a branch of QI, is located; QI is re-quired to file a copy of that statement withthe tax authority of that country; and thatcountry has an income tax treaty in effectwith the United States.If the documentation is provided by anentity (other than a flow-through entity),QI may nevertheless treat the accountholder as a foreign person if QI–(d) Has in its possession, or obtains, doc-umentation that substantiates that the en-tity is actually organized or created underthe laws of a foreign country; (e)Obtains a valid Form W-8, if the initialdocumentation provided was not a FormW-8, and the Form W-8 contains a perma-nent residence outside the United Statesand a mailing address outside the UnitedStates (or if a mailing address is inside theUnited States the account holder providesadditional documentary evidence suffi-cient to establish the account holder’s for-eign status); or(f) Is required to report annually a pay-ment to the account holder on a tax infor-mation statement in the country in whichQI, or a branch of QI, is located; QI is re-quired to file a copy of that statement withthe tax authority of that country; and thatcountry has an income tax treaty in effectwith the United States.(iii) QI shall not treat documentation asvalid for purposes of establishing an ac-count holder’s status as a foreign person ifthe account holder has standing instruc-tions directing QI to pay amounts from itsaccount to an address or an account main-tained in the United States. QI may treatdocumentation as valid for establishingforeign status even though the accountholder has such standing instructions ifthe account holder provides a reasonableexplanation in writing that supports itsforeign status.(3) Rules for Establishing ResidencyUnder An Income Tax Treaty.

(i) QI shall not treat an account holderas a resident under an income tax treaty ifthe permanent residence address on aForm W-8 is not in the applicable treatycountry. QI may, however, rely on theForm W-8 if the account holder providesa reasonable explanation for the perma-nent residence address outside the treaty(e.g., the address is the address of abranch located outside the treaty countryin which the entity is a resident) or QI hasin its possession, or obtains, documentary

evidence that establishes residency in atreaty country.

(ii) QI shall not treat an account holderas a resident under an income tax treaty ifthe permanent residence address on aForm W-8 is in the applicable treaty coun-try but QI has a mailing or residence ad-dress for the account holder (whether ornot contained on the Form W-8) outsidethe applicable treaty country. A mailingaddress that is a P.O. Box, in-care-of ad-dress, or address at a financial institution(if the financial institution is not a benefi-cial owner) shall not preclude QI fromtreating the account holder as a resident ofan applicable treaty country if such ad-dress is in the applicable treaty country.If QI has a mailing or residence addressfor the account holder outside the applica-ble treaty country, QI may neverthelessrely on the form if–

(a) QI has in its possession, or obtains,additional documentation supporting theaccount holder’s claim of residence in theapplicable treaty country (and the addi-tional documentation does not contain anaddress outside the treaty country);

(b) QI has in its possession, or obtains,documentation that establishes that theaccount holder is an entity organized in atreaty country (or an entity managed andcontrolled in a treaty country, if the ap-plicable treaty so requires);

(c) QI knows that the address outside theapplicable treaty country (other than a P.O.Box, or in-care-of address) is a branch of abank or insurance company; or

(d) QI obtains a written statement fromthe account holder that reasonably estab-lishes entitlement to treaty benefits.

(iii) QI shall not treat documentary evi-dence as valid for purposes of establish-ing residency in a treaty country if QI hasa mailing or residence address for the ac-count holder (whether or not on the docu-mentary evidence) that is outside the ap-plicable treaty country, or the onlyaddress that QI has (whether in or outsideof the applicable treaty country) is a P.O.Box, an in-care-of address, or the addressof a financial institution (if the financialinstitution is not the beneficial owner).QI may nevertheless rely on the docu-mentary evidence if–

(a) QI has in its possession, or obtains,additional documentary evidence support-ing the account holder’s claim of resi-dence in the applicable treaty country

(and the documentary evidence does notcontain an address outside the applicabletreaty country, a P.O. Box, an in-care-ofaddress, or the address of a financial insti-tution);

(b) QI has in its possession, or obtains,documentary evidence that establishesthat the account holder is an entity orga-nized in a treaty country (or an entitymanaged and controlled in a treaty coun-try, if the applicable treaty so requires); or

(c) QI obtains a valid Form W-8 thatcontains a permanent residence addressand a mailing address in the applicabletreaty country.

(iv) QI shall not treat documentation asvalid for purposes of establishing an ac-count holder’s residence in an applicabletreaty country if the account holder hasstanding instructions for QI to payamounts from its account to an address oran account outside the treaty country un-less the account holder provides a reason-able explanation, in writing, establishingthe account holder’s residence in the ap-plicable treaty country.

(C) Reason to know–Indirect Ac-count Holders. QI shall be considered tohave reason to know that relevant infor-mation or statements contained in docu-mentation provided by an indirect accountholder are unreliable or incorrect if a rea-sonably prudent person in the position ofa qualified intermediary would questionthe claims made. QI shall have reason toknow that indirect account holder docu-mentary evidence provided by a nonquali-fied intermediary or a flow-through entityis unreliable or incorrect if a nonqualifiedintermediary or flow-through entity doesnot provide QI with the names of the indi-rect account holders, their addresses, allo-cation information allocating payments toeach indirect account holder, and suffi-cient information for QI to report pay-ments on Forms 1042-S and Forms 1099.In addition, QI shall have reason to be-lieve that an indirect account holder is notentitled to a reduced rate of withholdingunder an income tax treaty if the nonqual-ified intermediary or flow-through entityhas not provided sufficient information sothat QI can verify that the indirect accountholder has provided a TIN, if required,and made the necessary statements re-garding limitations on benefits provisionsand deriving the income under section894 of the Code and the regulations there-

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under. Sec. 5.11. Documentation Validity Pe-riod. (A) Documentation Other than FormW-9. QI may rely on valid documentaryevidence obtained from account holdersin accordance with applicable know-your-customer rules as long as the documen-tary evidence remains valid under thoserules or until QI knows, or has reason toknow, that the information contained inthe documentary evidence is incorrect.QI may rely on the representations de-scribed in section 5.03 of this Agreementobtained in connection with such docu-mentation for the same period of time asthe documentation. QI may rely on aForm W-8 until its validity expires underTreas. Reg. §1.1441–1(e)(4)(ii) and mayrely on documentary evidence (other thandocumentary evidence obtained pursuantto applicable know-your-customer rules)until its validity expires under Treas. Reg.§1.6049–5(c)(2).(B) Form W-9. QI may rely on a validForm W-9 as long as it has not been in-formed by the IRS or another withholdingagent that the form is unreliable. If QIhas primary Form 1099 reporting andbackup withholding responsibility, it mayrely on a Form W-9 unless one of the con-ditions of Treas. Reg.§31.3406(h)–3(e)(2)(i) through (v) apply.Sec. 5.12. Maintenance and Retentionof Documentation.(A) Maintaining Documentation. QIshall maintain documentation by retainingthe original documentation, a certifiedcopy, a photocopy, a microfiche, or byelectronic storage or similar means ofrecord retention. For accounts openedprior to January 1, 2001, if QI was not re-quired under its know-your-customerrules to maintain originals or copies ofdocumentation, QI may rely on its ac-count information if it has complied withall other aspects of its know-your-cus-tomer rules regarding establishment of anaccount holder’s identity, it has a recordthat the documentation required under theknow-your-customer rules was actuallyexamined by an employee of QI in accor-dance with the know-your-customer rules,and it has no information in its possessionthat would require QI to treat the docu-mentation as invalid under the rules ofsection 5.10(B) of this Agreement. (B) Retention Period. QI shall retain an

account holder’s documentation obtainedunder this section 5 for as long as docu-mentation is required to be retained underknow-your-customer rules identified inthe relevant Attachment(s) to this Agree-ment, whether or not the documentationwas obtained pursuant to those rules.Sec. 5.13. Application of PresumptionRules. (A) In General. QI shall apply the pre-sumption rules of section 5.13(C) of thisAgreement if QI cannot reliably associatea payment with valid documentation froman account holder other than a nonquali-fied intermediary or a flow-through en-tity. The presumption rules cannot beused to grant a reduced rate of withhold-ing. For example, the portfolio interestexception of sections 871(h) and 881(c)of the Code shall not apply to a personthat is presumed to be foreign. Further,QI must apply the presumption ruleswhen required and may not rely on its ac-tual knowledge regarding an accountholder’s status as a U.S. or foreign per-son. For example, if the account holder ispresumed to be a U.S. non-exempt recipi-ent, QI must treat the account holder assubject to 31% backup withholding on areportable payment even though QI actu-ally knows that the account holder is aforeign person. Notwithstanding the pre-ceding sentence, QI must rely on its ac-tual knowledge regarding an accountholder rather than what is presumed undersection 5.13(C) of this Agreement if,based on such knowledge, it should with-hold an amount greater than the withhold-ing rate under the presumption rules or itshould report on Form 1042-S or Form1099 an amount that would otherwise notbe reported. Thus, if an account holder ispresumed to be a foreign person with re-spect to an amount subject to withhold-ing, QI must treat the account holder assubject to 30 percent withholding and re-port the payment on Form 1042-S unlessQI has actual knowledge that the accountholder is a U.S. non-exempt recipient, inwhich case it must withhold 31 percentfrom the gross amount of the payment andreport the payment on Form 1099. Fail-ure to follow the presumption rules mayresult in liability for underwithholding,penalties, and interest.(B) Reliably Associating a PaymentWith Documentation. A payment can bereliably associated with documentation if

it is considered reliably associated withdocumentation under the rules of Treas.Reg. §1.1441–1(b)(2)(vii). Generally, QIcan reliably associate a payment withdocumentation if, for that payment, itholds valid documentation, as describedin section 5 of the Agreement, from an ac-count holder other than a nonqualified in-termediary or flow-through entity; it canreliably determine how much of the pay-ment relates to the valid documentationprovided by such an account holder; andit has no actual knowledge or reason toknow that any of the information or state-ments in the documentation are incorrect.Sections 5.13(B)(1)–(5) of this Agree-ment describe whether a payment is reli-ably associated with documentation if thepayment is made to an intermediary orflow-through entity.(1) Reliably Associating a PaymentWith Documentation Provided by aNonqualified Intermediary or a Flow-Through Entity. Generally, QI can reli-ably associate a payment with documen-tation provided by a nonqualifiedintermediary or a flow-through entityonly to the extent it can reliably associatethe payment with a valid Form W-8IMY;it can determine the portion of the pay-ment that relates to valid documentation,associated with the Form W-8IMY, froman account holder other than a nonquali-fied intermediary or flow-through entity;and the nonqualified intermediary orflow-through entity provides sufficient in-formation for QI to report the paymentson Form 1042-S or Form 1099, if report-ing is required. Notwithstanding the pre-ceding sentence, to the extent a paymentis not subject to reporting on Form 1042-S or Form 1099, QI can reliably associatethe payment with valid documentationprovided it can determine the portion ofthe payment allocable to a group of docu-mented account holders (other than non-qualified intermediaries or flow-throughentities) for whom withholding and re-porting is not required. For example, a QIcan treat a payment of deposit interest al-locable to a group of documented foreignaccount holders and documented U.S. ex-empt recipients as reliably associated withvalid documentation. If the documenta-tion attached to a nonqualified intermedi-ary or flow-through entity’s Form W-8IMY is documentation from anothernonqualified intermediary or flow-

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through entity, then the qualified interme-diary must apply the rules of this para-graph to that other nonqualified interme-diary or flow-through entity.(2) Reliably Associating a PaymentWith a Withholding Certificate Pro-vided By a Qualified Intermediary.Generally, QI can reliably associate apayment with documentation provided byanother qualified intermediary that doesnot assume either primary NRA withhold-ing responsibility or primary Form 1099reporting and backup withholding respon-sibility to the extent the other qualified in-termediary provides a valid Form W-8IMY and a withholding statement thatallocates the payment among withholdingrate pools for foreign account holders andwithholding rate pools attributable to eachU.S. non-exempt recipient account holderfor which the other qualified intermediaryhas provided a valid Form W-9. The pre-sumption rules shall not apply, however,even if a payment cannot be allocated toeach U.S. non-exempt recipient accountholder to the extent the alternative proce-dures of section 6.03(B) of this Agree-ment apply.(3) Reliably Associating a Paymentwith Documentation Provided by aQualified Intermediary That AssumesPrimary NRA Withholding Responsi-bility . Generally, QI can reliably associ-ate a payment with valid documentationprovided by another qualified intermedi-ary that assumes primary NRA withhold-ing responsibility, but not primary Form1099 reporting and backup withholdingresponsibility, to the extent it can associ-ate the payment with a valid Form W-8IMY and the withholding statement as-sociated with the Form W-8IMY allocatesthe payment between a single withholdingrate pool attributable to all foreign per-sons for which the qualified intermediaryassumes primary NRA withholding re-sponsibility and to withholding rate poolsattributable to each U.S. non-exempt re-cipient account holder for which the otherqualified intermediary has provided avalid Form W-9. The presumption rulesshall not apply, however, even if a pay-ment cannot be allocated to each U.S.non-exempt recipient account holder tothe extent the alternative procedures ofsection 6.03(B) of this Agreement apply.(4) Reliably Associating a PaymentWith Documentation Provided by a

Qualified Intermediary that AssumesPrimary Form 1099 Reporting andBackup Withholding Responsibility.Generally, QI can reliably associate apayment with valid documentation pro-vided by another qualified intermediarythat assumes primary Form 1099 report-ing and backup withholding responsibil-ity, but not primary NRA withholding re-sponsibility, to the extent it can associatethe payment with a valid Form W-8IMYand a withholding statement that allocatesthe payment among withholding ratepools for foreign account holders.(5) Reliably Associating a PaymentWith Documentation Provided by aQualified Intermediary that AssumesBoth Primary NRA Withholding Re-sponsibility and Primary Form 1099Reporting and Backup WithholdingResponsibility. Generally, QI can reli-ably associate a payment with valid docu-mentation provided by another qualifiedintermediary that assumes both primaryNRA withholding responsibility and pri-mary Form 1099 reporting and backupwithholding responsibility if QI can asso-ciate the payment with a valid Form W-8IMY and a withholding statement thatdesignates the accounts for which theother qualified intermediary is acting as aqualified intermediary and is assumingprimary NRA withholding and primaryForm 1099 reporting and backup with-holding responsibility.(C) Presumption Rules. The presump-tion rules are as follows:(1) Payments Made Outside the UnitedStates to an Offshore Account ofAmounts Subject to NRA Withholding.An amount that is subject to NRA with-holding that is paid outside the UnitedStates to an account that is maintainedoutside the United States is presumedmade to an undocumented foreign ac-count holder. Therefore, QI must treat theamount as subject to withholding at a rateof 30 percent on the gross amount paidand report the payment to an unknown ac-count holder on Form 1042-S.(2) Payments of Deposit Interest andOID on Short-Term Obligations. Anamount of U.S. source deposit interest(other than an amount that is part of thepurchase price of a certificate of depositsold in a transaction other than a redemp-tion) or an amount of U.S. source interestor original issue discount on the redemp-

tion of a short-term obligation that is paidoutside the United States to an offshoreaccount is presumed made to an undocu-mented U.S. non-exempt recipient ac-count holder. QI must backup withhold at31 percent and report such amounts onForm 1099 unless it has provided suffi-cient information for another payor fromwhich it receives such amounts to backupwithhold and report the payments and QIdoes not know that the other payor hasfailed to backup withhold or report.(3) Foreign Source Income, BrokerProceeds, and Certain Other Amounts.QI shall presume that the following pay-ments are made to an exempt recipientprovided that such amounts are paid out-side the United States to an account main-tained outside the United States:(i) Foreign source income;(ii) Broker proceeds;(iii) Original issue discount paid in a saleother than a redemption;(iv) Interest paid as part of the purchaseprice of an obligation when the instru-ment is sold between interest paymentdates; (v) Amounts held on deposit with banksor other financial institutions for twoweeks or less;(vi) Amounts of original issue discountarising from a sale and repurchase trans-action that is completed within two weeksor less; or(vii) Amounts described in Treas. Reg.§§1.6049-5(b)(7), (10), and (11).Such amounts are not subject to withhold-ing or reporting.(4) Other Payments. Any payment notcovered in sections 5.13(C)(1), (2) or (3)of this Agreement shall be presumedmade to a U.S. non-exempt recipient andtherefore shall be subject to Form 1099reporting and to backup withholding.Backup withholding shall not be required,however, if the exception provided inTreas. Reg. §31.3406(g)–1(e) applies.For example, any reportable paymentpaid inside the United States or paid to aU.S. account is presumed made to a U.S.non-exempt recipient and shall be subjectto backup withholding and reporting onForm 1099 as paid to an unknown owner.

SECTION 6. QUALIFIEDINTERMEDIARY WITHHOLDINGCERTIFICATE AND DISCLOSUREOF ACCOUNT HOLDERS TOWITHHOLDING AGENT

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Sec. 6.01. Qualified IntermediaryWithholding Certificate. QI agrees tofurnish a qualified intermediary withhold-ing certificate to each withholding agentfrom which it receives a reportableamount as a qualified intermediary. Thequalified intermediary withholding cer-tificate is a Form W-8IMY (or acceptablesubstitute form) that certifies that QI isacting as a qualified intermediary, con-tains QI’s QI-EIN, and provides all otherinformation required by the form. QI alsoagrees to furnish each withholding agentto whom it provides a Form W-8IMY thewithholding statement described in sec-tion 6.02 of this Agreement. QI is not re-quired to disclose, as part of its Form W-8IMY or its withholding statement, anyinformation regarding the identity of anaccount holder that is a foreign person ora U.S. exempt recipient. However, tothe extent it does not assume primaryForm 1099 reporting and backup with-holding responsibility, QI must provide toa withholding agent the Forms W-9 ob-tained from each U.S. non-exempt recipi-ent account holder on whose behalf QI re-ceives a reportable amount. If a U.S.non-exempt recipient that must be dis-closed has not provided a Form W-9, QImust, to the extent it has not assumed pri-mary Form 1099 reporting and backupwithholding, disclose the name, address,and TIN (if available) to the withholdingagent. QI is not required, however, to dis-close the identity of a U.S. non-exemptrecipient if QI is prohibited by law frommaking the disclosure and QI follows theprocedures of section 6.04 of this Agree-ment.Sec. 6.02. Withholding Statement. (A) In General. QI agrees to provide toeach withholding agent from which QI re-ceives reportable amounts as a qualifiedintermediary a written statement (the“withholding statement”) described inthis section 6.02. The statement forms anintegral part of the Form W-8IMY. Thewithholding statement may be provided inany manner, and in any form, to which QIand the withholding agent mutually agree.For example, QI and the withholdingagent may agree to establish a procedureto furnish withholding statement informa-tion electronically. The procedure mustcontain sufficient safeguards to ensurethat the information received by the with-holding agent is the information sent by

QI and must also document all occasionsof user access that result in the submis-sion or modification of withholding state-ment information. In addition, the QI andthe withholding agent must be capable ofproviding a hard copy of all withholdingstatements provided by the QI. The with-holding statement shall be updated asoften as necessary for the withholdingagent to meet its reporting and withhold-ing obligations under this Agreement. (B) Content of Withholding Statement.The withholding statement must containsufficient information for a withholdingagent to apply the correct rate of with-holding on payments from the accountsidentified on the statement and to prop-erly report such payments on Forms1042-S and Forms 1099, as applicable.The withholding statement must–(1) Designate those accounts for which QIacts as a qualified intermediary;(2) Designate those accounts for which QIassumes primary NRA withholding re-sponsibility and/or primary Form 1099 re-porting and backup withholding responsi-bility; and(3) Provide information regarding with-holding rate pools, as described in section6.03 of this Agreement, if necessary.Sec. 6.03. Withholding Rate Pools.(A) In General. QI shall provide as partof its withholding statement withholdingrate pool information in a manner suffi-cient for the withholding agent to meet itsNRA and backup withholding responsi-bilities and its Form 1042-S and Form1099 reporting responsibilities. With-holding rate pool information is not re-quired to the extent QI has assumed bothprimary NRA withholding responsibilityand primary Form 1099 reporting andbackup withholding responsibility and allthe information required for the withhold-ing agent to report payments on Form1042-S (e.g., the type of income) arewithin the knowledge of the withholdingagent. A withholding rate pool is a pay-ment of a single type of income (e.g., in-terest, dividends) determined in accor-dance with the categories of incomereported on Form 1042-S or Form 1099,as applicable, that is subject to a singlerate of withholding (e.g., 0%, 10%, 15%,or 30%). To the extent QI does not as-sume primary Form 1099 and backupwithholding responsibility, QI’s withhold-ing statement must establish a separate

withholding rate pool for each U.S. non-exempt recipient account holder that QIhas disclosed to the withholding agent un-less QI uses the alternative procedures insection 6.03(B) of this Agreement. QIshall determine withholding rate poolsbased on valid documentation obtainedunder section 5 of this Agreement, or if apayment cannot be reliably associatedwith valid documentation, on the pre-sumption rules of section 5.13(C) of thisAgreement. If QI has an account holderthat is another intermediary (whether aqualified intermediary, a non-qualified in-termediary, or a private arrangement in-termediary) or a flow-through entity, QImay combine the account holder informa-tion provided by the intermediary or flow-through entity with QI’s direct accountholder information to determine QI’swithholding rate pools.(B) Alternative Procedure for U.S.Non-Exempt Recipients. QI may, bymutual agreement with the withholdingagent, establish a single withholding ratepool (not subject to backup withholding)for all U.S. non-exempt recipient accountholders for whom QI has provided FormsW-9 prior to the withholding agent payingany reportable amounts or, if applicable,designated broker proceeds. Alterna-tively, QI may include such U.S. non-ex-empt recipients in a zero rate withholdingpool that includes U.S. exempt recipientsand foreign persons exempt from NRAwithholding provided that all the condi-tions of this paragraph 6.03(B) are met.QI may establish a separate withholdingrate pool (subject to 31% withholding) forall U.S. non-exempt recipient accountholders for whom QI has not providedForms W-9 prior to the withholding agentpaying any reportable amounts or, if ap-plicable, designated broker proceeds. IfQI chooses the alternative procedure ofthis section 6.03(B), QI must provide suf-ficient information to the withholdingagent no later than January 15 of the yearfollowing the year in which the reportableamounts and designated broker proceeds,if applicable, are paid that allocates suchpayments to each U.S. non-exempt recipi-ent account holder. Failure to providesuch information will result in the appli-cation of penalties to the QI under sec-tions 6721 and 6722 of the Code and shallconstitute an event of default under sec-tion 11.04 of this Agreement.

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Sec. 6.04. Legal Prohibitions AgainstDisclosure of U.S. Non-Exempt Recipi-ents.(A) Accounts Established Prior to Jan-uary 1, 2001. If QI knows an accountholder is a U.S. non-exempt recipient andthe account holder’s account was estab-lished with QI prior to January 1, 2001 (apre-2001 account), QI agrees to the fol-lowing procedures:(1) If QI is prohibited by law, includingby contract, from disclosing to a with-holding agent or to the IRS on Form 1099the account holder’s name, address, andTIN, for reportable payments paid to theaccount holder, then QI must–(i) Request from the account holder theauthority to make such a disclosure;(ii) Request from the account holder theauthority to sell any assets that generate,or could generate, reportable payments;or(iii) Request that the account holder dis-close himself by mandating QI to providea Form W-9 completed by the accountholder.(2) QI must make the requests describedin section 6.04(A)(1) at least two timesduring each calendar year and in a mannerconsistent with QI’s normal communica-tions with the account holder (e.g., bymail, telephone, etc.). If QI is not autho-rized to initiate communications with theaccount holder (e.g., QI can only commu-nicate with the account holder in person),QI must make the request at the time andin the manner that QI is authorized tocommunicate with the account holder.(3) Until QI receives a waiver of all prohi-bitions against disclosure or authorizationto sell all assets that generate, or couldgenerate, reportable payments, or a man-date from the account holder to provide aForm W-9, QI shall backup withhold onall reportable payments paid to the ac-count holder and report those paymentson Form 1099 or, in the case of reportableamounts and designated proceeds, pro-vide another withholding agent with allthe information required for that with-holding agent to backup withhold and re-port the payments on Form 1099. If theaccount holder disposes of any assets thatgenerate, or could generate, reportablepayments prior to providing QI with awaiver of all prohibitions against disclo-sure or authorization to sell all such as-sets, QI shall apply backup withholding

and Form 1099 reporting in accordancewith sections 3 and 8 of this Agreement.(4) If QI has not assumed primary Form1099 reporting and backup withholdingresponsibility but is authorized, or is man-dated, to disclose the account holder’sname, address, TIN and reportableamounts (and, designated broker proceedsif section 3.05(C) of this Agreement ap-plies) to a withholding agent, QI mustprovide the account holder’s Form W-9(or, if a Form W-9 was not obtained, theaccount holder’s name, address, and TIN,if available) to the withholding agent to-gether with appropriate withholding ratepool information within 30 days of thedate QI receives such authorization. (5) If QI is authorized to dispose of theaccount holder’s assets that generate, orcould generate, reportable payments, QImust sell or exchange all such assetswithin 60 days of receiving authorization.In addition, if QI later discovers that anaccount contains such assets, QI must sellsuch assets within 60 days of the discov-ery. See sections 3 and 8 of this Agree-ment for backup withholding and Form1099 reporting responsibilities.(6) If QI is not authorized to disclose theaccount holder’s identity or to sell or ex-change all of the account holder’s assetsthat generate or could generate reportablepayments, but QI is not prohibited by law,including by contract, from disposing ofthe account holder’s assets even though ithas not obtained specific authorization,QI must sell or exchange all such assetson or before December 31, 2002, andapply backup withholding and Form 1099reporting in accordance with sections 3and 8 of this Agreement.(B) Account Holder Discovered to beU.S. Non-Exempt Recipient. If QI’srecords indicate that the account holder ofa pre-2001 account is a foreign personand the QI discovers that the accountholder is a U.S. non-exempt recipient, QIshall follow the procedures of section6.04(A) of this Agreement, except that ifQI may legally sell or exchange the ac-count holder’s assets that generate, orcould generate, reportable payments with-out authorization, QI must sell or ex-change all such assets on or before thedate that is 365 days after QI learns thatthe account holder is a U.S. non-exemptrecipient, or, if later, December 31, 2002.(C) Accounts Opened on or After Janu-

ary 1, 2001. QI agrees to the followingprocedures for accounts opened by U.S.non-exempt recipients on or after January1, 2001 (post-2000 accounts):(1) If QI is prohibited by law, includingby contract, from disclosing to a with-holding agent or to the IRS on Form 1099the account holder’s name, address, andTIN, for reportable payments paid to theaccount holder, then QI must–(i) Request from the account holder theauthority to make such a disclosure;(ii) Request from the account holder, priorto opening the account, the authority toexclude from the account holder’s ac-count any assets that generate, or couldgenerate, reportable payments; or(iii) Request that the account holder dis-close himself by mandating QI to transfera Form W-9 completed by the accountholder.(2) If QI is authorized to disclose the ac-count holder’s name, address, TIN (ifavailable) and reportable amounts (anddesignated broker proceeds, if section3.05(C) of this Agreement applies), QImust obtain a valid Form W-9 from theaccount holder and, to the extent QI doesnot have primary Form 1099 and backupwithholding responsibility, provide theForm W-9 to the appropriate withholdingagent promptly after obtaining the FormW-9. If a Form W-9 is not obtained, thenQI must provide the account holder’sname, address, and TIN, if any, to thewithholding agents from whom QI re-ceives reportable amounts (and, if applic-able, designated broker proceeds) on be-half of the account holder together withappropriate withholding rate pool infor-mation relating to the account holder. Tothe extent QI has assumed primary Form1099 reporting and backup withholding, itmust backup withhold on all reportablepayments until it receives a valid FormW-9.(3) If QI is not authorized to disclose anaccount holder’s name and other requiredinformation but is authorized to excludefrom the account holder’s account any as-sets that generate, or could generate, re-portable payments, QI must follow proce-dures designed to ensure that it will nothold any assets that generate, or couldgenerate, reportable payments in the ac-count holder’s account.(4) If QI is authorized to exclude from theaccount holder’s account any assets that

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generate, or could generate, reportablepayments and QI discovers that the ac-count contains such assets, QI must sellsuch assets within 60 days of discoveringsuch assets and apply backup withholdingand Form 1099 reporting in accordancewith sections 3 and 8 of this Agreement.(5) QI agrees that if any account holder ina post-2000 account is discovered, afterthe opening of the account, to be a U.S.non-exempt recipient then QI will–(i) Immediately correct the withholdingstatement information provided to thewithholding agent, if necessary, and(ii) Either obtain a Form W-9 within 60days of discovering that the account holderis a U.S. non-exempt recipient, and, if QIhas not assumed primary Form 1099 re-porting and backup withholding responsi-bility, provide the Form W-9 to the appro-priate withholding agents together withappropriate withholding pool informationpromptly after obtaining the Form W-9 or,if QI is not authorized to disclose accountholder information, sell all of the accountholder’s assets that generate or could gen-erate reportable payments within 60 calen-dar days from the day that QI discovers theaccount holder is a U.S. non-exempt recip-ient. QI must backup withhold, or instructa withholding agent to backup withhold onany reportable payments made after thetime QI discovers the account holder’sU.S. non-exempt recipient status and be-fore obtaining a valid Form W-9 from theaccount holder.

SECTION 7. TAX RETURNOBLIGATIONS

Sec. 7.01. Form 1042 Filing Require-ment. (A) In general. QI shall file a return onForm 1042, whether or not QI withheldany amounts under chapter 3 of the Code,on or before March 15 of the year follow-ing any calendar year in which QI acts asa qualified intermediary. A separate Form1042 must be filed by each legal entitythat is a qualified intermediary covered bythis Agreement. Form 1042 shall be filedat the address indicated on the form or atany other address at which the IRS noti-fies QI under the provisions of section12.06 of this Agreement. In addition tothe information specifically requested onForm 1042 and the accompanying in-structions, QI shall attach to the form thefollowing information:

(1) A statement setting forth the amountsof any overwithholding or underwithhold-ing adjustments made under Treas. Reg.§1.1461-2 and sections 9.02 and 9.05 ofthis Agreement, and an explanation of thecircumstances that resulted in the over- orunder- withholding.(2) A statement that sets forth the aggre-gate amounts of reportable payments paidto U.S. non-exempt recipient accountholders, and the number of such accountholders, whose identity is prohibited byforeign law, including by contract, fromdisclosure. QI must separately reporteach type of reportable payment (deter-mined by reference to the types of incomereported on Forms 1099) and the numberof undisclosed account holders receivingsuch payments. See section 6.04 of thisAgreement.(B) Extensions For Filing Returns. QImay request an extension of the time forfiling Form 1042, or any of the informa-tion required to be attached to the form,by submitting Form 2758, Application forExtension of Time to File Certain Excise,Income, Information, and Other Returnson or before the due date of the return.The application must be in writing, prop-erly signed by a duly authorized agent ofQI, and shall clearly set forth the follow-ing:(1) The calendar year for which the exten-sion is requested; and(2) A full explanation of the reasons forrequesting the extension to assist the IRSin determining the period of extension, ifany, that will be granted.Sec. 7.02. Form 945 Filing Require-ment. QI shall file a return on Form 945on or before January 31 following the cal-endar year in which QI backup withheldany amount under section 3406 of theCode. Separate Forms 945 must be filedby each legal entity that is a qualified in-termediary covered by this Agreement.The form must be filed at the addressspecified in the instructions for Form 945or at any other address at which the IRSnotifies QI under the provisions of section12.06 of this Agreement. Sec. 7.03. Retention of Returns.QIshall retain Forms 945 and 1042 for theapplicable statute of limitations on assess-ments and collection under section 6501of the Code.

SECTION 8. INFORMATIONREPORTING OBLIGATIONS

Sec. 8.01. Form 1042-S Reporting.Ex-cept as otherwise provided in section 8.02of this Agreement, QI is not required tofile Forms 1042-S for amounts paid toeach separate account holder for whomsuch reporting would otherwise be re-quired. Instead, QI shall file a Form1042-S reporting the pools of income(“reporting pools”) as determined in sec-tion 8.03 of this Agreement. QI must fileits Forms 1042-S in the manner requiredby the regulations under chapter 3 of theCode and the instructions to the form, in-cluding any requirement to file the formsmagnetically or electronically. SeparateForms 1042-S must be filed by each legalentity that is a qualified intermediary cov-ered by this Agreement. Each qualifiedintermediary covered by this Agreementmay, however, allow its individualbranches to file Forms 1042-S providedthat all Forms 1042-S contain the QI-EINof the legal entity of which the branchforms a part. Any Form 1042-S requiredby this section 8 shall be filed on or be-fore March 15 following the calendar yearin which the payment reported on theform was made. QI may request an ex-tension of time to file Forms 1042-S bysubmitting Form 8809, Request for Ex-tension of Time to File Information Re-turns, by the due date of Forms 1042-S inthe manner required by Form 8809.Sec. 8.02. Recipient Specific Reporting.QI (whether or not it assumes primaryNRA withholding responsibility) is re-quired to file separate Forms 1042-S foramounts paid to each separate accountholder as described in this section 8.02.QI must file separate Forms 1042-S by in-come code, exemption code, recipientcode, and withholding rate.(A) QI must file separate Forms 1042-Sfor each qualified intermediary or with-holding foreign partnership accountholder that receives an amount subject toNRA withholding from QI (or from a PAIof QI), whether such account holder is adirect or indirect account holder. (B) QI must file separate Forms 1042-Sfor each foreign account holder of a non-qualified intermediary or foreign interestholder of a flow-through entity receivingan amount subject to NRA withholding(whether the nonqualified intermediary orflow-through entity is a direct or indirectaccount holder) to the extent QI can reli-ably associate such amounts with valid

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documentation from an account holderthat is not itself a nonqualified intermedi-ary or flow-through entity. In addition,QI must file separate Forms 1042-S foreach foreign account holder of a nonqual-ified intermediary or foreign interestholder of a flow-through entity that is anaccount holder of a PAI of QI (whetherthe nonqualified intermediary or flow-through entity is a direct or indirect ac-count holder of the PAI) to the extent QIcan reliably associate the amounts subjectto NRA withholding with valid documen-tation from an account holder that is notitself a nonqualified intermediary or flow-through entity. (C) QI must file separate Forms 1042-Smade out to an unknown recipient foramounts subject to withholding paid to anonqualified intermediary or flow-throughentity (whether the nonqualified interme-diary or flow-through entity is a direct orindirect account holder), to the extent thatQI cannot reliably associate such amountswith valid documentation from the ac-count holders of the nonqualified interme-diary or the interest holders of the flow-through entity. In addition, QI must fileseparate Forms 1042-S made out to an un-known recipient for amounts subject towithholding paid to a nonqualified inter-mediary or flow-through entity that is a di-rect or indirect account holder of a PAI ofQI to the extent that QI cannot reliably as-sociate such amounts with valid documen-tation from the account holders of suchnonqualified intermediary or the interestholders of the flow-through entity.Sec. 8.03. Reporting Pools for Form1042-S Reporting. Except for amountsrequired to be reported under section 8.02of this Agreement, QI shall report allamounts subject to NRA withholding byreporting pools on a Form 1042-S if thoseamounts are paid to direct account holdersof QI or to direct account holders of a PAIof QI that are (or are presumed to be) for-eign persons. A separate Form 1042-Sshall be filed for each type of reportingpool. A reporting pool consists of incomethat falls within a particular withholdingrate and within a particular income code,exemption code, and recipient code as de-termined on Form 1042-S. QI may use asingle recipient code for all reportingpools except for amounts paid to foreigntax-exempt recipients, for which a sepa-rate recipient code must be used. For this

purpose, a foreign tax-exempt recipientincludes any organization that is not sub-ject to NRA withholding and is not liableto tax in its country of residence becauseit is a charitable organization, a pensionfund, or a foreign government.Sec. 8.04. Form 1099 Reporting Re-sponsibility. QI shall file Forms 1099and, unless filing magnetically, Form1096, for reportable payments made tothe persons specified in this section 8.04.Forms 1099 shall be filed on or before thedate prescribed for the particular Form1099 under chapter 61 of the Code and inthe manner required by regulations underchapter 61 of the Code and the instruc-tions to the forms, including any require-ment to file the forms magnetically orelectronically. Extensions of the time tofile Forms 1099 may be requested by sub-mitting Form 8809, Request for Exten-sion of Time to File Information Returns,in the manner required by the form. If QIis required to file Forms 1099, it must filethe appropriate form for the type of in-come paid (e.g., Form 1099-DIV for divi-dends, Form 1099-INT for interest, Form1099-B for broker proceeds). QI mustfile Forms 1099 in the situations listed insections 8.04(A) through (E) of thisAgreement regardless of whether it as-sumes primary Form 1099 reporting andbackup withholding responsibility unlessotherwise provided in those sections.(A) QI must file a Form 1099 made out toan unknown owner for the aggregateamount of a particular type of reportableamount paid to account holders that areU.S. non-exempt recipients (whether di-rect or indirect account holders) whoseidentity and account information are pro-hibited by law, including by contract,from being disclosed. However, QI is notrequired to file a Form 1099 for, orbackup withhold on, a reportable amountto the extent QI has provided sufficientinformation to another payor for thatpayor to report the reportable amount aspaid to an unknown owner and to backupwithhold on the reportable amount and QIdoes not know that the other payor hasfailed to report or backup withhold.(B) QI must file a Form 1099 made out toan unknown owner on the aggregateamount of a reportable payment that is nota reportable amount paid to a U.S. non-exempt recipient (whether a direct or indi-rect account holder) whose identity and

account information are prohibited bylaw, including by contract, from disclo-sure. Notwithstanding the previous sen-tence, QI is not required to report onForm 1099 and backup withhold on des-ignated broker proceeds to the extent thedesignated broker proceeds provisions ofsection 3.05 of this Agreement apply andQI does not know that the other payor hasfailed to report or backup withhold. (C) QI must file a Form 1099 for a re-portable amount paid to each U.S. non-exempt recipient account holder (whethera direct or indirect account holder) whoseidentity and account information are notprohibited by foreign law, including bycontract, from disclosure and for whomQI has not provided a Form W-9 to awithholding agent or has not provided theaccount holder’s name, address, TIN (ifavailable) and withholding rate pool in-formation to a withholding agent.(D) QI must file a Form 1099 for a re-portable payment (other than a reportableamount) paid to each U.S. non-exempt re-cipient (whether a direct or indirect ac-count holder), or to any account holderthat is presumed to be a U.S. non-exemptrecipient, whose identity and account in-formation are not prohibited by foreignlaw, including by contract, from disclo-sure. Notwithstanding the previous sen-tence, QI is not required to report onForm 1099 or backup withhold on desig-nated broker proceeds paid to a U.S. non-exempt recipient if the procedures of sec-tion 3.05 of this Agreement apply and QIdoes not know that the other payor hasfailed to report or backup withhold.(E) QI must file a Form 1099 for accountholders (whether direct or indirect) thatare, or are presumed to be, U.S. non-ex-empt recipients that receive reportableamounts for which QI has assumed pri-mary Form 1099 reporting and backupwithholding responsibility.(F) QI must file a Form 1099 for an ac-count holder (whether direct or indirect)that is a U.S. person (whether exempt ornon-exempt) if QI has made a reportablepayment to which it applied backup with-holding and QI has not reported theamount under section 8.04(A)-(E) of thisAgreement.

SECTION 9. ADJUSTMENTS FOROVER- AND UNDER-WITHHOLDING; REFUNDS

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Sec. 9.01. Adjustments for NRA Over-withholding by Withholding Agent. QImay request a withholding agent to makean adjustment for amounts paid to QI onwhich the withholding agent has over-withheld under chapter 3 of the Code byapplying either the reimbursement proce-dure described in section 9.01(A) of thisAgreement or the set-off procedure de-scribed in section 9.01(B) of this Agree-ment within the time period prescribed forthose procedures. Nothing in this sectionshall be interpreted to require a withhold-ing agent to apply the reimbursement orset off procedures under sections 9.01(A)or (B) of this Agreement. (A) Reimbursement Procedure.QI mayrequest a withholding agent to repay QIfor any amount overwithheld under chap-ter 3 of the Code and for the withholdingagent to reimburse itself under the reim-bursement procedures of Treas. Reg.§1.1461-2(a)(2)(i) by making the requestto the withholding agent prior to the duedate for filing the Form 1042 and Form1042-S (without regard to extensions) forthe calendar year of overwithholding.(B) Set-off Procedure. QI may request awithholding agent to repay QI by apply-ing the amount overwithheld against anyamount which otherwise would be re-quired to be withheld under chapter 3 ofthe Code from income paid by the with-holding agent to QI. QI must make therequest before the earlier of the due date(without regard to extensions) for thewithholding agent to file Form 1042-S forthe calendar year of overwithholding orthe date that the Form 1042-S is actuallyfiled with the IRS. Sec. 9.02. Adjustments for NRA Over-withholding by QI. QI may make an ad-justment for amounts paid to its accountholders that it has overwithheld underchapter 3 of the Code by applying eitherthe reimbursement or set-off proceduresdescribed in this section within the timeperiod prescribed for those procedures.(A) Reimbursement Procedure.QI mayrepay its account holders for an amountoverwithheld and reimburse itself by re-ducing, by the amount of tax actually re-paid to the account holders, the amount ofany subsequent deposit of tax required tobe made by QI under section 3.08 of thisAgreement. For purposes of this section9.02(A), an amount that is overwithheldshall be applied in order of time to each of

the QI’s subsequent deposit periods in thesame calendar year to the extent that thewithholding taxes required to be de-posited for a subsequent deposit periodexceed the amount actually deposited. Anamount overwithheld in a calendar yearmay be applied to deposit periods in thecalendar year following the calendar yearof overwithholding only if:(1) QI states on a Form 1042-S (issued, ifapplicable, to the account holders of theincome or otherwise to a reporting pool),filed by March 15 of the calendar yearfollowing the calendar year of overwith-holding, the amount of tax withheld andthe amount of any actual repayments; and(2) QI states on a Form 1042, filed byMarch 15 of the calendar year followingthe calendar year of overwithholding, thatthe filing of the Form 1042 constitutes aclaim for credit in accordance with Treas.Reg. §1.6414–1.(B) Set-Off Procedure. QI may repay itsaccount holders by applying the amountoverwithheld against any amount whichotherwise would be required under chap-ter 3 of the Code to be withheld from apayment made by QI to the account hold-ers before the earlier of March 15 of thecalendar year following the calendar yearof overwithholding or the date that theForm 1042-S is actually filed with theIRS. For purposes of making a return onForm 1042 or 1042-S for the calendaryear of overwithholding, and for purposesof making a deposit of the amount with-held, the reduced amount shall be consid-ered the amount required to be withheldfrom such income under chapter 3 of theCode.Sec. 9.03. Repayment of Backup With-holding. If QI erroneously withholds, asdefined under Treas. Reg. §31.6413(a)–3,an amount under section 3406 of the Codefrom an account holder, QI may refundthe amount erroneously withheld as pro-vided in Treas. Reg. §31.6413(a)–3.Sec. 9.04. Collective Credit or RefundProcedures for NRA Overwithholding.If there has been overwithholding underchapter 3 of the Code on amounts subjectto NRA withholding paid to QI’s accountholders during a calendar year and theamount has not been recovered under thereimbursement or set-off proceduresunder sections 9.01 or 9.02 of this Agree-ment, QI may request a credit or refund ofthe total amount overwithheld by follow-

ing the procedures of this section 9.04.QI shall not include in its collective re-fund claim payments made to an indirectaccount holder or to a direct accountholder that is a nonqualified intermediaryor flow-through entity. QI shall followthe procedures set forth under sections6402 and 6414 of the Code, and the regu-lations thereunder, to claim the credit orrefund. No credit or refund will be al-lowed after the expiration of the statutoryperiod of limitation for refunds under sec-tion 6511 of the Code. QI may use thecollective refund procedures under thissection 9.04 only if the following condi-tions are met:(A) QI must not have issued Forms 1042-S to the account holders that received thepayment that was subject to overwith-holding;(B) QI must submit together with itsamended return on which it claims acredit or refund a statement of the reasonfor the overwithholding;(C) QI must submit together with itsamended return on which it claims acredit or refund a statement that it has re-paid the amount of overwithholding to theappropriate account holders prior to filingthe claim for credit or refund; and(D) QI must retain a record showing thatit repaid the account holders the amountof the overwithholding.Sec. 9.05. Adjustments for NRA Under-withholding. If QI knows that an amountshould have been withheld under chapter3 of the Code from a previous payment toan account holder but was not withheld,QI may either withhold from future pay-ments made to the same account holder orsatisfy the tax from property that it holdsin custody for the account holder or prop-erty over which it has control. The addi-tional withholding or satisfaction of thetax owed may only be made before thedue date of the Form 1042 (not includingextensions) for the calendar year in whichthe underwithholding occurred. QI’s re-sponsibilities will be met if it informs awithholding agent from which it receivedthe payment of the underwithholding andthe withholding agent satisfies the under-withholding.Sec. 9.06. NRA UnderwithholdingAfter Form 1042 Filed. If, after a Form1042 has been filed for a calendar year,QI, QI’s external auditor, or the IRS de-termines that, due to QI’s failure to carry

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out its obligations under this Agreement,QI has underwithheld tax for such year,QI shall file an amended Form 1042 to re-port and pay the underwithheld tax. QIshall pay the underwithheld tax, the inter-est due on the underwithheld tax, and anyapplicable penalties, at the time of filingthe amended Form 1042. If QI fails tofile an amended return, the IRS shallmake such return under section 6020 ofthe Code. See section 10.04 of thisAgreement for procedures that apply ifunderwithholding is discovered as part ofa statistical sampling of accounts.Sec. 9.07. Special Rule Regarding Fail-ure to Deposit Penalties.Solely for pur-poses of applying section 6656 of theCode (failure to make deposit of taxes),neither QI nor its withholding agent willbe considered to have made an underpay-ment of a deposit of NRA withholdingtaxes if the conditions of this paragraphare met. The conditions of this paragraphare that–(A) The withholding agent or QI makesits deposits within the time (deposit pe-riod) required by section 6302 of theCode, or if applicable, section 3.08 of thisAgreement;(B) The deposit is not less than 90 percentof the aggregate amount of the tax re-quired to be withheld under chapter 3 ofthe Code during the deposit period applic-able to the withholding agent or QI; and(C) QI and the withholding agent deter-mine the difference between the totalamount required to be deposited and theamount actually deposited as of the end ofthe 3rd, 6th, 9th, and 12th months of thecalendar year and the difference is de-posited no later than the 15th day of thesecond following month (i.e., May 15,August 15, November 15 and February15, respectively). In determining whetherthere has been an underpayment, reim-bursements and set-offs shall be takeninto account.

SECTION 10. EXTERNAL AUDITPROCEDURES

Sec. 10.01. In General.Unless QI re-quests an IRS audit in lieu of an externalaudit, the IRS agrees not to conduct an on-site audit of QI, or any PAI with which QIhas an agreement, with respect to with-holding and reporting obligations coveredby this Agreement provided that an exter-nal auditor designated in Appendix B of

this Agreement conducts an audit of QI,and any PAI, in accordance with this sec-tion 10. QI shall permit the external audi-tor to have access to all relevant records ofQI for purposes of performing the externalaudit, including information regardingspecific account holders. QI shall permitthe IRS to communicate directly with theexternal auditor and to review the auditprocedures followed by the external audi-tor. QI represents that there are no legalprohibitions that prevent the external audi-tor from examining any information rele-vant to the external audit to be performedunder this section 10 and that there are nolegal prohibitions that prevent the IRSfrom communicating directly with the au-ditor. QI shall permit the IRS to examinethe external auditor’s work papers and re-ports. However, the external auditor is notrequired to divulge the identity of QI’s ac-count holders to the IRS.Sec. 10.02. Designation of External Au-ditor . QI’s external auditor must be oneof the auditors listed in Appendix B ofthis Agreement, unless QI and the IRSagree, prior to the audit, to substitute an-other auditor. QI shall not propose an ex-ternal auditor unless it has a reasonablebelief that the auditor is subject to laws,regulations, or rules that impose sanctionsfor failure to exercise its independenceand to perform the audit competently.The IRS has the right to reject a proposedexternal auditor, or to revoke its accep-tance of an external auditor, if the IRS, inits sole discretion, reasonably believesthat the auditor is not independent or can-not perform an effective audit under thisAgreement.Sec. 10.03. Timing and Scope of Exter-nal Audits. QI shall have the external au-ditor conduct an audit of the second fullcalendar year and the fifth full calendaryear that this Agreement is in effect, sub-ject to section 10.06 of this Agreement.The external auditor shall verify whetherQI is in compliance with this Agreementby conducting an audit that meets the re-quirements of this section 10.03. The ex-ternal auditor shall verify whether QI is incompliance with its QI agreement by pro-viding a report to the IRS. The reportmust be received by the IRS, at the ad-dress set forth in section 12.06 of thisAgreement, no later than June 30 of theyear following the year being audited.The IRS may, however, upon request by

the external auditor, extend the due dateof the audit report upon good cause. Thereport must disclose that the external au-ditor has, at a minimum, performed thefollowing checks listed in this paragraph10.03, and set forth how each of thosechecks was performed and the results ofthe checks. QI’s (or a PAI’s) external au-ditor is encouraged to contact the IRS atthe address set forth in section 12.06 ofthis Agreement and submit an audit plan(which includes, if relevant, the extent towhich the external auditor proposes torely on QI’s internal audit procedures)prior to performing the audit so that theaudit may be conducted in the most effi-cient and least costly manner possible.(A) Documentation. The external audi-tor must–(1) Verify that QI has training materials,manuals, and directives that instruct theappropriate QI employees how to request,collect, review, and maintain documenta-tion in accordance with this Agreement;(2) Review QI’s account opening proce-dures and interview QI’s employees, todetermine if appropriate documentation isrequested from account holders and, ifobtained, that it is reviewed and main-tained in accordance with this Agreement;(3) Verify that QI follows procedures de-signed to inform account holders thatclaim a reduced rate of withholding underan income tax treaty about any applicablelimitation on benefits procedures;(4) Review QI’s accounts, using a validsample of accounts for which treaty bene-fits are claimed, to ensure that QI is ob-taining the treaty statements required bysection 5.03(B);(5) Review information, using a validsample, contained in account holder filesto determine if the documentation validitystandards of section 5.10 of this Agree-ment are being met. For example, the ex-ternal auditor must verify that changes inaccount holder information (e.g., achange of address to a U.S. address orchange of account holder status from for-eign to U.S.) are being conveyed to QI’swithholding agent, or, if QI assumes pri-mary NRA withholding responsibility orprimary Form 1099 reporting and backupwithholding responsibility, that QI is ap-plying the appropriate withholding rate;(6) Review accounts, using a valid sampleof U.S. non-exempt recipient account hold-ers, to determine if QI is obtaining Forms

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W-9 from those customers whose identityis not prohibited by law from disclosure,and that QI is transmitting those forms to awithholding agent to the extent QI does notassume primary Form 1099 reporting andbackup withholding responsibility with re-spect to reportable amounts and, if applica-ble, designated broker proceeds;(7) Review accounts, using a valid sampleof U.S. non-exempt recipient accountholders whose identity and account infor-mation is prohibited by law, including bycontract, from disclosure, to verify that–(i) Such accounts exist in only rare andunusual circumstances (and detailing inthe audit report the nature of such circum-stances); and(ii) The procedures of section 6.04 havebeen, and are being, followed.(8) Review QI’s agreements with its PAIsto ensure that the obligations imposed onthe PAIs are identical to the obligationsimposed on QI under this Agreement, ex-cept as otherwise provided in section4.02.(9) State in its external audit report if theauditor is aware that QI is in material vio-lation or is under investigation for viola-tion of any of the know-your-customerrules, practices, or procedures applicableto the offices audited. (10) State in its external audit report if theauditor is aware that QI removes U.S.non- exempt recipients from accountscovered by this Agreement for the pur-pose of circumventing the Form 1099 re-porting and backup withholding provi-sions of this Agreement.(B) Withholding Rate Pools.The exter-nal auditor must–(1) Verify that QI has training materials,manuals, and directives that instruct theappropriate QI employees how to deter-mine withholding rate pools based ondocumentation and the presumption rules;(2) Interview employees responsible fordetermining withholding rate pools to as-certain if they are adequately trained todetermine those pools and that they fol-low adequate procedures for determiningthose pools;(3) Review QI’s procedures for preparingthe withholding statements associatedwith QI’s Forms W-8IMY and verify thatthe withholding statements provided towithholding agents convey complete andcorrect information on a timely basis;(4) Perform test checks, using a valid

sample of account holders assigned toeach withholding rate pool, and crosscheck that assignment against the docu-mentation provided by, or presumptionrules that apply to, the account holder, thetype of income earned, and the withhold-ing rate applied;(5) Perform test checks, using a validsample of accounts of U.S. non-exemptrecipients, to verify that appropriate with-holding rate pools are established for U.S.non-exempt recipients; and(6) Verify, if QI is using the alternativeprocedure for U.S. non-exempt recipientscontained in section 6.03(B) of thisAgreement, that QI is providing sufficientand timely information to withholdingagents that allocates reportable paymentsto U.S. non-exempt recipients.(C) Withholding Responsibilities. Theexternal auditor must–(1) To the extent QI has assumed primaryNRA withholding responsibility, performtest checks, using a valid sample of for-eign account holders, to verify that QI iswithholding the proper amounts;(2) To the extent QI has not assumed pri-mary NRA withholding responsibility,verify that QI has fulfilled its responsibili-ties under section 3.02 of this Agreement;(3) To the extent QI has assumed primaryForm 1099 reporting and backup with-holding responsibility, perform testchecks using a valid sample of U.S. non-exempt recipient account holders to verifythat QI backup withheld when required;(4) To the extent QI has not assumed pri-mary Form 1099 reporting and backupwithholding responsibility, perform testchecks using a valid sample of U.S. non-exempt account holders to verify that QIhas fulfilled its backup withholding re-sponsibilities under sections 3.04, 3.05and 3.06 of this Agreement;(5) Review the accounts of U.S. non-ex-empt recipient account holders whoseidentity is prohibited by law, including bycontract, from disclosure and verify thatQI or another payor is backup withhold-ing on reportable payments made to suchaccount holders;(6) Review a valid sample of accounts ofU.S. non-exempt recipient account hold-ers and determine if assets that generateor could generate reportable payments areheld in an account of any U.S. non-ex-empt recipient account holders whoseidentity is prohibited by law, including by

contract, from disclosure, and ascertainthe reason why such assets have not beendisposed of or the account holder dis-closed; and(7) Verify that amounts withheld weretimely deposited in accordance with sec-tion 3.08 of this Agreement.(D) Return Filing and Information Re-porting. The external auditor must–(1) Obtain copies of original and amendedForms 1042 and Forms 945, and anyschedules, statements, or attachments re-quired to be filed with those forms, anddetermine whether the amounts of in-come, taxes, and other information re-ported on those forms are accurate by–(i) Reviewing work papers;(ii) Reviewing Forms W-8IMY, togetherwith the associated withholding state-ments, that QI has provided to withhold-ing agents;(iii) Reviewing copies of Forms 1042-Sthat withholding agents have provided QI;(iv) Reviewing account statements fromwithholding agents;(v) Reviewing correspondence betweenQI and withholding agents; and (vi) Interviewing personnel responsiblefor preparing the Forms 1042 and 945 andthe work papers used to prepare thoseforms.(2) Obtain copies of original and cor-rected Forms 1042-S and Forms 1099 to-gether with the work papers used to pre-pare those forms and determine whetherthe amounts reported on those forms areaccurate by–(i) Reviewing the Forms 1042-S receivedfrom withholding agents;(ii) Reviewing the Forms W-8IMY, andthe associated withholding statements,that QI has provided withholding agents;(iii) Reviewing a valid sample of accountstatements issued by QI to account hold-ers; and(iv) Interviewing QI’s personnel responsi-ble for preparing the Forms 1042-S and, ifapplicable, Forms 1099, and the work pa-pers used to prepare those forms.(3) Thoroughly review the statements at-tached to amended Forms 1042 filed toclaim a refund, ascertain their veracity,and determine the causes of any overwith-holding reported and ensure QI did notissue Forms 1042-S to persons whom itincluded as part of its collective credit orrefund.(4) Determine, in the case of collective

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credits or refunds, that QI repaid the ap-propriate account holders prior to request-ing a collective refund or credit.(E) Change in Circumstances.The ex-ternal auditor must verify that in thecourse of the audit it has not discoveredany significant change in circumstances,as described in section 11.03(A), (D), or(E) of this Agreement.Sec. 10.04. Use of Statistical Sampling.If the external auditor is required to makea determination based on a valid sampleof accounts, it shall use a statistical sam-pling whenever an examination of all ofaccounts within a particular class of ac-counts would be prohibitive in terms oftime and expense. If it is reasonable toexamine all accounts in connection with aparticular issue, statistical sampling tech-niques shall not be used. If statisticalsampling techniques are required, the ex-ternal auditor must determine a samplesize that provides a 95 percent confidencelevel. If statistical sampling has beenused and the auditor determines that un-derwithholding has occurred with respectto the sampled accounts, the IRS will de-termine the total amount of underwithheldtax by projecting the underwithholdingover the entire population of similar ac-counts. For this purpose, QI agrees toprovide the IRS with the information(e.g., number of accounts and amounts)required to project the underwithholding.QI shall either report and pay, in accor-dance with section 9.06 of this Agree-ment, the underwithheld tax determinedunder the IRS projection or propose an-other amount of underwithholding basedon a more accurate population, a more ac-curate projection technique, or an exami-nation of all similar accounts. If the IRSdoes not agree with the amount proposedby QI, the IRS shall assess a tax by mak-ing a return under section 6020 of theCode.Sec. 10.05. External Auditor’s Report.Upon completion of the audit of QI andany PAI, the external auditor shall issue areport, or reports, of audit findings di-rectly to the IRS by sending the originalreport to the IRS at the address set forth insection 12.06 of this Agreement by June30 following the calendar year being au-dited, or if that date falls on a Saturday orSunday, the next U.S. business day. Thereport must be in writing, in English, andcurrency amounts must be stated in U.S.

dollars. The report must fully describethe scope of the audit, the methodologies(including sampling techniques) used todetermine whether QI is in compliancewith the provisions of this Agreement,and the result of each such determination.The report must also specifically addresseach of the items in section 10.03 of thisAgreement.Sec. 10.06. Expanding Scope and Tim-ing of External Audit. Upon review ofthe external auditor’s report, the IRS mayrequest, and QI must permit, the externalauditor to perform additional audit proce-dures, or to expand the external audit tocover some or all of the calendar years forwhich the period of limitations for assess-ment of taxes has not expired. In addi-tion, the IRS may request, and QI agreesto permit, the external auditor to performan audit for one or more calendar yearsnot scheduled for audit under section10.03 of this Agreement.

SECTION 11. EXPIRATION,TERMINATION AND DEFAULT

Sec. 11.01. Term of Agreement.ThisAgreement shall be in effect on_________ and shall expire on December31 of the fifth full calendar year after theyear in which this Agreement first takeseffect. This Agreement may be renewedas provided in section 11.06 of this Agree-ment.Sec. 11.02. Termination of Agreement.This Agreement may be terminated by ei-ther the IRS or QI prior to the end of itsterm by delivery of a notice of termina-tion to the other party in accordance withsection 12.06 of this Agreement. TheIRS, however, shall not terminate theAgreement unless there has been a signif-icant change in circumstances, as definedin section 11.03 of this Agreement, or anevent of default has occurred, as definedin section 11.04 of this Agreement, andthe IRS determines, in its sole discretion,that the significant change in circum-stances or the event of default warrantstermination of this Agreement. In addi-tion, the IRS shall not terminate thisAgreement in the event of default if QIcan establish to the satisfaction of the IRSthat all events of default for which it hasreceived notice have been cured withinthe time period agreed upon. The IRSshall notify QI, in accordance with sec-tion 11.05 of this Agreement, that an

event of default has occurred and that theIRS intends to terminate the Agreementunless QI cures the default. A notice oftermination sent by either party shall takeeffect on the date specified in the notice.Sec. 11.03. Significant Change in Cir-cumstances.For purposes of this Agree-ment, a significant change in circum-stances includes, but is not limited to–(A) An acquisition of all, or substantiallyall, of QI’s assets in any transaction inwhich QI is not the surviving legal entity;(B) A change in U.S. federal law or pol-icy, or applicable foreign law or policy,that affects the validity of any provisionof this Agreement, materially affects theprocedures contained in this Agreement,or affects QI’s ability to perform its oblig-ations under this Agreement;(C) A ruling of any court that affects thevalidity of any provision of this Agree-ment;(D) A material change in the know-your-customer rules and procedures set forth inany Attachment to this Agreement; or(E) A significant change in QI’s businesspractices that affects QI’s ability to meetits obligations under this Agreement.Sec. 11.04. Events of Default.For pur-poses of this Agreement, an event of de-fault occurs if QI fails to perform any ma-terial duty or obligation required underthis Agreement, and includes, but is notlimited to, the occurrence of any of thefollowing:(A) QI fails to implement adequate proce-dures, accounting systems, and internalcontrols to ensure compliance with thisAgreement;(B) QI underwithholds an amount that QIis required to withhold under chapter 3 ofthe Code and fails to correct the under-withholding or to file an amended Form1042 reporting, and paying, the appropri-ate tax;(C) QI underwithholds an amount that QIis required to backup withhold under sec-tion 3406 of the Code;(D) QI makes a misrepresentation onForms W-8IMY or the associated with-holding statement that results in under-withholding by a withholding agent;(E) QI makes excessive refund claims;(F) Documentation described in section 5of this Agreement is lacking, incorrect, orunreliable for a significant number of di-rect account holders;(G) QI fails to timely file Forms 945,

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1042, 1042-S, or 1099 or files forms thatare materially incorrect or fraudulent orfails to provide information necessary fora withholding agent or payor to file Forms1099 with respect to disclosed U.S. per-sons;(H) QI fails to have an external audit per-formed when required, QI’s external audi-tor fails to provide its report directly tothe IRS on a timely basis, QI fails to co-operate with the external auditor, or QI orits external auditor fails to cooperate withthe IRS;(I) QI fails to disclose to a withholdingagent, or to the IRS, U.S. nonexempt re-cipient account holders to the extent thedisclosure is not prohibited by foreignlaw, including by contract;(J) QI fails to inform the IRS of anychange in the know-your-customer rulesdescribed in any Attachment to thisAgreement within 90 days of the changebecoming effective;(K) QI fails to inform the IRS within 90days of any significant change in its busi-ness practices to the extent that change af-fects QI’s obligations under this Agree-ment;(L) QI fails to inform the IRS of any pri-vate arrangement, as described in section4 of this Agreement;(M) QI fails to cure a default identified bythe IRS or by an external auditor; (N) QI makes any fraudulent statement or amisrepresentation of material fact with re-gard to this Agreement to the IRS, a with-holding agent, or QI’s external auditor;(O) The IRS determines that QI’s externalauditor is not sufficiently independent toadequately perform its audit function orthe external auditor fails to provide anaudit report that complies with section 10of this Agreement; (P) An intermediary with which QI has aPAI agreement is in default with thatagreement and QI fails to meet its obliga-tion to terminate that agreement withinthe time period specified in section 4.03of this Agreement; (Q) QI has not complied with the proce-dures of section 6.04 of this Agreement orhas any undisclosed U.S. non-exempt re-cipients (except in rare and unusual cir-cumstances) whose accounts contain as-sets that generate, or could generate,reportable payments;(R) QI is prohibited by any law from dis-closing the identity of an account holder

or account information to QI’s externalauditor;(S) QI, to the extent it has primary Form1099 reporting and backup withholdingresponsibility, fails to comply with the re-quirements of chapter 61 and section3406 of the Code;(T) QI, to the extent that it elects the alter-native withholding rate pool proceduresof section 6.03(B) of this Agreement (re-garding U.S. non-exempt recipient ac-count holders) fails to provide allocationinformation by January 15th as requiredby that section;(U) QI fails to make deposits in the timeand manner required by section 3.08 ofthis Agreement or fails to make adequatedeposits, taking into account the proce-dures of 9.07 of this Agreement;(V) QI fails to permit the external audi-tor to perform additional audit proce-dures, or to expand the external audit tocover some or all of the calendar yearsfor which the period of limitations forassessment of taxes has not expiredunder the provisions of section 10.06 ofthis Agreement; or(W) QI removes U.S. non-exempt recip-ients from accounts covered by thisAgreement for the purpose of circum-venting the Form 1099 reporting andbackup withholding provisions of thisAgreement. Sec. 11.05. Notice and Cure.Upon theoccurrence of an event of default, theIRS may deliver to QI a notice of defaultspecifying the event of default that hasoccurred. QI shall respond to the noticeof default within 60 days (60-day re-sponse) from the date of the notice ofdefault. The 60-day response shall con-tain an offer to cure the event of defaultand the time period in which the curewill be accomplished or shall state thereasons why QI does not agree that anevent of default has occurred. If QIdoes not provide a 60-day response, theIRS may deliver a notice of terminationas provided in section 11.02 of thisAgreement. If QI provides a 60-day re-sponse, the IRS shall either accept or re-ject QI’s statement that no default hasoccurred or accept or reject QI’s pro-posal to cure an event of default. If theIRS rejects QI’s contention that no de-fault has occurred or rejects QI’s pro-posal to cure a default, the IRS will offera counter-proposal to cure the event of

default. Within 30 days of receiving theIRS’s counter-proposal, QI shall notifythe IRS (30-day response) whether itcontinues to maintain that no default hasoccurred or whether it rejects the IRS’scounter-proposal to cure an event of de-fault. If QI’s 30-day response states thatno default has occurred or it rejects theIRS’s counter-proposal to cure, the par-ties shall seek to resolve their disagree-ment within 30 days of the IRS’s receiptof QI’s 30-day response. If a satisfac-tory resolution has not been achieved atthe end of this latter 30-day period, or ifQI fails to provide a 30-day response,the IRS may terminate this Agreementby providing a notice of termination inaccordance with section 11.02 of thisAgreement. If QI receives a notice oftermination from the IRS, it may appealthe determination within 30 days of thedate of the notice of termination bysending a written notice to the addressspecified in section 12.06 of this Agree-ment. If QI appeals the notice of termi-nation, this Agreement shall not termi-nate until the appeal has been decided.If an event of default is discovered inthe course of an external audit, the QImay cure the default, without followingthe procedures of this section 11.05, ifthe external auditor’s report describesthe default and the actions that QI tookto cure the default and the IRS deter-mines that the cure procedures followedby QI were sufficient. If the IRS deter-mines that QI’s actions to cure the de-fault were not sufficient, the IRS shallissue a notice of default and the proce-dures described in this section 11.05shall be followed.Sec. 11.06. Renewal.If QI intends torenew this Agreement, it shall submit anapplication for renewal to the IRS no ear-lier than one year and no later than sixmonths prior to the expiration of thisAgreement. Any such application for re-newal must contain an update of the infor-mation provided by QI to the IRS in con-nection with the application to enter intothis Agreement, and any other informa-tion the IRS may request in connectionwith the renewal process. This Agree-ment shall be renewed only upon the sig-natures of both QI and the IRS. Either theIRS or QI may seek to negotiate a newqualified intermediary agreement ratherthan renew this Agreement.

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SECTION 12. MISCELLANEOUSPROVISIONS

Sec. 12.01.QI’s application to become aqualified intermediary and all the Appen-dices and Attachments to this Agreementare hereby incorporated into and made anintegral part of this Agreement. ThisAgreement, QI’s application, and the Ap-pendices and Attachments to this Agree-ment constitute the complete agreementbetween the parties.Sec. 12.02.This Agreement may beamended by the IRS if the IRS determinesthat such amendment is needed for thesound administration of the internal rev-enue laws or internal revenue regulations.The agreement may also be modified byeither QI or the IRS upon mutual agree-ment. Such amendments or modificationsshall be in writing. Sec. 12.03.Any waiver of a provision ofthis Agreement is a waiver solely of thatprovision. The waiver does not obligatethe IRS to waive other provisions of thisAgreement or the same provision at alater date.

Sec. 12.04.This Agreement shall be gov-erned by the laws of the United States. Anylegal action brought under this Agreementshall be brought only in a United Statescourt with jurisdiction to hear and resolvematters under the internal revenue laws ofthe United States. For this purpose, QIagrees to submit to the jurisdiction of suchUnited States court.Sec. 12.05. QI’s rights and responsibili-ties under this Agreement cannot be as-signed to another person.Sec. 12.06.Notices provided under thisAgreement shall be mailed registered,first class airmail. Notice shall be di-rected as follows:

To the IRSAssistant Commissioner (International)Foreign Payments DivisionOP:IN:I:FP950 L’Enfant Plaza South, SWWashington, DC 20024

All notices sent to the IRS must includethe QI’s QI-EIN.

To QI:

Sec. 12.07.QI, acting in its capacity as aqualified intermediary or in any other ca-pacity, does not act as an agent of the IRS,nor does it have the authority to hold itselfout as an agent of the IRS.

IN WITNESS WHEREOF, the aboveparties have subscribed their names tothese presents, in duplicate.

Signed this day of ,

(name and title of person signing for QI)

(name and title of person signing for IRS)

January 24, 2000 412 2000–4 I.R.B.

Appendix A

[Name of QI]

[Name of country] (see Attachment 1, for description of know-your customer rules).

[Name of country] (see Attachment 2, for description of know-your customer rules).

.

.

.

.

[Name of entity affiliated with QI]

[Name of country] (see Attachment ____, for description of know-your customer rules).

[Name of country] (see Attachment ____, for description of know-your customer rules).

Appendix B

QI and the IRS agree that any of the following auditors may be used by QI, or any PAI with which QI has an agreement, to per-form the external audits required by section 10 of this Agreement.

[Names, addresses, telephone, and fax numbers of external auditors]

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ATTACHMENT

1. QI is subject to the following laws andregulations of [name of country] govern-ing the requirements of QI to obtain docu-mentation confirming the identity of QI’saccount holders.2. QI represents that [name and citationsto laws and regulations identified in item1, above] are enforced by [name of en-forcement body] and QI shall provide theIRS with an English translation of any re-ports or other documentation issued by[name of enforcement body] that relatesto QI’s failure to comply with [laws andregulations identified in 1, above].3. QI represents that the following penal-ties apply for failure to obtain, maintain,and evaluate documentation obtainedunder [name and citations to laws andregulations identified in item 1].4. QI shall use the following specific doc-umentary evidence to comply with sec-tion 5 of this Agreement:

a. For natural persons:b. For legal persons:

5. QI shall follow the procedures set forthbelow to confirm the identity of accountholders that do not open accounts in person.

SECTION 5. EFFECTIVE DATE

This revenue procedure is effective onJanuary 24, 2000. The IRS may concludeagreements under this revenue procedureat any time after that date, but such agree-ments will not have effect before the datespecified in the agreement.

SECTION 6. EFFECT ON OTHERREVENUE PROCEDURES

This revenue procedure supersedesRev. Proc. 98–27, 1998–15 I.R.B. 30. Inaddition, Notice 99–8, 1999–5 I.R.B. 26is obsoleted.

SECTION 7. FURTHERINFORMATION

For further information regarding thisrevenue procedure, telephone the Office ofAssistant Commissioner (International) at(202) 874-1800 (not a toll-free number).

Cash or Deferred Arrangements;Nondiscrimination

Notice 2000–3

I. PURPOSE

This notice provides additional guidanceregarding 401(k) plans that are intended tosatisfy the 401(k) safe harbors. This guid-ance responds to comments and sugges-tions regarding ways to make it easier foremployers both to adopt and to administer401(k) safe harbor plans. The notice:• Encourages adoption of 401(k) safe

harbor plans by giving sponsors of ex-isting 401(k) plans the flexibility towait as late as December 1 of a calen-dar year to decide to adopt the 401(k)safe harbor 3-percent employer non-elective contribution method for thatcalendar year;

• Permits 401(k) safe harbor plans tomatch elective or employee contribu-tions on the basis of compensation fora payroll period, month, or quarter;

• Provides an extended period of time— until May 1, 2000 — for 401(k)plan sponsors adopting the 401(k)safe harbor methods for the first timein 2000 to provide the required safeharbor notice to employees;

• Provides explicitly that 401(k) safeharbor plans are permitted to requiresalary reduction elections to be madeusing whole percentages of pay orwhole dollar amounts;

• Permits plan sponsors to provide the401(k) safe harbor notice electroni-cally and otherwise simplifies the no-tice requirement;

• Permits 401(k) safe harbor plans toprovide matching contributions on anemployee’s aggregate employee andelective contributions;

• Makes clear that 401(k) safe harborplans are permitted to apply to em-ployee after-tax contributions a suspen-sion similar to the 12-month suspen-sion that may be applied to employeeelective contributions after an in-ser-vice withdrawal of those contributions;

• Permits plan sponsors using the401(k) safe harbor matching contribu-tion method to exit the safe harborprospectively during a plan year (andswitch to ADP and ACP nondiscrimi-nation testing) if employees are noti-fied beforehand;

• Clarifies the interaction between the401(k) safe harbors and the election toseparately test otherwise excludableemployees for purposes of the§ 410(b) minimum coverage require-

ments; and• Makes clear how the 401(k) safe har-

bor rules apply in the case of a profitsharing plan to which a 401(k) featureis added for the first time during aplan year.

In addition to modifying the guidanceprovided in Notice 98–52, 1998–46 I.R.B.16, relating to 401(k) safe harbor plans,this notice requests comments regardingtwo significant areas that relate to 401(k)plans in general. The two areas are (1)potential approaches for simplifying themultiple use test applicable to § 401(k)plans, and (2) potential approaches for ap-plying the highly compensated employeedefinition under § 414(q), the nondiscrim-ination requirements under § 401(k) and401(m), and possibly other applicablequalification requirements, when a plansponsor is involved in a merger, acquisi-tion, disposition, or similar transaction.

II. BACKGROUND

A. SBJPA Amendments to §§ 401(k),401(m), and 414(q)

Under § 401(k)(3) and § 401(m)(2) ofthe Code, the actual deferral percentage(“ADP”) and the actual contribution per-centage (“ACP”) of highly compensatedemployees (“HCEs”) are compared withthose of nonhighly compensated employ-ees (“NHCEs”). Section 414(q) defines ahighly compensated employee for pur-poses of §§ 401(k) and 401(m), and forother purposes under the Code.

Section 1433(a) and (b) of the SmallBusiness Job Protection Act of 1996(“SBJPA”) added new §§ 401(k)(12) and401(m)(11) to the Code, effective for planyears beginning after December 31, 1998,to provide design-based safe harbor meth-ods for satisfying the ADP test containedin § 401(k)(3)(A)(ii) and the ACP testcontained in § 401(m)(2). Section401(k)(12) provides that a cash or de-ferred arrangement (“CODA”) is treatedas satisfying the ADP test if the CODAmeets certain contribution and notice re-quirements. Section 401(m)(11) providesthat a defined contribution plan is treatedas satisfying the ACP test with respect tomatching contributions if the plan meetsthe contribution and notice requirementscontained in § 401(k)(12) and in additionmeets certain limitations on the amountand rate of matching contributions avail-able under the plan.

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Section 1433(c) of SBJPA amended§ 401(k)(3)(A) and § 401(m)(2)(A), ef-fective for plan years beginning after De-cember 31, 1996, to provide for the use ofprior year data in determining the ADPand ACP of NHCEs, while current yeardata is used for HCEs. Alternatively, anemployer may elect to use current yeardata for determining the ADP and ACPfor both HCEs and NHCEs, but this elec-tion may be changed only as provided bythe Secretary. Prior to the effective dateof these amendments, plans were requiredto use current year data in determining theADP and ACP for both HCEs andNHCEs. Section 1433(d) of SBJPAamended § 401(k)(3) and § 401(m)(3) toprovide a special rule for determining theADP and ACP for NHCEs for the firstplan year of a plan (other than a successorplan) where the prior year testing methodis used.

Section 1433(e) of SBJPA amended§ 401(k)(8)(C) and § 401(m)(6)(C), effec-tive for plan years beginning after De-cember 31, 1996, to provide that the dis-tribution of excess contributions andexcess aggregate contributions will bemade on the basis of the amount of contri-butions by, or on behalf of, each HCE.Prior to the effective date of these amend-ments, plans were required to distributeexcess contributions and excess aggregatecontributions using a method based on theactual deferral ratio or actual contributionratio of each HCE.

Section 1431 of SBJPA amended§ 414(q)(1) to provide that the term“highly compensated employee” meansany employee who (1) was a 5-percentowner at any time during the year or thepreceding year, or (2) for the precedingyear had compensation from the employerin excess of $80,000 (as adjusted) and, ifthe employer so elects, was in the top-paid group for the preceding year. Theamendments made by § 1431 generallyapply to years beginning after December31, 1996.

B.Previous Guidance on the SBJPAAmendments to §§ 401(k), 401(m), and414(q)

Notice 972, 1997–1 C.B. 348, providesguidance on determining the individualswho are taken into account in computingthe ADP or ACP for NHCEs for the prioryear under the prior year testing method.The notice also prescribes rules for distri-

butions of excess contributions and ex-cess aggregate contributions.

Notice 97–45, 1997–2 C.B. 296, pro-vides guidance relating to the definitionof highly compensated employee under§ 414(q), as amended by § 1431 ofSBJPA.

Notice 98–1, 1998–3 I.R.B. 42, pro-vides guidance relating to the current andprior year ADP and ACP testing methods.

Notice 98–52 provides guidance on thesafe harbor methods under § 401(k)(12)for satisfying the ADP test contained in§ 401(k)(3)(A)(ii) and safe harbor meth-ods under § 401(m)(11) for satisfying theACP test contained in § 401(m)(2).

C. DefinitionsAny term used in this notice that is de-

fined in Notice 97–45, 98–1, or 98–52, orin the regulations under § 401(k), 401(m),or 414(q) has the same meaning as inthose notices and regulations. For exam-ple, the term “employee contribution”means any mandatory or voluntary contri-bution to the plan that is treated at thetime of contribution as an after-tax em-ployee contribution (e.g., by reporting thecontribution as taxable income subject toapplicable withholding requirements) andis allocated to a separate account to whichthe attributable earnings and losses are al-located.

In addition, for purposes of this notice,(1) a “401(k) safe harbor plan” means aCODA that is intended to satisfy the ADPtest safe harbor under section V of Notice98–52, and, if applicable, a defined con-tribution plan (including a § 403(b) plan)that is intended to satisfy the ACP testsafe harbor under section VI of Notice98–52, (2) the “401(k) safe harbor non-elective contribution method” means thealternative for satisfying the safe harborcontribution requirement of the ADP testsafe harbor under section V.B. of Notice98–52 that includes satisfying the non-elective contribution requirement undersection V.B.2. of Notice 98–52, (3) the“401(k) safe harbor matching contribu-tion method” means the alternative forsatisfying the safe harbor contribution re-quirement of the ADP test safe harborunder section V.B. of Notice 98–52 thatincludes satisfying the matching contribu-tion requirement under section V.B.1. ofNotice 98–52, and (4) a “401(k) safe har-bor method” means the 401(k) safe harbornonelective contribution method or the

401(k) safe harbor matching contributionmethod.

D. Effect on RegulationsBecause of the amendments made to

§§ 401(k), 401(m), and 414(q) by SBJPA,as well as by other recent legislation, cer-tain portions of §§ 1.401(k)–1,1.401(m)–1, 1.401(m)–2, and1.414(q)–1T of the Income Tax Regula-tions no longer reflect current law. How-ever, these regulations continue to applyto the extent they are not inconsistent withthe Code, Notices 97–2, 97–45, 98–1, and98–52, this notice, and any subsequentguidance.III. Questions and Answers Relating tothe 401(k) and (m) Safe Harbor Methods

Flexibility in Adoption of 401(k) SafeHarbor Nonelective Contribution Method

Q-1. By what date must the sponsor ofa 401(k) plan adopt the 401(k) safe harbornonelective contribution method for aplan year?

A-1. Generally, a plan that is intendedto satisfy the 401(k) safe harbor require-ments for a plan year must, prior to thebeginning of the plan year, contain lan-guage to that effect and must specify the401(k) safe harbor method that will beused. (However, see section XI.B. of No-tice 98–52 and Rev. Proc. 99–23,1999–16 I.R.B. 5, for the remedialamendment period applicable to planchanges incorporating the 401(k) safeharbor provisions.)

Notwithstanding section XI.A. of No-tice 98–52, a plan that provides that it willsatisfy the current year ADP (and, if ap-plicable, ACP) testing method for a planyear may be amended not later than 30days before the last day of the plan year tospecify that the 401(k) safe harbor non-elective contribution method will be usedfor the plan year (including that the safeharbor nonelective contribution will bemade), provided that the plan otherwisesatisfies the ADP (and, if applicable,ACP) test safe harbor for the plan year(including the notice requirement undersection V.C. of Notice 98–52, as modifiedby this notice). For purposes of the pre-ceding sentence, in applying the contentrequirement of section V.C.1 of Notice98–52:

(1) Instead of stating the amount of thesafe harbor nonelective contribution tobe made under the plan, the notice

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given to eligible employees before thebeginning of the plan year must pro-vide that (a) the plan may be amendedduring the plan year to provide that theemployer will make a safe harbor non-elective contribution of at least 3 per-cent to the plan for the plan year, and(b) if the plan is so amended, a supple-mental notice will be given to eligibleemployees 30 days prior to the last dayof the plan year informing them of suchan amendment, and(2) A supplemental notice must be pro-vided to all eligible employees no laterthan 30 days prior to the last day of theplan year stating that a 3 percent safeharbor nonelective contribution will bemade for the plan year. For administra-tive convenience, the supplemental no-tice may be provided separately or aspart of the safe harbor notice for thefollowing plan year.Similar rules apply if, pursuant to sec-

tion IX.A.1. of Notice 98–52, the safeharbor nonelective contribution is madeto another plan of the employer.

Thus, for example, a plan sponsor thatmaintains a calendar-year 401(k) planusing the current year ADP testingmethod and that wishes to have the flexi-bility to decide toward the end of a planyear whether or not to adopt the 401(k)safe harbor nonelective contributionmethod with respect to its 401(k) plancould achieve that flexibility by providingthe initial notice described in section V.C.of Notice 98–52 (as modified by thisQ&A-1, and Q&A-7 and Q&A-8 of thisnotice) before the beginning of the planyear, as provided under section V.C.2. ofNotice 98–52 (as modified by Q&A-9 ofthis notice). If the plan sponsor then de-cides to adopt the 401(k) safe harbor non-elective contribution method for the planyear, the plan sponsor must, by December1 of the plan year, (1) amend the 401(k)plan accordingly and (2) provide a sup-plemental notice to all eligible employeesstating that a 3-percent safe harbor non-elective contribution will be made for theplan year.

A plan sponsor that takes advantage ofthe flexibility provided under this Q&A-1is not required to continue using the401(k) safe harbor nonelective contribu-tion method for the following plan yearand is not limited in the number of yearsthat it takes advantage of this flexibility.

In order to further facilitate the adoptionof the 401(k) safe harbor nonelective con-tribution method under this Q&A-1, theService intends to provide a simplified,pre-approved means of adopting the401(k) safe harbor nonelective contribu-tion method under the Service’s masterand prototype plan program.

Safe Harbor Matching ContributionRequirements

Q-2. Can a 401(k) safe harbor planmatch elective and employee contribu-tions on a payroll-by-payroll basis (in-stead of on an annual basis) without mak-ing additional contributions at the end ofthe year to take into account the totalamount of an employee’s compensationfor the plan year?

A-2. Notwithstanding section VII.A.(or any other provision) of Notice 98–52,the requirements of sections V.B.1. andVI.B. of Notice 98–52 that relate tomatching contributions may be met for aplan year by meeting such requirementseither (1) with respect to the plan year as awhole, or (2) if the plan so provides, sepa-rately with respect to each payroll period(or with respect to all payroll periods end-ing with or within each month or plan-year quarter) taken into account under thearrangement for the plan year (the “payrollperiod method”). If the payroll periodmethod is used, however, matching contri-butions with respect to elective or em-ployee contributions made during a planyear quarter beginning after May 1, 2000must be contributed to the plan by the lastday of the following plan year quarter.Accordingly, in the case of a calendar yearplan that uses the payroll period method,matching contributions with respect toelective or employee contributions madeduring the calendar quarter beginning July1, 2000, must be contributed to the plan byDecember 31, 2000. The payroll periodmethod applies only for purposes of satis-fying the ADP safe harbor matching con-tribution requirements of § 401(k)(12)(section V.B.1. of Notice 98–52) and theACP safe harbor matching contribution re-quirements of § 401(m)(11) (section VI.B.of Notice 98–52).

Q-3. Can a 401(k) safe harbor plan re-quire that employees make elective con-tributions in whole percentages of pay orwhole dollar amounts?

A-3. Notwithstanding section

V.B.1.c.ii. of Notice 98–52, a plan willnot fail to satisfy the requirements of sec-tions V.B.1. and VI.B. of Notice 98–52that relate to matching contributionsmerely because the plan requires employ-ees to make cash or deferred or employeecontribution elections in whole percent-ages of compensation or whole dollaramounts.

Q-4. Can a 401(k) safe harbor plansuspend additional employee contribu-tions for up to 12 months after the in-ser-vice withdrawal of employee contribu-tions?

A-4. Notwithstanding section V.B.1.c.and section VI.B.3. of Notice 98–52, aplan will not fail to satisfy the ACP testsafe harbor of section VI of Notice 98–52merely because, after a withdrawal of em-ployee contributions from the plan, theplan suspends additional employee contri-butions for a period that does not exceed12 months. See section V.B.1.c.iv. of No-tice 98–52 for a similar exception that ap-plies for purposes of hardship distribu-tions of elective contributions.

Q-5. How do the rules of sectionsV.B.1. and VI.B.3. of Notice 98–52 applyto a plan that provides matching contribu-tions on both elective contributions andemployee contributions?

A-5. A plan will not fail to satisfy therequirements of section V.B.1.a., V.B.1.b.,or VI.B.3.(iii) of Notice 98–52 merely be-cause the plan provides matching contri-butions on both elective contributions andemployee contributions if, under theterms of the plan, either (1) the matchingcontributions provided on an employee’selective contributions are not affected bythe amount of the employee’s employeecontributions or (2) matching contribu-tions are made with respect to the sum ofan employee’s elective and employeecontributions under the same terms asmatching contributions are made with re-spect to elective contributions.

For example, a plan will not fail to sat-isfy the matching contribution require-ment of section V.B.1. or the ACP testsafe harbor of section VI of Notice 98–52merely because the plan provides a re-quired matching contribution equal to 100percent of the sum of each eligible em-ployee’s elective and employee contribu-tions up to 4 percent of compensation.This is the case even if, during a planyear, an eligible employee first makes

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employee contributions of 4 percent ofcompensation that are matched by the em-ployer and subsequently makes electivecontributions that go unmatched, pro-vided that the same match would havebeen available if the employee had in-stead made only elective contributions.

Q-6. May a plan that uses the 401(k)safe harbor matching contribution methodsuspend matching contributions on futureelective and employee contributions dur-ing a plan year and instead use the currentyear ADP (and, if applicable, ACP) test-ing method for the plan year?

A-6. A plan that uses the 401(k) safeharbor matching contribution method willnot fail to satisfy § 401(k) (or § 401(m))for a plan year merely because the plan isamended during the plan year to reduce oreliminate matching contributions, pro-vided:

(1) A supplemental notice is given to alleligible employees explaining the con-sequences of the amendment and in-forming them of the effective date ofthe reduction or elimination of match-ing contributions and that they have areasonable opportunity (including areasonable period) to change their cashor deferred elections and, if applicable,their employee contribution elections;(2) The reduction or elimination ofmatching contributions is effective noearlier than the later of (i) 30 days aftereligible employees are given the sup-plemental notice and (ii) the date theamendment is adopted;(3) Eligible employees are given a rea-sonable opportunity (including a rea-sonable period) prior to the reductionor elimination of matching contribu-tions to change their cash or deferredelections and, if applicable, their em-ployee contribution elections;(4) The plan is amended to provide thatthe ADP test and, if applicable, theACP test will be performed and satis-fied for the entire plan year using thecurrent year testing method; and(5) All other safe harbor requirementsare satisfied through the effective dateof the amendment.

Notice Requirement

Q-7. Can a plan use electronic mediato satisfy the 401(k) safe harbor notice re-quirement?

A-7. The Service and Treasury are cur-

rently reviewing the legal and policy is-sues relating to the satisfaction of the safeharbor notice requirement through the useof electronic media. Prior to the issuanceof additional guidance on this matter,however, a plan will not fail to satisfy thenotice requirement of section V.C. of No-tice 98–52 (as modified by this notice)with respect to an employee merely be-cause, instead of receiving the notice on awritten paper document, the employee re-ceives the notice through an electronicmedium reasonably accessible to the em-ployee, provided that (1) the system underwhich the electronic notice is provided isreasonably designed to provide the noticein a manner no less understandable to theemployee than a written paper documentand (2) under such system, at the time thenotice is provided, the employee is ad-vised that the employee may request andreceive the notice on a written paper doc-ument at no charge, and, upon request,that document is provided to the em-ployee at no charge. This Q&A-7 also ap-plies for purposes of providing the sup-plemental notices under Q&A-1 andQ&A-6 of this notice.

Q-8. Can a safe harbor notice cross-reference the plan’s summary plan de-scription for a portion of the informationrequired in the notice?

A-8. Section V.C. of Notice 98–52 pro-vides that the notice requirement of thatsection is satisfied if each eligible em-ployee for the plan year is given writtennotice of the employee’s rights and oblig-ations under the plan and the notice satis-fies the content requirement of paragraph1 of that section and the timing require-ment of paragraph 2 of that section.

Notwithstanding paragraph 1.a. of sec-tion V.C. of Notice 98–52, a plan will notfail to satisfy the content requirementmerely because, in the case of the infor-mation described in items (ii) (relating toany other contributions under the plan),(iii) (relating to the plan to which safeharbor contributions will be made), (iv)(relating to the type and amount of com-pensation that may be deferred), and (vii)(relating to withdrawal and vesting provi-sions) of paragraph 1.a., the notice insteadcross-references the relevant portions ofan up-to-date summary plan descriptionthat has been provided (or concurrently isprovided) to the employee. However, thenotice must still accurately describe (1)

the safe harbor matching or nonelectivecontribution formula used under the plan(including a description of the levels ofmatching contributions, if any, availableunder the plan) and state that these contri-butions (as well as elective contributions)are fully vested when made and (2) howto make cash or deferred elections (in-cluding any administrative requirementsthat apply to such elections) and the peri-ods available under the plan for makingsuch elections. In addition, the noticemust also provide information that makesit easy for eligible employees to obtainadditional information about the plan (in-cluding an additional copy of the sum-mary plan description) such as telephonenumbers, addresses and, if applicable,electronic addresses, of the individuals oroffices from whom employees can obtainsuch plan information.

Q-9. By what date must the safe harbornotice be provided to employees in thecase of a plan that adopts a 401(k) safeharbor method for the first time in theyear 2000?

A-9. Generally, the notice requiredunder section V.C. of Notice 98–52 mustbe provided in accordance with the timingrequirements of section V.C.2. (i.e., thenotice must be provided within a reason-able period before the beginning of theplan year (or, in the year an employee be-comes eligible, within a reasonable periodbefore the employee becomes eligible)).However, in an effort to allow plan spon-sors that are considering the adoption of a401(k) safe harbor method to fully utilizethe guidance provided in this notice forplan years beginning in the year 2000, theService and Treasury have determinedthat transition relief is appropriate. Ac-cordingly, in the case of a plan sponsorthat adopts a 401(k) safe harbor methodfor the first time with respect to a plan fora plan year that begins on or after January1, 2000 and on or before June 1, 2000, thenotice described in section V.C. of Notice98–52 satisfies the timing requirement forthat plan year if the notice is given on orbefore May 1, 2000. This transition reliefapplies whether the 401(k) safe harbormethod is adopted under a newly estab-lished 401(k) plan or under a preexisting401(k) plan.

In order to satisfy the 401(k) safe har-bor requirements for the plan year, how-ever, a plan that uses the transition relief

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provided under this Q&A-9 still must sat-isfy the otherwise applicable require-ments of Notice 98–52 (as modified bythis notice) with respect to the entire planyear. Thus, for example, in the case of a401(k) plan that uses the 401(k) safe har-bor matching contribution method,matching contributions still must be madewith respect to elective contributionsmade prior to the date the safe harbor no-tice is provided to employees in the sameamount as if the 401(k) safe harbormatching contribution method had beenin place since the beginning of the planyear.

Interaction Between Safe HarborMethods and § 410(b)(4) Election

Q-10. Is a plan required to provide safeharbor matching or nonelective contribu-tions to participants who have not yet at-tained age 21 and completed a year of ser-vice if the plan uses one of the 401(k) safeharbor methods?

A-10. As provided in section IX.B.1.of Notice 98–52, if, pursuant to§ 410(b)(4)(B), an employer applies§ 410(b) separately to the portion of aplan (within the meaning of § 414(l)) thatbenefits only employees who satisfy ageand service conditions under the plan thatare lower than the greatest minimum ageand service conditions permitted under§ 410(a), the plan is treated as two sepa-rate plans for purposes of § 401(k), andthe ADP test safe harbor need not be satis-fied with respect to both plans in order forone of the plans to take advantage of theADP test safe harbor. Accordingly, a planthat uses one of the 401(k) safe harbormethods is not required to provide safeharbor matching or nonelective contribu-tions to participants who have not yet at-tained age 21 and completed a year of ser-vice. Those employees do not have to betreated as eligible employees for purposesof the 401(k) safe harbors, so long as theemployer has elected to treat them sepa-rately for coverage purposes pursuant to§ 410(b)(4). However, in such a case, theplan must specifically provide that elec-tive contributions (and, if applicable,matching contributions) on behalf ofthose employees will satisfy the ADP test(and, if applicable, the ACP test).

Addition of 401(k) Safe HarborProvisions to Existing Profit-Sharing

Plans

Q-11. Can a CODA that is added to anexisting profit-sharing plan for the firsttime during a plan year use a 401(k) safeharbor method for that plan year?

A-11. Generally, the safe harbor re-quirements must be satisfied for the entireplan year (see sections V.A. and VI.A. ofNotice 98–52). In addition, except in thecase of a newly established plan, the planyear must be 12 months long (see sectionX of Notice 98–52). Notwithstandingthese requirements, however, in the caseof a CODA that is added to an existingprofit-sharing, stock bonus, or pre-ERISAmoney purchase pension plan for the firsttime during a plan year, the requirementsof section V of Notice 98–52 will betreated as being satisfied for the entireplan year and the CODA will not betreated as failing to satisfy the require-ments of section X of Notice 98–52, pro-vided (1) the plan is not a successor plan(within the meaning of Notice 98–1), (2)the CODA is made effective no later than3 months prior to the end of the plan year,and (3) the requirements of Notice 98–52are otherwise satisfied for the entire pe-riod from the effective date of the CODAto the end of the plan year. Thus, an exist-ing calendar-year profit-sharing plan thatdoes not contain a CODA may beamended as late as October 1 to add aCODA that uses a 401(k) safe harbormethod for that plan year.

A similar rule applies for purposes ofsection VI of Notice 98–52 in the case ofthe addition of matching contributions forthe first time to an existing defined contri-bution plan at the same time as the adop-tion of the CODA.

IV SIMPLIFYING THE LIMITATIONON MULTIPLE USE

The limitation on multiple use appliesto the current and prior year ADP andACP testing methods (i.e., the nondis-crimination testing methods that § 401(k)plans must satisfy if they do not satisfythe 401(k) safe harbors or the SIMPLE401(k) requirements). The limitation onmultiple use is a nondiscrimination provi-sion intended to limit the extent to whichhighly compensated employees receivegreater benefits (as a percentage of pay)than nonhighly compensated employees,primarily under § 401(k) plans that pro-

vide for matching contributions. The Ser-vice and Treasury are considering ap-proaches that would substantially sim-plify the limitation on multiple useadministratively, while retaining most ofthe value of this limitation in ensuring afairer distribution of benefits under§ 401(k) plans and, in many cases, en-couraging employers to make fully-vestednonelective contributions on behalf ofnonhighly compensated employees.

Generally, the average rate of electivecontributions under a § 401(k) plan on be-half of highly compensated employeesmay not exceed 125 percent of the aver-age rate of elective contributions on be-half of nonhighly compensated employ-ees. However, the Code provides an“alternative limitation” that permits theaverage rate of elective contributionsunder a § 401(k) plan on behalf of highlycompensated employees to exceed 125percent of the average rate on behalf ofnonhighly compensated employees, pro-vided that average rate for highly com-pensated employees is not greater than 2percentage points more than the averagerate for nonhighly compensated employ-ees and is not greater than 200 percent ofthat of nonhighly compensated employ-ees. The alternative limitation is particu-larly relevant where the average rate ofelective contributions on behalf of non-highly compensated employees is rela-tively low. For example, if the averagerate of elective contributions on behalf ofnonhighly compensated employees is 4percent of pay, then the average rate ofelective contributions on behalf of highlycompensated employees may not exceed6 percent of pay. Absent the alternativelimitation, the average rate of electivecontributions on behalf of highly compen-sated employees could not exceed 5 per-cent in such a case. Similar rules applyseparately to the average rate of matchingand employee after-tax contributions ofhighly compensated employees under a§ 401(m) plan.

Section 401(m)(9) requires the Secre-tary of the Treasury to “prescribe suchregulations as may be necessary to carryout the purposes of this subsection andsubsection (k) including . . . such regula-tions as may be necessary to prevent themultiple use of the alternative limitationwith respect to any highly compensatedemployee.” Accordingly, while the alter-

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native limitation may be used to satisfyeither the nondiscrimination test for elec-tive contributions or the nondiscrimina-tion test for matching and employee after-tax contributions, the alternativelimitation is not available to satisfy bothtests. Absent the statutorily contemplatedlimitation on multiple use, the combinedrates of elective and matching contribu-tions on behalf of highly compensatedemployees under a § 401(k) plan that pro-vides for matching contributions could,for example, be as much as 8 percent (i.e.,an ADP of 4 percent and an ACP of 4 per-cent) while the combined rates for non-highly compensated employees could beas little as 4 percent (i.e., an ADP of 2 per-cent and an ACP of 2 percent). In thiscase, the limitation on multiple use wouldreduce this 4-percentage-point disparityto 2_ percentage points.

While many employers choose to com-ply with the limitation on multiple use byreducing or limiting the elective and/ormatching contributions on behalf ofhighly compensated employees, otheremployers instead increase the employercontributions made on behalf of non-highly compensated employees. Accord-ingly, because of the limitation on multi-ple use, some moderate-incomeemployees covered under 401(k) plansthat provide matching contributions re-ceive employer-provided benefits thatamount to hundreds of dollars a year.

However, the approach taken under ex-isting regulations in implementing thelimitation on multiple use may be unnec-essarily complicated. As a result, the Ser-vice and Treasury are reviewing potentialchanges to these regulations that wouldsubstantially simplify the application ofthe limitation on multiple use.

Under one possible approach, themulti-step mathematical test used in de-termining the aggregate limit on the ratesof contributions for highly compensatedemployees would be replaced by a simple“look-up” table that is based on ranges ofaggregate contribution rates for nonhighlycompensated employees. For example,such a table could provide that if the com-bined ADP and ACP on behalf of non-highly compensated employees is be-tween 5 percent and 6 percent, then thecombined ADP and ACP on behalf ofhighly compensated employees could beas much as 3 percentage points higher.

Alternatively, or in addition, the scopeof the limitation’s application might benarrowed slightly in order to give relief incases where the value of the limitationwould be inconsequential in comparisonto the administrative expense of compli-ance. For example, where the combinedADP and ACP on behalf of nonhighlycompensated employees exceeds a certainlevel (e.g., 9 percent or 10 percent), thelimitation on multiple use might bedeemed satisfied.

The Service and Treasury welcomecomments on these and other potential ap-proaches for simplifying the limitation onmultiple use. Comments on the effect ofthe SBJPA changes to the methods forcorrecting excess contributions and ex-cess aggregate contributions and the rela-tion of those changes to corrections ofmultiple use limitation failures are alsowelcome. In addition, comments are wel-come regarding whether it is more appro-priate (as a matter of authority or other-wise) for simplification of the limitationon multiple use to be effected administra-tively or legislatively.

V POTENTIAL APPROACHES FORAPPLYING VARIOUSQUALIFICATION REQUIREMENTSIN MERGERS, ACQUISITIONS,DISPOSITIONS, AND SIMILARTRANSACTIONS

The Service and Treasury are in theprocess of developing guidance regardingthe application of the nondiscriminationrequirements under § 401(k) and§ 401(m), and the highly compensatedemployee definition under § 414(q), insituations where the entities sponsoringthe plans are involved in mergers, acquisi-tions, dispositions, or similar transactions.Uncertainty among plan sponsors regard-ing the appropriate application of variousqualification requirements in the contextof business transactions and reorganiza-tions may be leading to reduced employeeprotections, increased transaction costsfor employers, and the inconsistent appli-cation of these requirements among dif-ferent employers.

The guidance developed by the Serviceand Treasury will be designed to balancethe need to protect employees’ pensionrights and benefits and provide for the fairdistribution of tax-favored pension bene-fits with the potential burdens on employ-

ers of data collection and compliance inthe context of business transactions andreorganizations. Simplified alternativesmay be provided to address those types oftransactions in which the information flowbetween the selling and purchasing enti-ties or other entities involved in the trans-actions traditionally has been minimal.

As part of this process, the Service andTreasury are seeking comments from planparticipants, plan sponsors, and other in-terested parties regarding the following:

(1) The types of business transactionsand reorganizations (e.g., stock acquisi-tions, acquisitions of substantially allthe assets of a trade or business, orother economically similar transac-tions) that reasonably would warrantcontinuity of treatment for purposes ofthe nondiscrimination requirementsunder § 401(k) and § 401(m) and thehighly compensated employee defini-tion under § 414(q), as well as the de-gree of specificity that is desirable orappropriate in describing these transac-tions.(2) The application of the nondiscrimi-nation requirements under § 401(k) and§ 401(m) and the highly compensatedemployee definition under § 414(q) incases where plans are combined or di-vided during (instead of at the begin-ning of) a plan year as a result of abusiness transaction or reorganizationthat occurs during a plan year.(3) Whether more than one testing al-ternative may be appropriate when ap-plying the nondiscrimination require-ments under § 401(k) and § 401(m) inthe case of mid-year transactions. Forexample, under certain circumstances,one approach to mid-year businesstransactions that also involve combin-ing plans might be to give plan spon-sors the option of applying the § 401(k)and § 401(m) nondiscrimination re-quirements on a pre-transaction andpost-transaction basis as if there wereseparate short plan years for the un-combined and combined plans, or ap-plying these requirements once on thebasis of the entire plan year for thecombined plan. A similar approachmight apply in cases where plans aredivided as a result of mid-year businesstransactions.(4) The application of other plan quali-fication provisions (in addition to the

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nondiscrimination requirements for§ 401(k) and § 401(m) plans and thehighly compensated employee defini-tion under § 414(q)) in the context ofbusiness transactions and reorganiza-tions, whether or not such transactionsoccur in the middle of a plan year. Forexample, § 414(a)(2) grants the Secre-tary of the Treasury the authority toprescribe regulations regarding thetreatment of service with a predecessoremployer as service with a successoremployer. Comments are invited onwhether regulations should be pro-posed to address situations in whichparticipants experience an interruptionof their vesting service under § 411(a)and eligibility service under § 410(a)by reason of certain business transac-tions or reorganizations.

VI REQUEST FOR COMMENTS

In addition to inviting comments on thepotential approaches for simplifying thelimitation on multiple use and for apply-ing various qualification requirements incases where plan sponsors are involved inmergers, acquisitions, and similar transac-tions, the Service and Treasury invitecomments on the 401(k) safe harbor guid-ance provided in this notice. It is antici-pated that further guidance in these areaswould take the form of proposed regula-tions.

Comments should be submitted byMarch 24, 2000, in writing, and shouldreference Notice 2000–3. Comments canbe addressed to CC:DOM:CORP:R (No-tice 2000–3), room 5228, Internal Rev-enue Service, POB 7604, Ben FranklinStation, Washington, DC 20044. In thealternative, comments may be hand deliv-ered between the hours of 8 a.m. and 5p.m. to CC:DOM:CORP:R (Notice2000–3), Courier’s Desk, Internal Rev-enue Service, 1111 Constitution AvenueNW., Washington, DC. Alternatively, tax-payers may transmit comments electroni-cally via the following Internet site: Cyn-thia.Grigsby@m1.irscounsel.treas.gov.

VII. EFFECT ON OTHERDOCUMENTS

Notice 98–52 is modified.

PAPERWORK REDUCTION ACT

The collection of information con-

tained in this notice has been reviewedand approved by the Office of Manage-ment and Budget (OMB) in accordancewith the Paperwork Reduction Act (44U.S.C. 3507) under control number 1545-1669.

An agency may not conduct or sponsor,and a person is not required to respond to,a collection of information unless the col-lection of information displays a validOMB control number.

The collections of information in thisnotice are in section III, Q&As 1 and 2.The collections of information are re-quired to enable personnel in the Tax Ex-empt and Government Entities Divisionof the Internal Revenue Service to deter-mine if an employer’s retirement plan sat-isfies the requirements to obtain favorabletax treatment and to inform plan partici-pants of their rights and obligations underthe plan. The likely respondents are busi-nesses or other for-profit institutions, andnot-for-profit institutions.

The estimated total annual reportingburden is 8,000 hours.

The estimated annual burden per re-spondent is 1 hour and 20 minutes. Theestimated number of respondents is 6,000.The estimated annual frequency of re-sponses is on occasion.

Books or records relating to a collec-tion of information must be retained aslong as their contents may become mater-ial in the administration of any internalrevenue law. Generally, tax returns andtax return information are confidential, asrequired by 26 U.S.C. 6103.

DRAFTING INFORMATION

The principal author of this notice isRoger Kuehnle of the Tax Exempt andGovernment Entities Division. For fur-ther information regarding this notice,please contact the Employee Plans’ tax-payer assistance telephone service at(202) 622-6074/6075 (not toll-free num-bers) between the hours of 1:30 and 3:30p.m. Eastern Time, Monday throughThursday.

Section 1504(d) Elections —Deferral of Termination

Notice 2000–7

PURPOSE

The purpose of this Notice is to provideguidance regarding the effect of the repealof certain Canadian banking legislationon elections under section 1504(d) of theInternal Revenue Code.

BACKGROUND

Section 1504(d) of the Code allows, incertain circumstances, a domestic corpo-ration owning or controlling, directly orindirectly, 100 percent of the capital stockof a Mexican or Canadian corporation, toelect to treat such corporation as a domes-tic corporation for all purposes of subtitleA of the Code. Among other require-ments, such an election may be made onlyif the sole purpose for maintaining suchcorporation is to comply with Canadian orMexican law regulating the title and oper-ation of property.

If an election under section 1504(d) isin effect with respect to a Canadian orMexican corporation, and the relevantprovision in Canadian or Mexican lawregulating the title and operation of prop-erty is repealed, it is the view of Treasuryand the IRS that the election under section1504(d) generally is terminated as of theeffective date of the repeal. However, aforeign corporation may continue to beviewed as maintained solely for the pur-pose of complying with Canadian orMexican law for a short period of timefollowing the repeal of that foreign law ifthe taxpayer takes reasonable and expedi-tious measures to respond to the change inforeign law and for good reason is unableto complete such measures by the effec-tive date of the repeal, as would be thecase if the taxpayer is required to obtainregulatory approval in order to convertthe foreign corporation to a branch of theU.S. parent and cannot obtain such ap-proval by the effective date of the repeal.In such a case, the foreign corporationwill continue to be viewed as maintainedsolely for the purpose of complying withCanadian or Mexican law only for so longas is reasonably necessary to convert tobranch form and only for so long as thetaxpayer persists in its efforts to convertto branch form during that period. TheIRS may issue guidance identifyingwhether and the extent to which this shortperiod of time exists in appropriate cir-cumstances not specifically addressed by

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this Notice. Following the end of anysuch period (or immediately upon the ef-fective date of the repeal of the foreignlaw if there is no such period), if the for-eign corporation remains in existence, itis no longer maintained solely for the pur-pose of complying with the repealed for-eign law.

Repeal of Canadian BankingLegislation

Until recently, Canada prohibited for-eign banks from operating in branch formwithin Canada, under the Bank Act(Canada), S.C. 1991, c. 46 (“OriginalAct”). Canadian banking operations of aforeign bank were required to be con-ducted within a Canadian corporation.Thus, Canadian banking subsidiaries ofU.S. banks may have qualified for theelection under section 1504(d).

Effective June 28, 1999, the Original Actwas amended to permit foreign banks toperform certain specified banking functionsin Canada directly through foreign branchesrather than through Canadian subsidiaries(“Amended Act”). Under the AmendedAct, all Canadian subsidiaries of foreignbanks seeking to convert to a branch opera-tion must obtain the approval of the Minis-ter of Finance and the Office of the Superin-tendent of Financial Institutions.

In addition, on May 11, 1999, theCanadian government announced its in-tention to enact legislation that wouldallow an indefinite deferral of the Cana-dian tax imposed upon the liquidation of aCanadian banking subsidiary as part of itsconversion to branch form (“Relief Legis-lation”). Department of Finance Release99–044 (May 11, 1999). Under the ReliefLegislation, relief will be available only ifthe bank complies, on or before Decem-ber 31, 2000, with paragraphs 1.0(1.1)(b)and (c) of the draft “Guide to ForeignBank Branching” issued by the Office of

the Superintendent of Financial Institu-tions (“Foreign Branch Guide”). In addi-tion, the Canadian banking subsidiarymust complete its conversion to branchform on or before the earlier of (i) the daythat is six months after the day that theSuperintendent of Financial Institutionsmakes an order in respect of the foreignbank under subsection 534(1) of theAmended Act, or (ii) December 31, 2002.The terms of the proposed Relief Legisla-tion indicate that Canada has determinedthat the period described above is a rea-sonable period for taxpayers to take thesteps necessary to convert to branch form.

Effect of Repeal of Canadian BankingLegislation

Except as provided in the followingsentence, a Canadian banking subsidiarythat was, immediately prior to June 28,1999, maintained solely for the purposeof complying with the Original Act shallbe considered to be maintained solely forthe purpose of complying with the Origi-nal Act until the earlier of the date that issix months after the day that the Superin-tendent of Financial Institutions makes anorder in respect of the foreign bank undersubsection 534(1) of the Amended Act, orDecember 31, 2002. If, however, thebank does not comply with paragraphs1.0(1.1)(b) and (c) of the Foreign BranchGuide on or before December 31, 2000,the Canadian banking subsidiary shall beconsidered to be maintained solely for thepurpose of complying with the OriginalAct only until December 31, 2000.

After the applicable period described inthe preceding paragraph, any Canadianbanking subsidiary remaining in existenceshall be maintained solely for the purposeof complying with foreign law as to titleand operation of property only if it ismaintained solely for the purpose of com-plying with the Amended Act or any other

applicable Canadian law regulating thetitle and operation of property.

The principal author of this notice isKenneth D. Allison of the Office of Associ-ate Chief Counsel (International). How-ever, other personnel from the IRS and theTreasury Department participated in its de-velopment. For further information regard-ing this notice contact Mr. Allison at 202-622-3860 (not a toll-free call).

Weighted Average Interest RateUpdate

Notice 2000–8

Notice 88–73 provides guidelines fordetermining the weighted average interestrate and the resulting permissible range ofinterest rates used to calculate current lia-bility for the purpose of the full fundinglimitation of § 412(c)(7) of the InternalRevenue Code as amended by the Om-nibus Budget Reconciliation Act of 1987and as further amended by the UruguayRound Agreements Act, Pub. L. 103-465(GATT).

The average yield on the 30-year Trea-sury Constant Maturities for December1999 is 6.35 percent.

The following rates were determinedfor the plan years beginning in the monthshown below.

Drafting Information

The principal author of this notice isTodd Newman of Employee Plans, Tax Ex-empt and Government Entities Division.For further information regarding this no-tice, call the Employee Plans Actuarial hot-line, (202) 622-6076 between 2:30 and3:30 p.m. Eastern time (not a toll-free num-ber). Mr. Newman’s number is (202) 622-8458 (also not a toll-free number).

January 24, 2000 420 2000–4 I.R.B.

90% to 105% 90% to 110%Weighted Permissible Permissible

Month Year Average Range Range

January 2000 6.01 5.41 to 6.31 5.41 to 6.61

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2000–4 I.R.B. 421 January 24, 2000

Notice of Proposed Rulemakingand Notice of Public Hearing

Credit for Increasing ResearchActivities

REG–105606–99

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Notice of proposed rulemak-ing and notice of public hearing.

SUMMARY: This document containsproposed regulations relating to the com-putation of the credit for increasing re-search activities (the research credit) formembers of a controlled group and the al-location of the credit under section 41(f)of the Internal Revenue Code. These pro-posed regulations are intended to provideguidance on the proper method for com-puting the research credit for members ofa controlled group and the proper methodfor allocating the group credit to membersof the group. These proposed regulationsreflect changes to section 41 made by theRevenue Reconciliation Act of 1989 (the1989 Act). This document also providesnotice of a public hearing on these regula-tions.

DATES: Written or electronic commentsmust be received no later than April 5,2000. Outlines of topics to be discussedat the public hearing scheduled for April26, 2000 at 10 a.m. must be received byApril 5, 2000.

ADDRESSES: Send submissions to:CC:DOM:CORP:R (REG–105606–99),room 5226, Internal Revenue Service,POB 7604, Ben Franklin Station, Wash-ington, DC 20044. Submissions may behand delivered Monday through Fridaybetween the hours of 8 a.m. and 5 p.m. to:CC:DOM:CORP:R (REG–105606–99),Courier’s Desk, Internal RevenueService,1111 Constitution Avenue NW., Washing-ton, DC. Alternatively, taxpayers maysubmit comments electronically via theInternet by selecting the “Tax Regs” op-tion of the IRS Home Page, or by submit-ting comments directly to the IRS Internetsite at:http://www.irs.gov/prod/taxregs/regslist.html. The public hearing will be held in

room 2615, Internal Revenue Building,1111 Constitution Avenue, NW., Wash-ington, DC.

FOR FURTHER INFORMATION CON-TACT: Concerning the proposed regula-tions, Lisa J. Shuman at (202)622-3120(not a toll-free number); concerning sub-mission of comments, the hearing, and/orto be placed on the building access list toattend the hearing, La Nita Van Dyke at(202)622-7190 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information con-tained in this notice of proposed rulemak-ing has been submitted to the Office ofManagement and Budget for review in ac-cordance with the Paperwork ReductionAct of 1995 (44 U.S.C. 3507(d)). Com-ments on the collection of informationshould be sent to the Office of Manage-ment and Budget, Attn: Desk Officer forthe Department of the Treasury, Office ofInformation and Regulatory Affairs,Washington, DC 20503, with copies tothe Internal Revenue Service, Attn: IRSReports Clearance Officer, OP:FS:FP,Washington, DC 20224. Comments onthe collection of information should be re-ceived by March 6, 2000. Comments are specifically requested con-cerning:

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 maybe minimized, including through the ap-plication of automated collection tech-niques or other forms of information tech-nology; and

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

The collection of information in thisproposed regulation is contained in thepreamble under the heading “ProposedEffective Date.“ The information is re-quired by the IRS to ensure that membersof a controlled group filing claims for re-fund based on a change in method of allo-cating the research credit to members ofthe group do not together claim in excessof 100% of the credit with respect to priortaxable years.

Estimated total annual reporting bur-den: 200 hours.

Estimated average annual burden hoursper respondent: 20 hours.

Estimated number of respondents: 10.Estimated frequency of responses: On

occasion.An agency may not conduct or sponsor,

and a person is not required to respond to,a collection of information unless it dis-plays a valid control number assigned bythe Office of Management and Budget.

Books or records relating to a collec-tion of information must be retained aslong as their contents may become mater-ial in the administration of any internalrevenue law. Generally, tax returns andtax return information are confidential, asrequired by 26 U.S.C. 6103.

Background

The research credit provisions originallyappeared in section 44F of the InternalRevenue Code of 1954 (the 1954 Code), asadded to the 1954 Code by section 221 ofthe Economic Recovery Tax Act of 1981.Section 471(c) of the Tax Reform Act of1984 redesignated section 44F as section30. Section 231 of the Tax Reform Act of1986 (the 1986 Act) redesignated section30 as section 41 and substantially modifiedthe research credit provisions. The 1989Act substantially revised the computationof the research credit.

On May 17, 1989, the IRS published inthe Federal Register(54 FR 21203) finalregulations under section 41. The 1989final regulations generally do not reflectthe amendments to section 41 made bythe 1986 Act, the 1989 Act, and other sub-sequent legislative revisions to the re-search credit.

The amendments proposed by this doc-ument contain proposed rules relating to

Part IV. Items of General Interest

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January 24, 2000 422 2000–4 I.R.B.

the computation of the research credit formembers of a controlled group and the al-location of the credit under section 41(f).These proposed regulations reflectchanges to the research credit rules madeby the 1989 Act and Small Business JobProtection Act of 1996, which introducedthe alternative incremental researchcredit.

Pre-1990 Rules for Computing theResearch Credit for Members of aControlled Group and Allocating theCredit among Members of the Group

Prior to the enactment of the 1989 Act,the research credit was computed by mul-tiplying the credit rate by the excess of thetaxpayer’s current year qualified researchexpenses over the average of the tax-payer’s qualified research expenses forthe preceding three years.

Before amendment by the 1989 Act,section 41(f)(1) provided rules for com-puting the research credit for members ofa controlled group (generally a group ofcorporations or unincorporated businesseslinked by common ownership of morethan 50 percent). Section 41(f)(1) treatedall members of a controlled group as asingle taxpayer for purposes of computingthe credit and allocated the credit to themembers of the group based on the mem-ber’s proportionate share of the increasein qualified research expenses giving riseto the credit.

The legislative history to the 1981 Actindicates that the research credit aggrega-tion rules were enacted to ensure that theresearch credit would be allowed only foractual increases in research expenditures.The aggregation rules were intended toprevent artificial increases in research ex-penditures by shifting expendituresamong commonly controlled or otherwiserelated persons. H. Rep. No. 97–201,1981–3 C.B. (Vol. 2) 364 and Sen. Rep.97–144, 1981–3 C.B. (Vol. 2) 442.

An example that appears in both§1.41–8(a)(4) of the 1989 regulations andthe legislative history to the 1981 Act il-lustrates the computation and allocationof the research credit under section41(f)(1) before the 1989 Act amendmentsto the research credit computation. In theexample, the allowable group researchcredit is allocated among the members ex-periencing an increase in qualified re-search expenses over their base period re-

search expenses. The member allocationis based on the ratio that each member’sincrease in its qualified research expensesover its base period research expensesbears to the sum of the group’s increasesin qualified research expenses.

Post-1989 Rules for Computing theResearch Credit for Members of aControlled Group and Allocating theRegular Research Credit amongMembers of the Group

In the 1989 Act, Congress revised thecomputation of the research credit. Con-gress retained the incremental structure ofthe credit but altered the computation tofocus on whether and the extent to whicha taxpayer increases the proportion of itsqualified research expenses relative to itsgross receipts.

Under section 41, as amended in 1989,the research credit is computed by multi-plying the credit rate by the excess of thetaxpayer’s current year qualified researchexpenses over a “base amount.” The baseamount is defined in section 41(c) as thegreater of: (1) fifty percent of the tax-payer’s credit year qualified research ex-penses (the minimum base amount); or,(2) the taxpayer’s “fixed-base percent-age” times the taxpayer’s average annualgross receipts for the four taxable yearspreceding the taxable year for which thecredit is being determined.

In general, a taxpayer’s fixed-base per-centage is defined in section 41(c)(3)(A)as the ratio that the taxpayer’s aggregatequalified research expenses for its taxableyears beginning after December 31, 1983,and before January 1, 1989 bear to its ag-gregate gross receipts for the same period.Section 41(c)(3)(B) provides rules forcomputing the fixed-base percentage forstart-up companies. Section 41(c)(3)(C)provides that the maximum fixed-basepercentage is 16%.

Section 41(f)(1), as amended by the1989 Act, continues to provide rules forcomputing the research credit for mem-bers of a controlled group. As under priorlaw, all members of a controlled group aretreated as a single taxpayer for purposesof computing the credit. However, the al-location rule was amended to eliminateany reference to an “increase” in qualifiedresearch expenses. Under the amendedallocation rule, the group credit is allo-cated among the members of the group

based on each member’s “proportionateshare of the qualified research expensesand basic research payments giving rise tothe credit.”

In explaining the 1989 Act revisions tothe research credit, the House Report sim-ply states that the rules relating to the ag-gregation of related persons and changesin ownership are the same as under pre-sent law with the modification that whena business changes hands, qualified re-search expenses and gross receipts for pe-riods prior to the change of ownership aretreated as transferred with the trade orbusiness which gave rise to those expen-ditures and receipts for purposes of re-computing a taxpayer’s fixed-base per-centage. H. Rep. No. 101-247 at 1202.The legislative history to the 1989 Actdoes not refer to the elimination of theword “increase” from the allocation rule.

In the light of the statutory changes en-acted in 1989, taxpayers have questionedthe proper method for computing the re-search credit for members of a controlledgroup and the proper method for allocat-ing the group credit to members of thegroup under the new rules.

The proposed regulations provide that,for purposes of computing the groupcredit, all of the computational rules ofsection 41 are applied on an aggregatebasis. This is consistent with the statutoryprescription that the controlled group betreated as a single taxpayer and is neces-sary to preclude taxpayers from creatingartificial increases in the credit by shiftingqualified research expenses and gross re-ceipts among commonly controlled orotherwise related persons.

In proposing rules for the allocation ofthe credit, Treasury and the IRS consid-ered, but were not persuaded by, certaintaxpayers’ argument that the eliminationof the word “increase” from the allocationrule in the statute requires that the creditbe allocated on the basis of the grossamount of qualified research expenses in-curred by the various members of the con-trolled group. Treasury and the IRS be-lieve that elimination of the word“increase” was necessitated by the 1989statutory amendments to the computationof the research credit, which afford acredit in certain circumstances even wherethe taxpayer (or each member of a con-trolled group) is decreasing its grossamount of qualified research expenses

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2000–4 I.R.B. 423 January 24, 2000

(e.g., because the taxpayer’s gross receiptsalso are decreasing). However, there is noindication that the elimination of the word“increase” was intended to suggest that thecredit be allocated without regard to its in-cremental nature. To the contrary, thestatutory prescription that the credit be al-located according to each member’s pro-portionate share of the qualified researchexpenses “giving rise to” the credit sup-ports a rule that allocates the credit tothose members whose share of currentyear qualified research expenses exceedstheir share of the base amount. Thus, theproposed regulation provides that thegroup research credit is allocated to eachmember based on the ratio that the mem-ber’s increase in its qualified research ex-penses over its base amount bears to thesum of each member’s increase in quali-fied research expenses over its baseamount. The member’s base amount iscomputed by multiplying the group fixed-base percentage by the member’s averageannual gross receipts for the four preced-ing tax years.

In order to prevent manipulation of theamount of credit allocated to a consoli-dated group of corporations that is amember of a controlled group with othertaxpayers, Treasury and the IRS consid-ered a special rule for allocating the re-search credit that would treat all membersof a consolidated group as a single tax-payer for purposes of allocating the re-search credit among members of the con-trolled group. Treasury and the IRSrequest comments on special rules for al-locating the research credit among mem-bers of a controlled group that contains aconsolidated group of corporations.

Allocation of the Credit for BasicResearch Payments and the AlternativeIncremental Research Credit

The proposed regulations also addressthe computation and allocation of thegroup credit for basic research payments(certain amounts paid to qualified organi-zations for basic research) and for the al-ternative incremental research credit (anelective alternative method of computingthe research credit, under which taxpayersare assigned a lower three-tiered fixedbase percentage, and the credit rate is re-duced).

As in the case of the regular credit forqualified research expenses, the proposed

regulations provide that all computationswith respect to the group credit for basicresearch payments and the alternative in-cremental research group credit are un-dertaken on an aggregate basis. Similarly,these group credits are allocated to thevarious group members on an incrementalbasis.

Proposed Effective Date

The regulations generally are proposedto be applicable for taxable years endingon or after the date proposed regulationsare filed with the Federal Register, but arealso proposed to be retroactive in certainlimited circumstances to prevent abuse.To prevent taxpayers that are members ofa controlled group from together claimingin excess of 100% of the credit with re-spect to prior taxable years, the rules forallocating the group credit would apply toany taxable year beginning after Decem-ber 31, 1989, in which, as a result of in-consistent methods of allocation, themembers of a controlled group as a wholeclaimed more than 100% of the allowablegroup credit. In the case of a group whosemembers have different taxable years andwhose members used inconsistent meth-ods of allocation, the members of thegroup as a whole shall be deemed to haveclaimed more than 100% of the allowablegroup credit.

No claim for refund (1) attributable to achange in method of allocation; (2) per-taining to a taxable year ending beforeDecember 30, 1999; and (3) filed afterDecember 30, 1999, will be allowed un-less the taxpayer submits a statementidentifying all members of the controlledgroup for the taxable year at issue. Thestatement must contain a declarationsigned by the taxpayer under penalties ofperjury that states: “To the best of myknowledge and belief, taking into accountprior claims, this amended claim and anyrelated adjustments, no more than thetotal amount of the group credit will be al-located to the members of the controlledgroup.”

Special Analyses

It has been determined that this noticeof proposed rulemaking is not a signifi-cant regulatory action as defined in Ex-ecutive Order 12866. Therefore, a regu-latory assessment is not required. It alsohas been determined that section 553(b)

of the Administrative Procedure Act (5U.S.C. chapter 5) does not apply tothese regulations. It is hereby certifiedthat the collection of information con-tained in these regulations will not havea significant economic impact on a sub-stantial number of small entities. Thiscertification is based on the expectationthat few, if any, small entities will fileclaims for refund attr ibutable to achange in method of allocating the re-search credit among members of its con-trolled group. Accordingly, a Regula-tory Flexibil i ty Analysis under theRegulatory Flexibility Act (5 U.S.C.chapter 6) is not required. Pursuant tosection 7805(f) of the Internal RevenueCode, this notice of proposed rulemak-ing will be submitted to the Chief Coun-sel for Advocacy of the Small BusinessAdministration for comment on its im-pact on small business.

Comments and Public Hearing

Before these proposed regulations areadopted as final regulations, considera-tion will be given to any written com-ments (preferably a signed original andeight (8) copies) or electronic commentsare submitted timely to the IRS. Treasuryand the IRS request comments on theclarity of the proposed regulations andhow they may be made easier to under-stand. All comments will be available forpublic inspection and copying.

A public hearing has been scheduledfor April 26, 2000 at 10 a.m. in room2615, Internal Revenue Building, 1111Constitution Avenue, NW., Washington,DC. Due to building security procedures,visitors must enter at the 10th Street en-trance, located between Constitution andPennsylvania Avenues, NW. 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 entrancearea more than 15 minutes before thehearing starts. For information abouthaving your name placed on the buildingaccess list to attend the hearing, see the“FOR FURTHER INFORMATIONCONTACT” section of this preamble.

The rules of 26 CFR 601.601(a)(3)apply to the hearing. Persons who wish topresent oral comments at the hearing mustsubmit written or electronic commentsand an outline of the topics to be dis-

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January 24, 2000 424 2000–4 I.R.B.

cussed and the time to be devoted to eachtopic (preferably a signed original andeight (8) copies by April 5, 2000). A pe-riod of 10 minutes will be allotted to eachperson making comments.

An agenda showing the scheduling ofthe speakers will be prepared after thedeadline for receiving outlines haspassed. Copies of the agenda will beavailable free of charge at the hearing.

Drafting Information

The principal author of these proposedregulations is Lisa J. Shuman of the Of-fice of the Assistant Chief Counsel(Passthroughs and Special Industries).However, personnel from other offices ofthe IRS and the Treasury Department par-ticipated in their development.

* * * * *

Proposed Amendments to theRegulations

Accordingly, 26 CFR part 1 is pro-posed to 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 §1.41-0, the table of contents

is amended by revising the entries for§1.41–8(a), (a)(1), (a)(4), and (b) andadding entries for §1.41–8(a)(5) and(a)(6) to read as follows:§1.41–0 Table of contents.* * * * *§1.41–8 Aggregation of expenditures.(a) Controlled group of corporations; tradesor businesses under common control.(1) In general.* * * * *(4) Allocation of credit for basic research

payments. (5) Allocation of alternative incrementalresearch credit.(6) Examples.(b) For taxable years beginning beforeJanuary 1, 1990.* * * * *

Par. 3. In §1.41–8, paragraphs (a)(1),(a)(4), (b), and (c)(1) are revised andparagraphs (a)(5) and (a)(6) are added toread as follows:§1.41–8 Aggregation of expenditures.

(a) Controlled group of corporations;trades or businesses under common con-trol—(1) In general. In determining theamount of the credit for increasing re-search activities allowed with respect to atrade or business that at the end of its tax-able year is a member of a controlledgroup of corporations or a member of agroup of trades or businesses under com-mon control, all members of the group aretreated as a single taxpayer. Thus, forpurposes of determining the amount ofthe credit, all of the rules in section 41, in-cluding, for example, the rules in section41(c)(2) (pertaining to the minimum baseamount), section 41(c)(3)(B) (pertainingto the fixed-base percentage for start-upcompanies), and section 41(c)(3)(C) (per-taining to maximum base amount) are ap-plied only to the aggregate computationof the base amount. The credit (if any) al-lowed to any member is determined onthe basis of the ratio that its increase (ifany) in its qualified research expensesover its base amount bears to the aggre-gate increases in qualified research ex-penses over the base amount of all mem-bers of the group. For purposes of thepreceding sentence, a member computesits base amount by multiplying the groupfixed-base percentage by the member’saverage annual gross receipts for the four

preceding tax years.

* * * * *

(4) Allocation of credit for basic re-search payments. The credit (if any) at-tributable to basic research payments al-lowed to a member is determined on thebasis of the ratio that its excess (if any) ofbasic research payments over its qualifiedorganization base period amount bears tothe aggregate excess of basic researchpayments over the qualified organizationbase period amount of all members in thegroup. For purposes of the preceding sen-tence, a member computes its qualifiedorganization base period amount usingsimilar principles to those used in para-graph (a)(1) to determine the member’sbase amount.

(5) Allocation of alternative incremen-tal research credit. If the credit is com-puted under the alternative incrementalresearch credit rules, the credit (if any) al-lowed to the member is determined on thebasis of the ratio that its excess (if any) ofqualified research expenses over 1% of itsaverage annual gross receipts for the fourtaxable years preceding the taxable yearfor which the credit is being determinedbears to the aggregate excess of qualifiedresearch expenses over 1% of the averageannual gross receipts of all members ofthe group for the four taxable years pre-ceding the taxable year for which thecredit is being determined.

(6) Examples. The following examplesillustrate the provisions of this paragraph(a):

Example 1. (i) Facts. A controlled group of threecorporations (all of which are calendar-year taxpay-ers) had qualified research expenses for the credityear 1999, qualified research expenses for the period1984 through 1988, gross receipts for the period1984 through 1988, and average annual gross re-ceipts for the four years preceding the credit year asfollows:

A B C Total

Credit Year Qualified $200x $20x $110x $330xResearch Expenses

1984-1988 Qualified $40x $10x $100x $150xResearch Expenses

1984-1988 Gross Receipts $1,000x $350x $150x $1500x

Average Annual Gross $1,200x $200x $300x $1700xReceipts for 4 years preceding Credit Year

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Example 2. (i) Facts. The facts are the same asin Example 1except that A had no qualified re-search expenses during the credit year. The fol-

lowing table shows the group’s qualified researchexpenses for the credit year, qualified research ex-penses for the period 1984 through 1988, gross re-

ceipts for the period 1984 through 1988, and aver-age annual gross receipts for the four years preced-ing the credit year:

2000–4 I.R.B. 425 January 24, 2000

(ii) Computation of the group credit. (A) Thegroup research credit is computed as if the three cor-porations are one taxpayer. The research credit isequal to 20 percent of the excess of the group’s ag-gregate credit year qualified research expenses overthe group’s base amount.

(B) The group’s base amount equals the greaterof fifty percent of the group’s credit year qualifiedresearch expenses (the minimum base amount); or,the group’s fixed-base percentage times the group’saverage annual gross receipts for the four taxableyears preceding the credit year. The group’s fixed-

base percentage is the ratio that the group’s aggre-gate qualified research expenses for the taxableyears beginning after December 31, 1983, and be-fore January 1, 1989 bear to its aggregate gross re-ceipts for the same period. Therefore, the group’sfixed-base percentage is 150x/1500x or 10% and thegroup’s base amount is $170x, the greater of 50% of$330 or 10% of $1,700x.

(C) The group’s research credit is equal to 20 per-cent of the excess of the group’s aggregate credityear qualified research expenses over the group’sbase amount. That is 20% of ($330x - $170x) or

$32x. (iii) Allocation of the group credit. The group re-

search credit of $32x is allocated to the members ofthe group based on the ratio that the member’s in-crease in its qualified research expenses over themember’s base amount bears to the sum of the mem-ber increases in qualified research expenses overtheir base amounts. The member’s base amount iscomputed by multiplying the group fixed-base per-centage of 10% by the member’s average annualgross receipts for the four preceding tax years. The$32x credit is allocated as follows:

Member Credit Year Member Increase Ratio CreditQualified BaseResearch AmountExpenses

A $200x $120x $80x 80/160 $16x

B $20x $20x 0

C $110x $30x $80x 80/160 $16x

A B C Total

Credit Year Qualified 0 $20x $110x $130xResearch Expenses

1984-1988 Qualified $40x $10x $100x $150xResearch Expenses

1984-1988 Gross Receipts $1,000x $350x $150x $1500x

Average Annual Gross $1,200x $200x $300x $1700xReceipts for 4 years preceding Credit Year

Member Credit 1 % of Member Increase Ratio CreditYear Average

Qualified Annual Gross Research Receipts for Expenses 4 Preceding

Tax Years

A $0 $12x 0 0

B $20x $2x $18x 18/125 $.427284x

C $110x $3x $107x 107/125 $2.539966x

(ii) Computation of the group credit. Underthese facts, the controlled group’s credit year qual-ified research expenses are less than the group’sbase amount of $170x, and no credit is allowed tothe group unless the group elects to use the alter-native incremental research credit under section41(c)(4).

If the group elects to use the alternative incre-

mental credit under section 41(c)(4), the group isallowed a credit equal to .0165($25.5x - $17x) +.022($34x - $25.5x) + .0275($130x - $34x) or$2.96725x.

(iii) Allocation of the group credit. Assumingthat the group elects to use the alternative incre-mental research credit under section 41(c)(4), thegroup research credit of $2.96725x is allocated to

the members of the group based on the ratio thatthe member’s qualified research expenses over onepercent of the member’s average annual gross re-ceipts for the four preceding years bears to thesum of the member increases in qualified researchexpenses over one percent of their average annualgross receipts for the four preceding years. The$2.96725x credit is allocated as follows:

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January 24, 2000 426 2000–4 I.R.B.

Example 3.(i) Facts. A controlled group of threecorporations (all of which are calendar-year taxpay-ers) had qualified research expenses for the credit

year 1999, qualified research expenses for the period1984 through 1988, gross receipts for the period1984 through 1988, and average annual gross re-

ceipts for the four years preceding the credit year asfollows:

A B C1 Total

Credit Year Qualified $200x $20x $50x $270xResearch Expenses

1984-1988 Qualified $55x $15x 0 $70xResearch Expenses

1984-1988 Gross Receipts $1000x $400x 0 $1400x

Average Annual Gross $1200x $200x 0 $1400xReceipts for 4 years preceding Credit Year

Member CreditYear Member Increase Ratio CreditQualified BaseResearch AmountExpenses

A $200x $60x $140x 14/20 $18.9x

B $20x $10x $10x 1/20 $1.35x

C $50x 0 $50x 5/20 $6.75x

A B C Total

Credit Year Qualified $200x $20x $50x $270xResearch Expenses

1984-1988 Qualified $55x $15x 0 $70xResearch Expenses

1984-1988 Gross Receipts $1,000x $400x 0 $1,400x

Average Annual Gross $1,200x $200x $1,000x $2,400xReceipts for 4 years preceding Credit Year

1C began business in 1999.

(ii) Computation of the group credit. (A) Thegroup research credit is computed as if the three cor-porations are one taxpayer. The research credit isequal to 20 percent of the excess of the group’s ag-gregate credit year qualified research expenses overthe group’s base amount.

(B) The group’s base amount equals the greaterof: fifty percent of the group’s credit year qualifiedresearch expenses (the minimum base amount), or,the group’s fixed-base percentage times the group’saverage annual gross receipts for the four taxable

years preceding the credit year. The group’s fixed-base percentage is the ratio that the group’s aggre-gate qualified research expenses for the taxableyears beginning after December 31, 1983, and be-fore January 1, 1989 bear to its aggregate gross re-ceipts for the same period. Therefore, the group’sfixed-base percentage is 70x/1400x or 5% and thegroup’s base amount is $135x, the greater of 50% of$270x or 5% of $1,400x.

(C) The group’s research credit is equal to 20 per-cent of the excess of the group’s aggregate credit yearqualified research expenses over the group’s baseamount. That is 20% of ($270x - $135x) or $27x.

(iii) Allocation of the group credit. The group re-search credit of $27x is allocated to the members ofthe group based on the ratio that the member’s in-crease in its qualified research expenses over themember’s base amount bears to the sum of the mem-ber increases in qualified research expenses overtheir base amounts. The member’s base amount iscomputed by multiplying the group fixed-base per-centage of 5% by the member’s average annualgross receipts for the four preceding tax years. The$27x credit is allocated as follows:

Example 4. (i) Facts. The facts are the same as inExample 3except that C began business in 1989. A,B, and C had qualified research expenses for the

credit year 1999, qualified research expenses for theperiod 1984 through 1988, gross receipts for the pe-riod 1984 through 1988, and average annual gross

receipts for the four years preceding the credit yearas follows:

IRB 2000-4 1/28/00 10:26 AM Page 426

(b) For taxable years beginning beforeJanuary 1, 1990.For taxable years begin-ning before January 1, 1990, see § 1.41-8in effect prior to December 30, 1999 ascontained in 26 CFR part 1 revised April1, 1999.

(c) Tax accounting periods used—(1)In general. The credit allowable to amember of a controlled group of corpora-tions or of a group of trades or businessesunder common control is that member’sshare of the aggregate credit computed asof the end of such member’s taxable year.In computing the aggregate credit in thecase of a group whose members have dif-ferent taxable years, a member shall gen-erally treat the taxable year of anothermember that ends with or within thecredit year of the computing member asthe credit year of that other member. Incomputing the aggregate base amount, thegross receipts taken into account with re-spect to another member shall include thatother member’s gross receipts for the fourtaxable years of that other member pre-ceding the credit year of that other mem-ber.* * * * *

John M. Dalrymple,Acting Deputy Commissioner

of Internal Revenue.

(Filed by the Office of the Federal Register on De-cember 30, 1999, 2:06 p.m., and published in theissue of the Federal Register for January 4, 2000, 65F.R. 258)

Deposits of Excise Tax

Announcement 2000–5

AGENCY: Internal Revenue Service(IRS), Treasury

ACTION: Advance notice of proposedrulemaking.

SUMMARY: This document invitescomments from the public on issues thatthe IRS may address in proposed regula-tions relating to the requirements for ex-cise tax returns and deposits. All materi-als submitted will be available for publicinspection and copying.

DATES: Written and electronic commentsmust be submitted by April 6, 2000.

ADDRESSES: Send submissions to:CC:DOM:CORP:R (REG–103827–99),room 5226, Internal Revenue Service,POB 7604, Ben Franklin Station, Wash-ington, DC 20044. Submissions may behand delivered Monday through Fridaybetween the hours of 8 a.m. and 5 p.m. to:CC:DOM:CORP:R (REG–103827–99),Courier’s Desk, Internal Revenue Ser-vice, 1111 Constitution Avenue NW.,Washington, DC. Alternatively, taxpayersmay send submissions electronically viathe Internet by selecting the “Tax Regs”option on the IRS Home Page, or directlyto the IRS Internet site athttp://www.irs.ustreas.gov/tax_regs/regslist.html.

FOR FURTHER INFORMATION CON-TACT: Concerning submissions, theRegulations Unit, (202) 622-7180; con-cerning the proposals, Susan Athy, (202)622-3130 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

The Excise Tax Procedural Regulations(26 CFR part 40) set forth the require-ments related to filing the Quarterly Fed-eral Excise Tax Return, Form 720, andmaking deposits of excise taxes. Certainprovisions of the current regulations arecomplicated. The IRS is interested insimplifying the filing and deposit rulesboth as to the timing and the calculationof the correct amount to deposit. Simpli-fication would reduce recordkeeping bur-dens and costs for taxpayers, improvecompliance, and facilitate proper admin-istration of the excise taxes and trustfunds. The IRS requests comments onhow the regulations can be simplified;comments are requested in particular onthe following issues.

Time for Filing Returns

The regulations currently provide thatthe Form 720 generally must be filed by thelast day of the first calendar month follow-ing the quarter for which it is made. How-ever, in the case of returns related to taxesimposed by chapter 33 (communicationsand air transportation) and section 4681(ozone-depleting chemicals), the due dateis the last day of the second calendar month

2000–4 I.R.B. 427 January 24, 2000

(ii) Computation of the group credit.(A) Thegroup research credit is computed as if the three cor-porations are one taxpayer. The research credit isequal to 20 percent of the excess of the group’s ag-gregate credit year qualified research expenses overthe group’s base amount.

(B) The group’s base amount equals the greaterof: fifty percent of the group’s credit year qualifiedresearch expenses (the minimum base amount), or,the group’s fixed-base percentage times the group’saverage annual gross receipts for the four taxableyears preceding the credit year. The group’s fixed-

base percentage is the ratio that the group’s aggre-gate qualified research expenses for the taxableyears beginning after December 31, 1983, and be-fore January 1, 1989 bear to its aggregate gross re-ceipts for the same period. Therefore, the group’sfixed-base percentage is 70x/1400x or 5% and thegroup’s base amount is $135x, the greater of 50% of$270x or 5% of $2,400x.

(C) The group’s research credit is equal to 20 per-cent of the excess of the group’s aggregate credit yearqualified research expenses over the group’s baseamount. That is 20% of ($270x- $135x) or $27x.

(iii) Allocation of the group credit. The group re-search credit of $27x is allocated to the members ofthe group based on the ratio that the member’s in-crease in its qualified research expenses over themember’s base amount bears to the sum of the mem-ber increases in qualified research expenses overtheir base amounts. The member’s base amount iscomputed by multiplying the group fixed-base per-centage of 5% by the member’s average annualgross receipts for the four preceding tax years. The$27x credit is allocated as follows:

Member CreditYear Member Change Ratio CreditQualified BaseResearch AmountExpenses

A $200x $60x $140x 14/15 $25.2x

B $20x $10x $10x 1/15 $1.8x

C $50x 50x 0 0 0

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following the quarter for which it is made.The IRS requests comments on

whether there should be one filing datefor all Form 720 filers, such as 30 daysafter the end of the quarter. This wouldbe a simple rule that would apply equallyto all taxpayers.

Use of Government Depositaries

Background. The regulations currentlyprovide that excise taxes must be depositedon a semimonthly basis. Generally, taxesmust be deposited by the 9th day of thesemimonthly period following the semi-monthly period for which the deposit ismade (the 9-day rule). There are, however,exceptions to this rule. Taxes on ozone-de-pleting chemicals must be deposited by theend of the second semimonthly period fol-lowing the semimonthly period for whichthe deposit is made (the 30-day rule). Inaddition, for taxes imposed by section 4081(gasoline, diesel fuel, and kerosene), com-munications taxes, and air transportationtaxes, taxpayers may choose a deposit ruleother than the 9-day rule. For section 4081taxes, section 518 of the Highway RevenueAct of 1982 provides that a qualified per-son may deposit by the 14th day of thesemimonthly period following the semi-monthly period for which it is made if thedeposit is made by electronic funds transfer(the 14-day rule). For communications andair transportation taxes, if a person com-putes the amount of tax to be reported anddeposited on the basis of amounts consid-ered as collected, the person may depositthe taxes considered as collected during asemimonthly period by the third bankingday after the seventh day of the semi-monthly period (the alternative method).

The regulations also provide that theamount of the deposit for a semimonthlyperiod must equal the amount of net taxliability incurred during that period unlesseither the look-back quarter safe harborrule or the current liability safe harborrule applies. In general, the look-backquarter safe harbor rule is met if the de-posits for each semimonthly period in thequarter are at least 1/6 of the net liabilityreported for that tax in the second calen-dar quarter preceding the current quarter,and the current liability safe harbor rule ismet if the deposit for each semimonthlyperiod is at least 95 percent of the net taxliability for the semimonthly period. Safeharbor rules apply separately to each class

of tax. Each semimonthly deposit mustbe timely made at an authorized Govern-ment depository. Also, the amount of anyunderpayment must be paid by the duedate of the return, without extension. Afailure to meet all the deposit require-ments of a safe harbor rule for any semi-monthly period eliminates the availabilityof that safe harbor for the entire quarter.

As the above description of current regu-lations illustrates, the deposit rules are quitecomplicated, and taxpayers have experi-enced difficulty in complying with them.In addition, under existing safe harborrules, penalties for failure to deposit may beimposed for all semimonthly periods in aquarter if a taxpayer fails to deposit timelyand in the correct amount during any semi-monthly period in that quarter.

Request for Comments. With respect tothe deposit rules, the IRS specifically re-quests comments on the following issues:

1. Whether there should be a single de-posit date for all excise taxes, such as 14days after the end of the semimonthly pe-riod. (The IRS believes it would be ap-propriate to retain the alternative methodallowing communications and air trans-portation tax collectors to file returns andmake deposits based on amounts billed ortickets sold.)

2. Whether a taxpayer should have todeposit at least 95 percent of tax liability in-curred for the corresponding semimonthlyperiod (in lieu of the current requirement of100 percent with safe harbor rules).

3. Whether the amount required to bedeposited for a quarter should be com-puted without reduction for the amountsof any claims made on Schedule C ofForm 720 for that quarter.

Judith C. Dunn,Associate Chief

Counsel (Domestic).

(Filed by the Office of the Federal Register on Janu-ary 6, 2000, 8:45 a.m. , and published in the issue ofthe Federal Register for January 7, 2000, 65 F.R.1076)

Adequate Disclosure of Gifts;Correction

Announcement 2000–6

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Correction to final regulations.

SUMMARY: This document containscorrections to final regulations (T.D.8845, 1999–51 I.R.B. 684) which werepublished in the Federal Registeron Fri-day, December 3, 1999, 64 FR 67767, re-lating to the valuation of priorgifts in de-termining estate and gift tax liability, andthe period of limitations for assessingandcollecting gift tax.

DATES: This correction is effective De-cember 3, 1999.

FOR FURTHER INFORMATION CON-TACT: William L. Blodgett, (202) 622-3090, (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

The final regulations that are subject tothese corrections are under section 6501of the Internal Revenue Code.

Need for Correction

As published, final regulations (TD8845) contain errors that may prove to bemisleadingand are in need of clarification.

Correction of Publication

Accordingly, the publication of thefinal regulations (TD 8845), which werethe subject of FR Doc. 99–30944, is cor-rected as follows:

§301.6501(c)–1 [Corrected]

1. On page 67772, column 3,§301.6501(c)–1(f)(5), line 9 from the top ofthe column, thelanguage “transfer will notbe subject to inclusion” is corrected to read“transfer will be subject to inclusion”.

2. On page 67772, column 3,§301.6501(c)–1(f)(5), line 11 from thetop of the column, the language “pur-poses. On the other hand, if the” is cor-rected to read “purposes only to the extentthat a completed gift would be so in-cluded. On the other hand, if the”.

Cynthia E. Grigsby,Chief, Regulations Unit

Assistant Chief Counsel (Corporate).

(Filed by the Office of the Federal Regis-ter on January 6, 2000, 8:45 a.m., andpublished in the issue of the Federal Reg-ister for January 7, 2000, 65 F.R. 1059)

January 24, 2000 428 2000–4 I.R.B.

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2000–4 I.R.B. i January 24, 2000

Revenue rulings and revenue procedures(hereinafter referred to as “rulings”) thathave an effect on previous rulings use thefollowing defined terms to describe theeffect:

Amplified describes a situation whereno change is being made in a prior pub-lished position, but the prior position isbeing extended to apply to a variation ofthe fact situation set forth therein. Thus,if an earlier ruling held that a principleapplied to A, and the new ruling holdsthat the same principle also applies to B,the earlier ruling is amplified. (Comparewith modified, below).

Clarified is used in those instanceswhere the language in a prior ruling isbeing made clear because the languagehas caused, or may cause, some confu-sion. It is not used where a position in aprior ruling is being changed.

Distinguisheddescribes a situationwhere a ruling mentions a previouslypublished ruling and points out an essen-tial difference between them.

Modified is used where the substanceof a previously published position isbeing changed. Thus, if a prior rulingheld that a principle applied to A but notto B, and the new ruling holds that it ap-

plies to both A and B, the prior ruling ismodified because it corrects a publishedposition. (Compare with amplified andclarified, 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 usedin a ruling that lists previously publishedrulings that are obsoleted because ofchanges in law or regulations. A rulingmay also be obsoleted because the sub-stance has been included in regulationssubsequently adopted.

Revoked describes situations where theposition in the previously published rul-ing is not correct and the correct positionis being stated in the new ruling.

Superseded describes a situation wherethe new ruling does nothing more thanrestate the substance and situation of apreviously published ruling (or rulings).Thus, the term is used to republish underthe 1986 Code and regulations the sameposition published under the 1939 Codeand regulations. The term is also usedwhen it is desired to republish in a singleruling a series of situations, names, etc.,that were previously published over a pe-riod of time in separate rulings. If the

new ruling does more than restate thesubstance of a prior ruling, a combinationof terms is used. For example, modifiedand superseded describes a situationwhere the substance of a previously pub-lished ruling is being changed in part andis continued without change in part and itis desired to restate the valid portion ofthe previously published ruling in a newruling that is self contained. In this casethe previously published ruling is firstmodified and then, as modified, is super-seded.

Supplemented is used in situations inwhich a list, such as a list of the names ofcountries, is published in a ruling andthat list is expanded by adding furthernames in subsequent rulings. After theoriginal ruling has been supplementedseveral times, a new ruling may be pub-lished that includes the list in the originalruling and the additions, and supersedesall prior rulings in the series.

Suspended is used in rare situations toshow that the previous published rulingswill not be applied pending some futureaction such as the issuance of new oramended regulations, the outcome ofcases in litigation, or the outcome of aService study.

AbbreviationsThe following abbreviations in current use and for-merly used will appear in material published in theBulletin.

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 Contribution 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.—Statements of Procedral 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.

Definition of Terms

IRB 2000-4 1/28/00 10:26 AM Page 429

January 24, 2000 ii 2000–4 I.R.B.

Numerical Finding List1

Bulletins 2000–1 through 2000–3

Announcements:

2000–1, 2000–2 I.R.B. 2942000–2, 2000–2 I.R.B. 2952000–3, 2000–2 I.R.B. 2962000–4, 2000–3 I.R.B. 317

Notices:

2000–1, 2000–2 I.R.B. 2882000–4, 2000–3 I.R.B. 3132000–5, 2000–3 I.R.B. 3142000–6, 2000–3 I.R.B. 315

Proposed Regulations:

REG–101492–98, 2000–3 I.R.B. 326REG–106012–98, 2000–2 I.R.B. 290REG–116704–99, 2000–3 I.R.B. 325

Revenue Procedures:

2000–1, 2000–1 I.R.B. 42000–2, 2000–1 I.R.B. 732000–3, 2000–1 I.R.B. 1032000–4, 2000–1 I.R.B. 1152000–5, 2000–1 I.R.B. 1582000–6, 2000–1 I.R.B. 1872000–7, 2000–1 I.R.B. 2272000–8, 2000–1 I.R.B. 2302000–9, 2000–2 I.R.B. 2802000–10, 2000–2 I.R.B. 2872000–11, 2000–3 I.R.B. 309

Revenue Rulings:

2000–1, 2000–2 I.R.B. 2502000–2, 2000–3 I.R.B. 3052000–3, 2000–3 I.R.B. 297

Treasury Decisions:

8849, 2000–2 I.R.B. 2458850, 2000–2 I.R.B. 2658851, 2000–2 I.R.B. 2758852, 2000–2 I.R.B.2538854, 2000–3 I.R.B.3068856, 2000–3 I.R.B.298

1 A cumulative list of all revenue rulings, revenueprocedures, Treasury decisions, etc., published inInternal Revenue Bulletins 1999–27 through1999–52 is in Internal Revenue Bulletin 2000–1,dated January 3, 2000.

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2000–4 I.R.B. iii January 24, 2000

Finding List of Current Action onPreviously Published Items1

Bulletins 2000–1 through 2000–3

Notices:

97–19Modified by Rev. Proc. 2000–1, 2000–1 I.R.B. 4

Revenue Procedures:

92–13Modified, amplified, and superseded by Rev. Proc. 2000–11, 2000–3 I.R.B. 309

92–13AModified, amplified, and superseded by Rev. Proc. 2000–11, 2000–3 I.R.B. 309

94–12Modified, amplified, and superseded by Rev. Proc. 2000–11, 2000–3 I.R.B. 309

96–13Modified by Rev. Proc. 2000–1, 2000–1 I.R.B. 4

98–64Superseded by Rev. Proc. 2000–9, 2000–2 I.R.B. 280

99–1Superseded by Rev. Proc. 2000–1, 2000–1 I.R.B. 4

99–2Superseded byRev. Proc. 2000–2, 2000–1 I.R.B. 73

99–3Superseded by Rev. Proc. 2000–3, 2000–1 I.R.B. 103

99–4Superseded by Rev. Proc. 2000–4, 2000–1 I.R.B. 115

99–5Superseded by Rev. Proc. 2000–5, 2000–1 I.R.B. 158

99–6Superseded by Rev. Proc. 2000–6, 2000–1 I.R.B. 187

99–7Superseded by Rev. Proc. 2000–7, 2000–1 I.R.B. 227

99–8Superseded by Rev. Proc. 2000–8, 2000–1 I.R.B. 230

99–49Modified and amplified by Notice 2000–4, 2000–3 I.R.B. 313

99–51Superseded by Rev. Proc. 2000–3, 2000–1 I.R.B. 103

Treasury Decisions:

8734Modified by T.D. 8856, 2000–3, I.R.B. 298

8804Modified by T.D. 8856, 2000–3, I.R.B. 298

1 A cumulative list of previously published items inInternal Revenue Bulletins 1999–27 through1999–52 is in Internal Revenue Bulletin 2000–1,dated January 3, 2000.

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INTERNAL REVENUE BULLETINThe Introduction at the beginning of this issue describes the purpose and content of this publication. The weekly Internal Revenue

Bulletin is sold on a yearly subscription basis by the Superintendent of Documents. Current subscribers are notified by theSuperintendent of Documents when their subscriptions must be renewed.

CUMULATIVE BULLETINSThe contents of this weekly Bulletin are consolidated semiannually into a permanent, indexed, Cumulative Bulletin. These are

sold on a single copy basis and are not included as part of the subscription to the Internal Revenue Bulletin. Subscribers to the week-ly Bulletin are notified when copies of the Cumulative Bulletin are available. Certain issues of Cumulative Bulletins are out of printand are not available. Persons desiring available Cumulative Bulletins, which are listed on the reverse, may purchase them from theSuperintendent of Documents.

HOW TO ORDERCheck the publications and/or subscription(s) desired on the reverse, complete the order blank, enclose the proper remittance,

detach entire page, and mail to the Superintendent of Documents, U.S. Government Printing Office, Washington, DC 20402. Pleaseallow two to six weeks, plus mailing time, for delivery.

WE WELCOME COMMENTS ABOUT THEINTERNAL REVENUE BULLETIN

If you have comments concerning the format or production of the Internal Revenue Bulletin or suggestions for improving it, wewould be pleased to hear from you. You can e-mail us your suggestions or comments through the IRS Internet Home Page(www.irs.gov) or write to the IRS Bulletin Unit, OP:FS:FP:P:1, Room 5617, 1111 Constitution Avenue NW, Washington, DC 20224.

Internal Revenue ServiceWashington, DC 20224

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